Documentation is Everything in Some Tax Cases

Becker v. Commissioner shows why it is important for taxpayers to paper or document transactions at or near the time that the transactions take place.

Becker was an employee of and partial owner of a family business that is controlled by his father. Family discord resulted in Becker agreeing to sell his business interest back to the business and Becker no longer being employed by the family business. The business was to pay Becker $24 million in exchange for his business interest. As part of this agreement Becker executed an agreement not to complete with the family business for a period of three years.

Becker’s accountant later informed Becker that he missed a tax planning opportunity by not allocating part of the $24 million dollar proceeds to the covenant not to compete. Becker and the family business were not able to agree on an amount of the cost to allocate to the covenant not to compete. Becker and the family business made differing allocations on their tax returns. The IRS issued protective notices of deficiency to each party.

Had Becker allocated a portion of the monies received to the covenant not to complete, that amount would have been taxed at the ordinary tax rates (rather than the lesser capital gains tax rate), but the family business would have been able to take an amortization deduction for the portion allocated to the covenant not to compete.

The US tax court reviewed a number of tax cases that looked at the intent of the parties and the underlying documentation. The court held that no portion of the funds received by Becker were allocable to the covenant not to compete.

Based on the opinion, it sounds like this case would have never arisen had Becker’s accountant not raised this issue. Once the issue was raised, the family business had a lot to gain (by way of tax savings) by agreeing to a specific allocation.

While it did not happen in this case, it is this type of after-the-fact family and emotional issue often results in the US Treasury collecting more in tax revenues than the law would otherwise allow. These types of cases often arise between divorcing spouses and divorce settlements, employees and employee benefits, and even companies and personal injury settlements.