T.C. Memo. 2010-76



                     UNITED STATES TAX COURT



  RECOVERY GROUP, INC., ET AL.,1 Petitioners v. COMMISSIONER OF
                  INTERNAL REVENUE, Respondent



     Docket Nos. 12430-08,   29314-07,   Filed April 15, 2010.
                 29321-07,   29326-07,
                 29333-07,   29335-07,
                 29336-07,   29385-07.



          Recovery Group, Inc. (RG), an S corporation,
     redeemed all of the stock held by E, a minority
     shareholder and employee. In addition to paying E for
     his 23-percent interest in the company, RG also paid E
     $400,000 to enter into a 1-year covenant not to
     compete. RG deducted the cost of the covenant not to
     compete over its 12-month term. The IRS determined


     1
      Cases of the following petitioners are consolidated here:
Robert J. Glendon and Yvonne M. Glendon, docket No. 29314-07;
John S. Sumner, Jr., and Mary V. Sumner, docket No. 29321-07;
Stephen S. Gray and Linda Baron, docket No. 29326-07; Michael
Epstein and Barbara Epstein, docket No. 29333-07; Anthony J.
Walker and Pamela S. Mayer, docket No. 29335-07; Andre Laus and
Helen Laus, docket No. 29336-07; and Parham Pouladdej, docket No.
29385-07.
                                -2-

     that RG could not immediately deduct the covenant not
     to compete and determined built-in gains taxes under
     I.R.C. sec. 1374 and accuracy-related penalties for RG
     under I.R.C. sec. 6662. The disallowed deductions
     increased the taxable income flowing through RG to its
     shareholders, and the IRS also determined deficiencies
     in the shareholders’ tax.

          Held: The cost of the covenant not to compete may
     not be amortized over its 1-year term; the covenant is
     an amortizable I.R.C. sec. 197 intangible and must be
     amortized over 15 years.

          Held, further, RG reasonably relied on competent,
     fully informed professionals to prepare its tax returns
     and thereby satisfies the reasonable cause and good
     faith exception of I.R.C. sec. 6664(c) and avoids
     liability for the accuracy-related penalty.



     Peter L. Banis and D. Sean McMahon, for petitioners.

     Paul V. Colleran, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     GUSTAFSON, Judge:   These cases are before the Court pursuant

to section 6213(a)2 for redetermination of deficiencies in tax

and penalties for 2002 and 2003, which the Internal Revenue

Service (IRS) determined against Recovery Group, Inc. (Recovery

Group), and its shareholders.   The determination against Recovery

Group, an S corporation, was made pursuant to section 1374 (see

infra note 5) and was as follows:


     2
      Except as otherwise noted, all section references are to
the Internal Revenue Code (26 U.S.C.), and all Rule references
are to the Tax Court Rules of Practice and Procedure.
                                  -3-

                                                         Accuracy-Related
                                                            Penalties
                        Docket          Deficiencies         Sec. 6662
     Petitioner           No.           2002    2003      2002      2003

Recovery Group, Inc.   12430-08    $46,138    $70,011    $9,288    $14,002


The IRS determined the following deficiencies in the Federal

income taxes of Recovery Group’s shareholders:

            Petitioner(s)                 Docket No.     2002      2003

Robert J. & Yvonne M. Glendon              29314-07     $2,599    $2,825
John S. & Mary V. Sumner                   29321-07      2,824     3,071
Stephen S. Gray & Linda Baron              29326-07     20,790    22,603
Michael & Barbara Epstein                  29333-07      1,970      -0-
Anthony J. Walker & Pamela S. Mayer        29335-07      1,695     1,431
Andre & Helen Laus                         29336-07      5,197     4,494
Parham Pouladdej                           29385-07     10,395    11,301
  Total                                                 45,470    45,725


All of the disputed deficiencies result from the IRS’s

determination that the cost of a covenant not to compete must be

amortized over 15 years.    The IRS determined accuracy-related

penalties against Recovery Group only; it determined no penalties

against the subchapter S shareholders.

     The issues for decision are:

     1.   Whether Recovery Group may amortize the cost of a

covenant not to compete over its 12-month term or whether it must

amortize that cost over 15 years pursuant to section 197(a).          We

find that the covenant is an amortizable section 197 intangible,
                                 -4-

and we sustain respondent’s determination that it must be

amortized over 15 years.

     2.    Whether Recovery Group is liable under section 6662 for

accuracy-related penalties on the underpayments that result from

disallowance of the excess deductions it took by amortizing the

covenant not to compete over its 12-month term.    We find that

because Recovery Group reasonably relied on its accountants to

prepare its returns, it had reasonable cause and acted in good

faith in filing its returns and is not liable for the penalties.

                           FINDINGS OF FACT

     The parties do not dispute the facts in these cases that

relate to the amortization of the covenant not to compete, but

they do dispute the facts related to the accuracy-related

penalty.    We incorporate by this reference the stipulation of

facts filed June 24, 2009, and the attached exhibits.

     Recovery Group is a “turn-around, crisis-management

business” providing consulting and management services to

insolvent companies, together with services as bankruptcy

trustee, examiner in bankruptcy cases, and receiver in Federal

and State courts.    Recovery Group had its principal place of

business in Massachusetts when it filed its petition in this

Court.3


     3
      The residences of the Recovery Group shareholders when they
filed their respective petitions were as follows:
                                                   (continued...)
                                  -5-

Employee/Shareholder’s departure

     In 2002 James Edgerly, one of Recovery Group’s founders,

employees, and minority shareholders, informed its president,

Stephen Gray, that he wished to leave the company and to have his

shares bought out and settle various debts between himself and

the company.   Mr. Gray, who is also a founder and shareholder,

discussed the departure with the remaining shareholders and

developed a framework for the buyout.     He then asked the

company’s accountant, Ron Orleans, to calculate the buyout

numbers and tell Mr. Gray how the transaction should work.

Mr. Gray explained to Mr. Edgerly the structure and the financial

details of the proposed buyout agreement.     Mr. Edgerly considered

the offer and then accepted it.

     Mr. Edgerly held 18,625 shares of Recovery Group stock,

which represented 23 percent of the outstanding stock of the

company.   The agreement between Mr. Edgerly and Recovery Group

called for the company to pay him a total of $805,363.33, in

     3
      (...continued)
             Petitioner                 Docket No.     Residence

Robert J. & Yvonne M. Glendon           29314-07     Massachusetts
John S. & Mary V. Sumner                29321-07     North Carolina
Stephen S. Gray & Linda Baron           29326-07     Massachusetts
Michael & Barbara Epstein               29333-07     Massachusetts
Anthony J. Walker & Pamela S. Mayer     29335-07     Massachusetts
Andre & Helen Laus                      29336-07     Rhode Island
Parham Pouladdej                        29385-07     Massachusetts
                                -6-

payment of which the company gave him a $205,363.33 check and a

$600,000 promissory note payable over three years.   The company

and Mr. Edgerly itemized the buyout payment as follows:

                     Description                          Amount

Stock purchase price                                      $255,908
Noncompetition payment                                     400,000
Company’s debt to stockholder (principal)                   25,000
Company’s debt to stockholder (interest)                     2,553
Company’s note payable to stockholder (principal)          122,177
Company’s note payable to stockholder (interest)            11,976
Shareholder’s debt to company                              (12,250)
  Total due from company to stockholder                    805,364


The “Noncompetition payment” was for a “noncompetition and

nonsolicitation agreement” that prohibited Mr. Edgerly from,

inter alia, engaging in competitive activities from July 31,

2002, through July 31, 2003; and the $400,000 that Recovery Group

paid for the covenant was comparable to Mr. Edgerly’s annual

earnings.

     Mr. Orleans, Recovery Group’s accountant, was involved with

the buyout throughout.   As is noted above, he calculated the

buyout amounts.   Mr. Gray, Recovery Group’s president, did not

discuss the tax implications of the buyout with Mr. Orleans when

he asked him to compute the numbers.   When Recovery Group

executed the buyout, Mr. Gray did not consider the tax

ramifications of the deal; but he understood that some portion of

the buyout payment was tax deductible while the remainder was
                                 -7-

not.    Deductibility was not a consideration in his structuring

the deal; rather, he assumed that the tax results would be what

the accountants determined.

Recovery Group’s accountants

       Mr. Orleans began practicing as an accountant in 1973 and

has been a certified public accountant (C.P.A.) since 1976.     At

his accounting firm--Kanter, Troy, Orleans & Wexler, LLP--

Mr. Orleans was the relationship partner assigned to Recovery

Group.    He was responsible for overseeing Recovery Group’s

accounting operations and managing the preparation of Recovery

Group’s financial statements and tax returns.    Mr. Orleans worked

with Donald Troy, a tax specialist at his firm.    Mr. Troy was

licensed as a C.P.A. in 1986, and he held a bachelor’s degree in

accountancy and a master’s degree in taxation.    During the years

in issue, Mr. Troy was the accounting firm’s tax director.

Preparing Recovery Group’s returns

       Mr. Orleans relied upon Mr. Troy to make the technical

decisions on how Recovery Group’s tax returns should be prepared,

and Recovery Group relied upon the accountants to make these

decisions correctly.

       When considering how to report Recovery Group’s expense for

the covenant not to compete on its tax returns, Mr. Troy

consulted case law, together with the statutory language,

regulations, and legislative history of section 197.    He
                                   -8-

concluded that the covenant not to compete was not a section 197

intangible and thus was exempt from that section’s 15-year

amortization period.     Accordingly, he prepared Recovery Group’s

returns to amortize the covenant not to compete ratably over its

12-month term.   Since that 12-month term straddled the two years

2002 and 2003, he allocated the $400,000 between those two years

(rather than over the 15 years 2002 through 2016)--i.e., roughly

five-twelfths of the total ($166,663) in 2002 and the remainder,

approximately seven-twelfths ($233,337), in 2003.       Those amounts

constituted less than 2 percent of Recovery Group’s deductions

reported on the returns for those years.4

Approving Recovery Group’s returns

     Each year, Mr. Orleans presented the tax return for Recovery

Group to Mr. Gray.      Mr. Gray held brief discussions with

Mr. Orleans during those meetings, but he did not ask specific



     4
      The Forms 1120S, U.S. Income Tax Return for an S
Corporation, filed by Recovery Group reported the following:

                 Item                       2002            2003

Gross receipts or sales                  $15,387,209     $14,768,403
Total deductions                          15,342,784      14,787,971
Ordinary income (loss)                        19,889         (14,046)
Federal taxable income                       (23,571)         (6,639)

Total deductions included the $166,663 claimed in 2002 and the
$233,337 claimed in 2003 for the covenant not to compete, which
in turn represented 1.09 percent of Recovery Group’s total
deductions for 2002 and 1.58 percent of its deductions for 2003.
                                -9-

questions or closely review the returns prepared by the company’s

accountants.   Rather, he asked Mr. Orleans whether the returns

represented what the company had to file, and he accepted

Mr. Orleans’s representations that they did.    Mr. Gray did not

discuss tax issues with Mr. Troy or specifically approve tax

decisions he made, nor did he question Mr. Orleans about the

positions taken in the returns or seek a second opinion on his

accountants’ work.   Rather, because Mr. Gray’s expertise is in

business areas other than accounting and taxes, he left

accounting and tax decisions to the professionals at the

accounting firm that the company had hired.    Mr. Gray did not

review or inquire into the tax treatment of the covenant not to

compete, which was reflected on pages 19 and 27 of the 50-page

2002 return and on pages 18 and 26 of the 55-page 2003 return.

     Mr. Orleans signed the returns as the preparer, and Mr. Gray

signed them as Recovery Group’s president.    Recovery Group timely

filed its returns for the years in issue.

Notices of deficiency

     The IRS determined that the covenant not to compete was an

amortizable section 197 intangible, amortizable over 15 years

beginning with the month of acquisition.    Consequently, the IRS

partially disallowed Recovery Group’s deductions for the cost of

the covenant not to compete, allowing amortization deductions of

only $11,111 for 2002 and $26,667 for 2003, and disallowing
                               -10-

$155,552 for 2002 and $206,667 for 2003.5   The IRS also

determined accuracy-related penalties against Recovery Group for

2002 and 2003.

     The disallowance of most of the deductions claimed for the

covenant for each year increased Recovery Group’s income for each

year and hence each shareholder’s share of Recovery Group’s

income.   In notices of deficiency issued in October and November

2007 to the shareholders, the IRS determined deficiencies for the

shareholders accordingly.   The shareholders’ deficiencies all

turn on the appropriate treatment of the covenant not to compete,

and they require no separate analysis.

     The IRS issued a notice of deficiency to Recovery Group in

March 2008.   The shareholders and Recovery Group all timely filed

petitions in this Court.

                              OPINION

     As a general rule, the IRS’s determinations are presumed

correct, and the taxpayer has the burden of establishing that the

determinations in the notice of deficiency are erroneous.   Rule



     5
      The disallowance of the deductions resulted in positive
Federal taxable income and triggered a corporate-level built-in
gains tax for both years in issue under section 1374(a). Section
1374 imposes a corporate level tax on built-in gains recognized
by an S corporation during the 10 years following the
corporation’s conversion from C corporation to S corporation
status. Sec. 1374(a), (d)(3), (7). The parties agree that if
respondent’s position is sustained and the covenant not to
compete must be amortized over 15 years, then section 1374
applies.
                                -11-

142(a); Welch v. Helvering, 

, 115 (1933).     Similarly,

the taxpayer bears the burden of proving he is entitled to any

disallowed deductions that would reduce his deficiency.     INDOPCO,

Inc. v. Commissioner, 

, 84 (1992).6   With respect to a

taxpayer’s liability for penalties, section 7491(c) places the

burden of production on the Commissioner.

I.   Covenant not to compete

     The principal issue in these cases is whether the covenant

not to compete that Recovery Group and its departing 23-percent

shareholder entered into was, for purposes of section

197(d)(1)(E), “entered into in connection with an acquisition

(directly or indirectly) of an interest in a trade or business or

substantial portion thereof”.   Recovery Group contends that the

23-percent interest it acquired by redemption was not a

substantial interest and is therefore outside the reach of

section 197.   In support of its argument, Recovery Group cites

Frontier Chevrolet Co. v. Commissioner, 

, 294-295

(2001), affd. 

(9th Cir. 2003), which held that a

redemption of 75 percent of a corporation’s stock qualified as

the indirect acquisition of an interest in a trade or business

for purposes of section 197; and Recovery Group urges that its


     6
      Under certain circumstances the burden can shift to the IRS
with respect to factual disputes pursuant to section 7491(a).
However, Recovery Group does not contend that the burden has
shifted.
                                -12-

23-percent acquisition is not on a par with the obviously

substantial 75-percent acquisition in Frontier.    To resolve this

issue, we consider first the nature of a covenant not to compete

and then the provisions of section 197.

     A.   Intangible assets

     The residual goodwill of a business is an intangible asset

that is deemed to have an unlimited useful life, so that it

cannot be amortized by the business that developed that goodwill.

Houston Chronicle Publg. Co. v. United States, 

,

1247 (5th Cir. 1973); sec. 1.167(a)-3(a), Income Tax Regs.

(26 C.F.R.).    Rather, that component of value remains with a

business until the business ceases or is disposed of; and until

then no tax benefit is obtained from the expense of developing

the goodwill or for the value that is allocated to that

intangible.    However, an intangible asset that can be valued

distinctly and that has a measurable useful life is

distinguishable from residual goodwill and may be amortized over

its useful life.    See Newark Morning Ledger Co. v. United States,

, 566 (1993).

     One such intangible is a covenant not to compete (or a

“noncompetition covenant”), which is a “promise, usu[ally] in a

sale-of-business, partnership, or employment contract, not to

engage in the same type of business for a stated time in the same

market as the buyer, partner, or employer.”   Blacks’s Law
                                 -13-

Dictionary 420 (9th ed. 2009).    Someone purchasing a business or

buying out a departing shareholder-employee’s share of a business

may benefit from the seller’s assurance that he will not

thereafter undermine the business by using his status in and

familiarity with the business--that is, his assurance that he

will not carry out with him, when he leaves, the intangible

assets of the business (such as know-how, or customer

relationships, or the identities of suppliers).   Thus, a covenant

not to compete may have real and important value.    See Annabelle

Candy Co. v. Commissioner, 

, 7-8 (9th Cir. 1962), affg.

T.C. Memo. 1961-170.

     A covenant not to compete is an intangible asset that,

unlike goodwill, does have a limited useful life, defined in the

terms of the covenant; and the cost of obtaining such a covenant

is, therefore, amortizable ratably over the life of the covenant,

apart from the statute at issue in these cases (section 197).

Warsaw Photographic Associates, Inc. v. Commissioner, 

,

48 (1985); O’Dell & Co. v. Commissioner, 

, 467 (1974).

See generally sec. 1.167(a)-3, Income Tax Regs.

     However, intangible assets in general--and covenants not to

compete in particular--do present opportunities for distortion

and abuse in reporting one’s tax liability.   While the cost of

purchasing a shareholder’s stock is a capital expenditure that

does not yield any tax benefit until the stock is disposed of,
                                   -14-

the cost of a covenant not to compete will be promptly amortized

over its life (again, apart from section 197).       This dynamic

creates a tax-motivated incentive for a buyer to prefer that the

money changing hands in a buyout transaction be characterized as

paid for a covenant rather than for shares of stock.7

       B.      Enactment of section 197

       In the Omnibus Budget Reconciliation Act of 1993 (OBRA),

Pub. L. 103-66, sec. 13261, 107 Stat. 532, Congress enacted

section 197 to simplify the law regarding the amortization of

intangibles.       H. Rept. 103-111, at 777 (1993), 1993-3 C.B. 167,

353.       In an attempt to eliminate controversy between taxpayers

and the IRS regarding the tax treatment of the cost of acquiring

an intangible asset, Congress established a fixed period for

ratably amortizing that cost--recognizing that some of the

intangibles so amortized will have useful lives longer than that

period, and some will have useful lives shorter than that period.

C.B. at 336.

       Congress excluded self-created intangibles from section 197

(unless they were created in connection with a transaction

involving the acquisition of a trade or business or a substantial

       7
      In contrast, a departing individual employee-shareholder
has an incentive to allocate more of the price to the shares of
stock and less to the covenant not to compete, because he will
obtain capital gain treatment for his gain on the stock but
ordinary income treatment for the consideration for the covenant
not to compete. See Sonnleitner v. Commissioner, 

,
467 (5th Cir. 1979), affg. T.C. Memo. 1976-249.
                                -15-

portion thereof)

included certain

covenants not to compete as “amortizable section 197

intangibles”.   Prior law had allowed taxpayers to amortize those

covenants under section 167 over the life of the covenant.

however, required amortization over

15 years--a requirement applicable to covenants not to compete

that are described in subsection (d)(1)(E).

     C.   Statutory language

     Section 197 provides, in pertinent part:

     SEC. 197. AMORTIZATION OF GOODWILL AND CERTAIN OTHER
               INTANGIBLES.

          (a) General Rule. A taxpayer shall be entitled
     to an amortization deduction with respect to any
     amortizable section 197 intangible. The amount of such
     deduction shall be determined by amortizing the
     adjusted basis (for purposes of determining gain) of
     such intangible ratably over the 15-year period
     beginning with the month in which such intangible was
     acquired.

                  *    *    *    *     *   *       *

          (c) Amortizable Section 197 Intangible.      For
     purposes of this section--

               (1) In general. Except as otherwise
          provided in this section, the term
          “amortizable section 197 intangible” means
          any section 197 intangible--

                     (A) which is acquired by the
                taxpayer after the date of the
                enactment of this section, and

                     (B) which is held in
                connection with the conduct of a
                trade or business or an activity
                described in section 212.
                                -16-

                 *     *    *    *     *     *    *

          (d) Section 197 Intangible.      For purposes of this
     section--

               (1) In general. Except as otherwise
          provided in this section, the term “section
          197 intangible” means--

                 *     *    *    *     *     *    *

                    (E) any covenant not to
               compete (or other arrangement to
               the extent such arrangement has
               substantially the same effect as a
               covenant not to compete) entered
               into in connection with an
               acquisition (directly or
               indirectly) of an interest in a
               trade or business or substantial
               portion thereof * * *. [Emphasis
               added.]

     Thus, Mr. Edgerly’s covenant not to compete with Recovery

Group is a section 197 intangible if it was “entered into in

connection with an acquisition (directly or indirectly) of an

interest in a trade or business or substantial portion thereof”.

Sec. 197(d)(1)(E).   The applicability of several of the statutory

terms is not in dispute:   The covenant with Mr. Edgerly was

acquired by Recovery Group “after the date of the enactment of”

section 1978 and was “held in connection with the conduct of a




     8
      The effective date of Section 197 was August 10, 1993. See
OBRA sec. 13261(g), 107 Stat. 540; Spencer v. Commissioner, 

, 87 n.30 (1998), affd. without published opinion 

(11th Cir. 1999).
                                -17-

trade or business”.9    Sec. 197(c)(1).   Recovery Group does not

dispute that an acquisition of stock can be “an acquisition

(directly or indirectly) of an interest in a trade or

business”;10 and Recovery Group necessarily concedes that its

redemption of Mr. Edgerly’s stock was an indirect acquisition of

that stock.

     However, Recovery Group contends that Mr. Edgerly’s

23-percent stock interest was not “substantial”--a contention

that requires careful attention to the precise language of

section 197(d)(1)(E):    “acquisition * * * of an interest in a



     9
      Furthermore, a covenant not to compete that is a section
197 intangible may not be treated as disposed of (or becoming
worthless) even if the covenant expires or actually becomes
worthless, unless the entire interest in a trade or business that
was acquired with the covenant is also disposed of or becomes
worthless. Sec. 197(f)(1)(B); H. Conf. Rept. 103-213, at 694-695
(1993), 1993-3 C.B. 393, 572-573. Recovery Group does not assert
that the 23 percent of itself that it redeemed from Mr. Edgerly
became worthless when the term of the covenant expired;
accordingly, we need not and do not consider whether a deduction
is allowable under the disposition rules of section 197(f)(1).
These cases turn on whether the instant covenant not to compete
is an amortizable section 197 intangible. If it is, then a
15-year amortization is required by the statute.
     10
       If there were any doubt, the legislative history of
section 197 makes it clear that “For this purpose, an interest in
a trade or business includes not only the assets of a trade or
business, but also stock in a corporation that is engaged in a
trade or business or an interest in a partnership that is engaged
in a trade or business.” H. Conf. Rept. 103-213, supra at 677,
1993-3 C.B. at 555. See Frontier Chevrolet Co. v. Commissioner,

, 294-295 (2001) (redemption of stock qualifies as
the indirect acquisition of an interest in a trade or business
for purposes of section 197), affd. 

(9th Cir.
2003).
                                 -18-

trade or business or substantial portion thereof”.    Recovery

Group’s contention prompts three interpretive questions:

     •    What does “interest” mean?

     •    What does “thereof” modify?--“interest” or “trade or

          business”?

     •    If “thereof” modifies “interest”, then what is a

          “substantial portion” of an interest?

     Recovery Group maintains that “interest in a trade or

business” must mean a 100-percent ownership interest and that

“thereof” modifies “interest”.    Recovery Group therefore

concludes that a covenant gets 15-year amortization only if it

was obtained either in an acquisition of a 100-percent “interest

in a trade or business” or in an acquisition of a substantial

portion of an interest in a trade or business; and it argues that

Mr. Edgerly’s 23 percent portion that Recovery Group redeemed was

not “substantial”.

     Respondent maintains that “thereof” modifies “trade or

business”, and that “interest” means an ownership interest of any

percentage, large or small.   Respondent therefore concludes that

a covenant gets 15-year amortization if it was obtained either in

an acquisition of any “interest in a trade or business” (such as

Mr. Edgerly’s stock) or in an acquisition of a substantial

portion of a trade or business--i.e., a substantial portion of

its assets (not at issue here)--and respondent argues that it is
                               -19-

therefore immaterial whether Mr. Edgerly’s 23-percent stock

interest would be characterized as “substantial”.    We agree with

respondent, for the reasons we explain below; and we hold, in the

alternative, that a 23-percent stock interest is substantial.

     D.   Analysis of statutory terms and purpose

          1.   The meaning of “interest”

     The phrase “trade or business” appears in five different

places in section 197,11 but the phrase “an interest in a trade

or business” appears only in subsection (d)(1)(E).   An “interest”

is “[a] legal share in something; all or part[12] of a legal or



     11
      See section 197(c)(1)(B) (an “amortizable section 197
intangible” is “held in connection with the conduct of a trade or
business”), (2) (flush language) (self-created intangibles are
subject to section 197 if “created in connection with a trans-
action * * * involving the acquisition of assets constituting a
trade or business or substantial portion thereof”), (d)(1)(E)
(covenants not to compete); (e)(3)(A)(ii) (computer software is
not subject to section 197 if it “is not acquired in a
transaction * * * involving the acquisition of assets constitut-
ing a trade or business or substantial portion thereof”); and
(e)(7) (rights to service a mortgage are subject to section 197
if “acquired in a transaction * * * involving the acquisition of
assets * * * constituting a trade or business or substantial
portion thereof”).
     12
      As “interest” is used outside the context of section 197,
one who owns an “interest” may own a “fractional interest”, see,
e.g., Estate of Mellinger v. Commissioner, 

, 33
(1999), which might consist of a “minority interest”, see, e.g.,
Holman v. Commissioner, 

, 183 (2008), or a “majority
interest”, see, e.g., Estate of Bongard v. Comissioner, 

, 123 (2005), also referred to as a “controlling interest”,
see, e.g., Square D Co. & Subs. v. Commissioner, 

,
195 (2003); or one might own an “entire interest”, Shepherd v.
Commissioner, 

, 378 (2000), affd. 

(11th
Cir. 2002).
                                 -20-

equitable claim to or right in property”.    Black’s Law Dictionary

885 (9th ed. 2009) (emphasis added).    Thus, the word “interest”

sometimes does and sometimes does not have the significance that

Recovery Group urges--i.e., ownership of all of something

(namely, a trade or business).    However, Recovery Group’s

interpretation is problematic here.     Section 197(d)(1)(E) applies

in the case of an acquisition of “an interest”, not “the

interest”.   We must presume that Congress’s use of the indefinite

article before “interest” was deliberate.    Considering the

purpose of this language (to capture covenants obtained in

connection with both stock and asset acquisitions, as is

discussed below in part I.D.2) and our holding in Frontier

Chevrolet (discussed below in part I.E), we hold that “an

interest” in section 197(d)(1)(E) may consist of a portion--all

or a part--of the ownership interest in a trade or business.

     In Frontier Chevrolet we rejected the taxpayer’s contention

that only the acquisition of a new business triggered section

197(d)(1)(E).   Likewise, here we must reject Recovery Group’s

interpretation that “an interest” means only “the entire

interest.”   We hold, instead, that “an interest in a trade or

business” in section 197(d)(1)(E) includes the 23-percent

minority interest acquired by Recovery Group.13    Moreover,


     13
      We decide only the 23-percent case before us and do not
address hypothetical facts not present here (e.g., a de minimis
                                                   (continued...)
                                 -21-

Recovery Group’s interpretation of “an interest” becomes even

more problematic if, as we hold below, “thereof” refers not to

“an interest” but rather to “trade or business”.    If “an

interest” in section 197(d)(1)(E) meant “the entire interest”,

then a redemption could never trigger that section because a

corporation may not entirely deprive itself of shareholders by

redeeming all its stock.    Rather than overturn our holding in

Frontier Chevrolet as Recovery Group’s interpretation would

logically require, we affirm and apply to new facts the reasoning

from that case.

          2.      The antecedent of “thereof”

     Recovery Group counters with the argument that interpreting

“an interest” to mean even a minority interest nullifies the

subsequent language that looks to whether the acquisition is of a

“substantial portion”; but this argument reflects confusion about

what the “portion” is that the statute requires to be

“substantial”.    Recovery Group contends that in the statutory

phrase at issue--“an acquisition * * * of an interest in a trade

or business or substantial portion thereof”--the antecedent of

the word “thereof” is “interest”, so that 15-year amortization is

required when a covenant is entered into in connection with an

acquisition of either an (entire) interest or a substantial



     13
      (...continued)
stock interest in a publicly traded company).
                              -22-

portion of an interest in a trade or business.    The alternative

interpretation that “an interest” includes a minority interest

removes the effect (Recovery Group argues) of the statutory

provision that an interest must be “substantial” before it

triggers section 197.

     The fallacy in Recovery Group’s position is a grammatical

mistake about the antecedent of “thereof”.    Respondent contends,

and we agree, that the antecedent of “thereof” is “trade or

business”, so that 15-year amortization is required when a

covenant is entered into in connection with an acquisition of

either an interest (i.e., an entire or fractional stock interest)

in a trade or business or assets constituting14 a substantial

portion of a trade or business.   This reading coincides both with

explicit language in the legislative history and with the

legislative purpose.

     The legislative history is unmistakable on the point that

the “substantial portion” in section 197(d)(1)(E) is a

substantial portion of a trade or business.    The conference

report states:

          Exceptions to the definition of a section 197
     intangible

          In general.-- The bill contains several exceptions
     to the definition of the term “section 197 intangible.”


     14
      Section 197(d)(1)(E) does not include the words “assets
constituting” that we interpolate in the text above, but those
words are implicit there for the reasons discussed hereafter.
                                -23-

     Several of the exceptions contained in the bill apply
     only if the intangible property is not acquired in a
     transaction * * * that involves the acquisition of
     assets which constitute a trade or business or a
     substantial portion of a trade or business. * * *

          The determination of whether acquired assets
     constitute a substantial portion of a trade or business
     is to be based on all of the facts and circumstances,
     including the nature and the amount of the assets
     acquired as well as the nature and amount of the assets
     retained by the transferor. It is not intended,
     however, that the value of the assets acquired relative
     to the value of the assets retained by the transferor
     is determinative of whether the acquired assets
     constitute a substantial portion of a trade or
     business.

               *      *     *     *     *     *     *

          In determining whether a taxpayer has acquired an
     intangible asset in a transaction * * * that involves
     the acquisition of assets that constitute a trade or
     business or a substantial portion of a trade or
     business * * *, any employee relationships that
     continue (or covenants not to compete that are entered
     into) as part of the transfer of assets are to be taken
     into account in determining whether the transferred
     assets constitute a trade or business or a substantial
     portion of a trade or business.

H. Conf. Rept. 103-213, at 678-679, 1993-3 C.B. at 556-557

(emphasis added).    Thus, when Congress wrote “an interest in a

trade or business or substantial portion thereof” (emphasis

added), it referred to a substantial portion of a trade or

business (not a substantial portion of an interest in a trade or

business).   Subsection (d)(1)(E) thus presents a duality--

acquisition of a stock interest and acquisition of a substantial

portion of assets.    This duality was explicit in Congress’s

purpose.
                                -24-

     Congress’s purpose in enacting section 197(d)(1)(E) was to

impose 15-year amortization both when a stock acquisition15

includes a covenant not to compete and when a substantial asset

acquisition includes a covenant not to compete; and the

interpretation we adopt today accomplishes that purpose.

Section 197(d)(1)(E) includes the phrase “an interest in a trade

or business or substantial portion thereof” (emphasis added),

rather than the phrase “assets constituting a trade or business

or substantial portion thereof” (emphasis added) used

elsewhere.16   The “interest in” phrase was included with

reference to covenants not to compete in order to make it clear

that the acquisitions that trigger section 197 encompass “not

only the assets of a trade or business but also stock in a

corporation that is engaged in a trade or business”.    H. Conf.

Rept. 103-213, supra at 677, 1993-3 C.B. at 555 (emphasis added).

     Recovery Group’s interpretation of the statute would impose

the 15-year amortization in the case of an acquisition of an

entire stock interest or a substantial stock interest but would



     15
      See Frontier Chevrolet Co. v. 

(“both stock acquisitions and redemptions involve acquiring
an interest in a trade or business by acquiring stock of a
corporation engaged in a trade or business”).
     16
      The phrase “assets constituting a trade or business or
substantial portion thereof” (emphasis added) appears in
subsection (c)(2) (flush language) (self-created intangibles);
subsection (e)(3)(A)(ii) (computer software); and subsection
(e)(7) (rights to service a mortgage)).
                                 -25-

find the statute silent about asset acquisitions, thus failing to

vindicate the legislative purpose.      We prefer instead the

interpretation that accomplishes Congress’s aim to reach

covenants not to compete in both stock acquisitions (i.e.,

acquisitions of “an interest in a trade or business”) and

acquisitions of a “substantial portion” of the assets of “a trade

or business”.     Under this reading of the statute, the question

whether an acquisition is “substantial” arises only with

reference to asset acquisitions.     On the other hand, where a

covenant not to compete is entered into in connection with a

stock acquisition of any size--substantial or not substantial--

that covenant is an amortizable section 197 intangible.

             3.   What interest would be “substantial”?

     Even if “thereof” modified “an interest” and thereby limited

the application of section 197 to acquisitions of a “substantial

interest”, Recovery Group’s assumption that a 23-percent stock

interest is not substantial is not well supported.      The term

“substantial portion” is not defined in section 197 (enacted in

1993) nor in the regulations thereunder, so Recovery Group finds

a suggestion of its meaning in a 1997 amendment17 to an unrelated

provision--section 1397C, which defines “enterprise zone

business”.    The amendment made two changes that, when taken in



     17
      See Taxpayer Relief Act of 1997, Pub. L. 105-34, sec.
956(a)(1)-(3), 111 Stat. 890, 1997-4 C.B. (Vol. 1) 104.
                                -26-

tandem (Recovery Group says), show that “substantial portion”

must mean 50 percent or more.   First, the amendment substituted

“50 percent” in place of “80 percent” in section 1397C(b)(2) and

(c)(1); and second, it substituted “substantial portion” in place

of the term “substantially all” in section 1397C(b)(3)-(5) and

(c)(2)-(4).   Recovery Group infers therefrom that the pre-

amendment “substantially all” meant 80 percent or more, while the

post-amendment “substantial portion” means 50 to 80 percent.

From this Recovery Group argues that for an “interest” to be a

“substantial portion” under section 197, it must likewise be 50

percent or more.

      There are at least two fatal flaws in this argument.

First, the percentages in section 1397C(b)(2) and (c)(1)

(originally “80 percent” and now “50 percent”) refer to the

amount of a business’s gross income derived within an empowerment

zone; but the phrase “substantial portion” (in different

subsections--i.e., section 1397C(b)(3)-(5) and (c)(2)-(4)) refers

to the quantum of the business’s property used and services

performed in an empowerment zone.      Recovery Group’s argument

presumes that section 1397C expressly provides that a

“substantial portion” is one consisting of “50 percent” or more--

but the statute says no such thing.      The income percentage

provisions and the “substantial portion” provisions are

independent criteria for qualifying a business or a
                                -27-

proprietorship as an enterprise zone business.   Thus, even in

section 1397C itself, there is no connection between the

“substantial portion” term and the “50 percent” term; and

“substantial portion” is no more defined in section 1397C than it

is in section 197(d)(1)(E).    The most that can be said is that

the Congress that amended section 1397C had these “substantial

portion” and “50 percent” phrases in mind at the same time, but

in different connections.

     The second flaw in this argument is that the “empowerment

zone” provisions of section 1397C, amended in 1997, simply bear

no connection or similarity to the amortization-of-intangibles

provisions of section 197, enacted in 1993.   Recovery Group makes

no showing that the purposes of the two statutes have any

particular congruence or similarity, and we discern none.

Section 1397C is too remote an analogy to shed any light on the

meaning of section 197(d)(1)(E).   This is Recovery Group’s only

suggestion of statutory guidance on what is “substantial”, and we

do not find it illuminating.

     In other provisions one could find, in a variety of

circumstances, “substantial” percentages that are much less than

50 percent.   For example--

     •    For some retirement plan purposes, a “substantial

          owner” is one who, inter alia, “owns, directly or

          indirectly, more than 10 percent in value of either the
                                -28-

          voting stock of that corporation or all the stock of

          that corporation.”    29 U.S.C. sec. 1321(d)(3) (2006).

     •    A “substantial understatement” of tax is an

          understatement that “exceeds * * * 10 percent of the

          tax required to be shown on the return”.

          Sec. 6662(d)(1)(A).

     •    “[N]o substantial part” of a tax-exempt organization’s

          activity may be political activity, sec. 501(c)(3),

          with “substantial” defined, in effect, on a sliding

          scale that reaches as low as 7-1/2 percent of its

          expenditures (i.e., 150 percent, see sec. 501(h)(2), of

          “5 percent of the excess of the exempt purposes

          expenditures over $1,500,000”, sec. 4911(c)(2)).18

     •    For income tax treaty purposes, a “substantial

          interest” in a foreign company’s stock could be

          “10 percent or more”.   See 1972-1 C.B. 438, 439.

     •    For estate tax purposes, former section 2036(c)(3)(A)19

          defined a “substantial interest” in an enterprise as


     18
      Cf. Seasongood v. Commissioner, 

, 912
(6th Cir. 1955) (where “something less than 5% of the time and
effort of the League was devoted to the activities that the Tax
Court found to be ‘political’ * * * the so-called ‘political
activities’ of the League were not in relation to all of its
other activities substantial”), revg. 

(1954).
     19
      In 1990, former section 2036(c) was repealed, and former
subsection (d) was redesignated section 2036(c)). See Omnibus
Budget Reconciliation Act of 1990, Pub. L. 101-508, sec. 11601,
104 Stat. 1388-490.
                                  -29-

             the ownership of 10 percent or more of the voting power

             or income stream or both of such enterprise.

     However, we see no reason to suppose that the purposes of

section 197 would be served by measuring substantiality in ways

that were conceived to vindicate the purposes of those very

different provisions, which are no more like section 197 than the

“empowerment zone” provisions that Recovery Group puts forward.

If we look instead to the statute at issue for some explicit

indication of whether Congress would have considered a 23-percent

ownership interest to be significant and, presumably,

“substantial”, the only hint we find--if indeed it is even a

hint--is in the anti-churning20 rules in section 197(f)(9).      In

that provision Congress defined “related person” by importing

rules from sections 267(b) and 707(b)(1); but in doing so it

adjusted those rules by reducing the ownership percentage that

triggers restrictions--from 50 percent to 20 percent.


     20
          The anti-churning rules of section 197(f)(9) aim to:

     prevent taxpayers from converting existing goodwill,
     going concern value, or any other section 197
     intangible for which a depreciation or amortization
     deduction would not have been allowable under present
     law into amortizable property to which the bill
     applies.

H. Conf. Rept. 103-213, supra at 691, 1993-3 C.B. at 569.
Congress sought specifically to prevent taxpayers from
transferring property for the purpose of generating deductions,
and it imposed more stringent definitions of “related person” to
prevent transfers among related parties from qualifying an
intangible for amortization under the new provisions.
                                -30-

Sec. 197(f)(9)(C)(i).   Thus, in order for section 197(f)(9)(A) to

disqualify an otherwise eligible amortizable section 197

intangible, the taxpayer or a related person need own (directly

or indirectly) only 20 percent of the value of the outstanding

stock in a corporation to which he transferred or licensed, or

from which he acquired or licensed, that intangible.     Congress

did not declare such a 20-percent interest “substantial”; but the

provision does indicates that someone who owns as little as

20 percent of the stock of a company came within the focus of

Congress’s concern when it enacted section 197.   This

congressional concern behind section 197(f)(9) is admittedly

different from the specific concern behind section 197(d)(1)(E),

but the two provisions are part of the same enactment and pertain

to the same general subject:   tax avoidance using intra-owner

stock sales to affect the tax treatment of the cost of

intangibles.   That the anti-churning provision of section

197(f)(9) is triggered in the case of a 20-percent stock interest

might suggest that a 20-percent interest would be considered

“substantial”.21   And if so, then the 23-percent interest at

issue here would also be substantial.

     If, on the other hand, section 197(f)(9) bears no important

relation to section 197(d)(1)(E) and sheds no light on what would



     21
      We emphasize that we do not hold here that to be
“substantial” an interest must equal or exceed 20 percent.
                                 -31-

be a “substantial portion” of a stock interest for purposes of

triggering 15-year amortization of a covenant not to compete,

then section 197 does nothing to define “substantial”.

Nonetheless, even in that event, Recovery Group’s transaction

would still implicate the concern that Congress evinced in

enacting section 197(d)(1)(E).    Recovery Group paid a total of

$655,907 to Mr. Edgerly for his stock and his agreement not to

compete.   The covenant not to compete was for a short term--only

one year--and the stock was certainly not a negligible part of

the transaction.   Rather, the parties stated its value as

$255,907; it was enough stock that one could have avoided tax by

understating its value.   That is, the stock interest here was

“substantial” enough to implicate the risk that section

197(d)(1)(E) was designed to prevent.

     Thus, Recovery Group has not convinced us that a 23-percent

interest would not be considered “substantial”.   And in any

event, “thereof” does not modify “an interest”; and therefore an

interest need not be “substantial” to trigger the application of

section 197(d)(1)(E).

     E.    Frontier Chevrolet

     Recovery Group cites Frontier Chevrolet Co. v. Commissioner,

, 294-295 (2001), affd. 

(9th Cir.

2003), as if it contradicts this conclusion--as if Frontier

Chevrolet holds that a stock interest of more than 23 percent
                               -32-

must be acquired before a covenant not to compete will be treated

as a section 197 intangible, and as if a stock interest must be

equivalent to the 75-percent interest in Frontier Chevrolet in

order to be substantial.   This argument aggressively misreads

Frontier Chevrolet, which in fact says nothing at all about what

is “substantial” under section 197 and says nothing that would

help Recovery Group.

     We held in Frontier Chevrolet (where the taxpayer

corporation redeemed 75 percent of its stock) that a redemption

of stock qualifies as direct or indirect acquisition of an

interest in a trade or business for purposes of section 197.     We

rejected the taxpayer’s argument that the statute requires the

acquisition of an interest in a new or different trade or

business.   In affirming this Court’s holding that Frontier

entered into the covenant not to compete in connection with its

acquisition of an interest in a trade or business, and that it

must therefore amortize the cost of the covenant over 15 years,

the Court of Appeals for the Ninth Circuit confirmed that section

197 “only requires taxpayers to acquire an interest in a trade or

business”, not “an interest in a new trade or business” (as the

taxpayer had argued).   Frontier Chevrolet Co. v. 

.   The Court of Appeals considered only the case

before it, stating:

     The parties do not dispute that they entered into the
     covenant after the effective date of § 197, or that
                               -33-

     Frontier held the covenant in connection with the
     conduct of a trade or business. Accordingly, the only
     issue we address is whether a redemption of 75% of a
     taxpayer’s stock constitutes an indirect acquisition of
     an interest in a trade or business for purposes of
     § 197. We need not and do not decide whether all stock
     redemptions made in connection with an execution of a
     covenant not to compete constitute an acquisition of an
     interest in a trade or business within the meaning of
     § 197.

n.2.   Recovery Group lays special stress on the final

sentence of the Court of Appeals’ footnote, as if by disclaiming

a holding as to “all stock redemptions”, the Court of Appeals

thereby intimated that some stock redemptions do not constitute

“an acquisition * * * of an interest in a trade or business”

within the meaning of section 197(d)(1)(E); and Recovery Group

urges that its 23 percent acquisition was not substantial enough

to meet the standard for such acquisitions that is (it suggests)

implicit in Frontier Chevrolet.

     However, the taxpayer in Frontier Chevrolet argued that only

covenants entered into in connection with the acquisition of a

new trade or business were section 197 intangibles.   Both the Tax

Court and the Court of Appeals disagreed, holding that the

taxpayer’s redemption of 75 percent of its own stock effected an

indirect acquisition of a trade or business.   Neither court was

asked to rule or did rule on whether a redemption smaller than

75 percent might result in the acquisition of an interest in a

trade or business for purposes of section 197(d)(1)(E).
                               -34-

     We therefore answer in these cases a question not asked in

Frontier Chevrolet--namely, whether a corporation that redeems

not 75 percent but 23 percent of its stock thereby makes “an

acquisition (directly or indirectly) of an interest in a trade or

business”.

     The car dealership in Frontier Chevrolet redeemed a 75-

percent shareholder, and the remaining shareholder (i.e., the 25-

percent shareholder pre-redemption) became the sole shareholder.

Recovery Group makes much of the fact that none of its remaining

shareholders obtained a controlling interest in Recovery Group as

a result of the redemption at issue, unlike the sole remaining

shareholder in Frontier Chevrolet.    However, we do not interpret

the statute to require the acquisition of a controlling interest,

nor is our interpretation inconsistent with the Tax Court opinion

or the Court of Appeals opinion in that case.

     In both Frontier Chevrolet and these cases, the departing

shareholder agreed to refrain from competing with the company and

received consideration not only for stock but also for the

covenant not to compete.   Each covenant protected the company

against competition from a former shareholder; both companies

obtained the covenants via redemptions involving their

acquisition of “an interest in a trade or business” as is

discussed above in part I.D.2; and therefore both covenants not

to compete are amortizable section 197 intangibles.
                                 -35-

      We hold that Recovery Group’s redemption of 23 percent of

its stock was an acquisition of an interest in a trade or

business, that the covenant not to compete is thus a section 197

intangible, and that Recovery Group must amortize the $400,000

cost of the covenant over 15 years under section 197.     The IRS’s

deficiency determinations will be sustained.

II.   Accuracy-related penalty under section 6662

      A.    General principles

      Section 6662 imposes an “accuracy-related penalty” of

20 percent of the portion of the underpayment of tax attributable

to any substantial understatement of income tax.     See sec.

6662(a), (b)(2).22   By definition, an understatement of income

tax for an S corporation is substantial if it exceeds the greater

of $5,000 or 10 percent of the tax required to be shown on the

return.    Sec. 6662(d)(1).   Pursuant to section 7491(c), the

Commissioner bears the burden of production and must produce

sufficient evidence showing the imposition of the penalty is

appropriate in a given case.     Higbee v. Commissioner, 

      Under section 6662(b)(1), the accuracy-related penalty is
also imposed where an underpayment is attributable to the
taxpayer’s negligence or disregard of rules or regulations; and
respondent argues that Recovery Group’s position reflects
negligence. However, as we show below, respondent has
demonstrated that Recovery Group substantially understated its
income tax for the years in issue for purposes of
section 6662(b)(2). Thus, we need not consider whether, under
section 6662(b)(1), Recovery Group was negligent or disregarded
rules or regulations.
                                 -36-

438, 446 (2001).    Once the Commissioner meets this burden, the

taxpayer must come forward with persuasive evidence that the

Commissioner’s determination is incorrect.       Rule 142(a); Higbee

v. Commissioner, supra at 447.

     A taxpayer who is otherwise liable for the accuracy-related

penalty may avoid the liability if it successfully invokes one of

three other provisions:   Section 6662(d)(2)(B) provides that an

understatement may be reduced, first, where the taxpayer had

substantial authority for its treatment of any item giving rise

to the understatement or, second, where the relevant facts

affecting the item’s treatment are adequately disclosed and the

taxpayer had a reasonable basis for its treatment of that item.

Third, section 6664(c)(1) provides that, if the taxpayer shows

that there was reasonable cause for a portion of an underpayment

and that it acted in good faith with respect to such portion, no

accuracy related penalty shall be imposed with respect to that

portion.    Whether the taxpayer acted with reasonable cause and in

good faith depends on the pertinent facts and circumstances,

including its efforts to assess its proper tax liability, its

knowledge and experience, and the extent to which it relied on

the advice of a tax professional.       Sec. 1.6664-4(b)(1), Income

Tax Regs.
                                  -37-

     B.   Application to Recovery Group

          1.     Substantial understatement

     Recovery Group reported negative taxable income for both

2002 and 2003.   See supra note 4.       The IRS determined built-in

gains tax for both years and deficiencies of $46,138 for 2002 and

$70,011 for 2003, and we have upheld these determinations.

Recovery Group’s understatement for each year thus exceeds both

$5,000 and 10 percent of the tax required to be shown on its

return, and both understatements are therefore substantial.

Respondent has carried the burden of production imposed by

section 7491(c).      The accuracy-related penalty is mandatory; the

statute provides that it “shall be added”.       Sec. 6662(a).

Recovery Group bears the burden of proving any defenses, such as

substantial authority, disclosure and reasonable basis, and

reasonable cause and good faith.     See Higbee v. Commissioner,

supra at 446.

          2.     Defenses

                 a.     Substantial authority for positions taken

     Only where the weight of the authorities supporting the

treatment is substantial in relation to the weight of the

authorities supporting contrary positions does substantial

authority for a tax treatment exist.       See Norgaard v.

Commissioner, 

, 880 (9th Cir. 1991), affg. in part

and revg. in part on another ground T.C. Memo. 1989-390; sec.
                               -38-

1.6662-4(d)(3)(i), Income Tax Regs.    The substantial-authority

standard is less stringent than the more-likely-than-not standard

(met only when the likelihood of a position being upheld is

greater than 50 percent), but it is more stringent than the

reasonable-basis standard.   Sec. 1.6662-4(d)(2), Income Tax Regs.

“Substantial authority” is found in:    the Internal Revenue Code

and other statutes; regulations construing the statutes; case

law; and legislative intent reflected in committee reports.    Sec.

1.6662-4(d)(3)(iii), Income Tax Regs.   The weight of an authority

depends on its source, persuasiveness, and relevance.   Sec.

1.6662-4(d)(3)(ii), Income Tax Regs.

     Mr. Troy testified that the legislative history convinced

him that some covenants not to compete could still be amortized

over their useful lives under section 167.   In that conclusion he

was certainly correct; section 197 attaches only to certain

covenants not to compete--i.e., those acquired in connection with

the acquisition of an interest in a trade or business or

substantial portion thereof.   However, Mr. Troy’s reliance on the

Court of Appeals’ footnote in Frontier Chevrolet Co. v.

n.2, was misplaced.   The Court of

Appeals stated that it need not and did not decide whether all

stock redemptions constitute acquisitions of interests in a trade

or business.   The court left that question for another day.   The

most that can be said in Recovery Group’s favor is that Frontier
                                   -39-

Chevrolet did not foreclose the argument that a 23-percent

redemption is not an acquisition of an interest in a trade or

business; it does not affirmatively support that argument.

     While “a taxpayer may have substantial authority for a

position that is supported only by a well-reasoned construction

of the applicable statutory provision”, sec. 1.6662-4(d)(3)(ii),

Income Tax Regs., in these cases Recovery Group used its

unwarranted extrapolation from the footnote in Frontier Chevrolet

to impute into the statute a requirement that the interest

acquired be a majority interest or some substantial interest

greater than 23 percent.      This is not a well-reasoned statutory

construction.   We find that the substantial authority exception

does not apply.

                  b.     Disclosure and reasonable basis for treatment

     Provided the taxpayer adequately disclosed the relevant

facts affecting the tax treatment of an item and had a reasonable

basis for its treatment, no accuracy-related penalty may be

imposed for a substantial understatement of income tax with

respect to that item.      Sec. 6662(d)(2)(B)(ii); sec. 1.6662-4(e),

Income Tax Regs.       A taxpayer may adequately disclose by providing

sufficient information on the return to enable the IRS to

identify the potential controversy.       Schirmer v. Commissioner, 

, 285-286 (1987).      Recovery Group fails to qualify for
                                    -40-

this defense because it did not adequately disclose the item at

issue.

     Recovery Group’s returns for the years in issue list the

deductions for the covenant not to compete as individual line

items on two statements itemizing “other deductions” for each

year.    These entries recite “NON COMPETE EXPENSE” and the amount

deducted; they provide no further details, such as Recovery

Group’s entering into this covenant not to compete in the

redemption transaction with Mr. Edgerly.       We find that Recovery

Group’s returns did not include sufficient facts to provide the

IRS with actual or constructive knowledge of the potential

controversy involved with Recovery Group’s deduction of the cost

of the covenant not to compete.       While Recovery Group did list

the deduction on its return, merely claiming the expense was

insufficient to alert the IRS to the circumstances of the

acquisition of the covenant or the decision by Recovery Group’s

accountants not to treat the covenant as an amortizable section

197 intangible.        West Covina Motors, Inc. v. Commissioner, T.C.

Memo. 2008-237; see also Robnett v. Commissioner, T.C. Memo.

2001-17.   The adequate disclosure exception does not apply.

                  c.     Reasonable cause

     For purposes of section 6664(c), a taxpayer may be able to

demonstrate reasonable cause and good faith (and thereby escape

the accuracy-related penalty of section 6662) by showing its
                                -41-

reliance on professional advice.   See sec. 1.6664-4(b)(1), Income

Tax Regs.   However, reliance on professional advice is not an

absolute defense to the section 6662(a) penalty.    Freytag v.

Commissioner, 

, 888 (1987), affd. 

(5th

Cir. 1990), affd. 

(1991).   A taxpayer asserting

reliance on professional advice must prove:    (1) that his adviser

was a competent professional with sufficient expertise to justify

reliance; (2) that the taxpayer provided the adviser necessary

and accurate information; and (3) that the taxpayer actually

relied in good faith on the adviser’s judgment.    See Neonatology

Associates, P.A. v. Commissioner, 

, 99 (2000), affd.

(3d. Cir. 2002).

     Mr. Orleans, a certified public accountant, was involved

with the buyout agreement from the beginning, and he had access

to correct information and to all the information he needed to

properly evaluate the tax treatment of the cost of the covenant.

Mr. Orleans relied in turn on Mr. Troy, another qualified

professional and a tax specialist in his accounting firm, to

determine the tax treatment of the covenant.   Recovery Group’s

president, Mr. Gray, testified that he was a businessman and not

a tax expert and that he hired accountants to ensure that his

company’s books were properly kept and its tax returns were

properly filed.   We are satisfied that Recovery Group’s

accountants were competent professionals with sufficient
                                 -42-

expertise to justify Recovery Group’s reliance, that they had the

necessary information, and that Recovery Group actually relied on

its accountants in good faith.

     In United States v. Boyle, 

, 251 (1985), the

Supreme Court stated:

          When an accountant or attorney advises a taxpayer
     on a matter of tax law, such as whether a liability
     exists, it is reasonable for the taxpayer to rely on
     that advice. Most taxpayers are not competent to
     discern error in the substantive advice of an
     accountant or attorney. To require the taxpayer to
     challenge the attorney, to seek a “second opinion,” or
     to try to monitor counsel on the provisions of the Code
     himself would nullify the very purpose of seeking the
     advice of a presumed expert in the first place. * * *

Neither the special rules for the amortization of intangibles

that Congress enacted in section 197, nor the rule in

section 197(d)(1)(E) applying that regime to covenants not to

compete, nor the exception for such covenants when they are not

“entered into in connection with an acquisition (directly or

indirectly) of an interest in a trade or business or substantial

portion thereof”--none of these provisions is likely to be known

even to the sophisticated manager of a business like Recovery

Group.   Much less are these rules intuitive.   With the Internal

Revenue Code as complicated as it is, corporate taxpayers with

even moderately complex transactions are effectively required to

consult tax professionals to prepare their returns.   When they do

consult such professionals, when they disclose their facts, and
                                 -43-

when they then rely on the advice they are given, they should not

be penalized; and section 6664(c) assures that they will not be.

     After considering all the facts and circumstances, we find

that Recovery Group has established that it had reasonable cause

and acted in good faith with respect to the substantial

understatements of income tax for the years in issue.

Respondent’s determination of the accuracy-related penalty will

not be sustained.

     To reflect the foregoing,


                                        Decisions will be entered

                                   for respondent as to the

                                   deficiencies in all dockets and

                                   for petitioner in docket No.

                                   12430-08 as to the penalties

                                   under section 6662(a).