1995 U.S. Tax Ct. LEXIS 51">*51 Decision will be entered for respondent.
105 T.C. 227">*227 OPINION
RAUM,
1995 U.S. Tax Ct. LEXIS 51">*52 Petitioner, William H. Schaefer, Jr., resided in Baltimore, Maryland, at the time the petition in this case was filed. For a period of time prior to November 7, 1984, he was the sole shareholder of Schaefer/May Motor Sales, Ltd. (known as, and hereinafter referred to as, Toyota City), a Maryland corporation engaged in the sale and servicing of Toyota motor vehicles and parts in Glen Burnie, Maryland. On November 7, 1984, all of the assets of Toyota City were sold to an unrelated third party.
105 T.C. 227">*228 The sales agreement included a covenant not to compete with the buyer (referred to sometimes hereinafter simply as the covenant). Schaefer agreed in the covenant that for 3 years he would "not directly or indirectly own, manage, operate, join, control or participate in the ownership, management, operation or control of or be concerned in any manner with any business engaged in the sales or service of Honda or Toyota motor vehicles within a radius of five (5) miles of 5808 Ritchie Highway, Glen Burnie, Maryland [the address of the purchaser's place of business, apparently a Honda dealership]." The address of Toyota City was 7167 Ritchie Highway, Glen Burnie, Maryland. Since the date of the sale1995 U.S. Tax Ct. LEXIS 51">*53 of Toyota City, petitioner has not actually rendered any service whatsoever that relates in any way to the sale or service of Toyota or Honda automobiles.
Payments under the covenant were to be made on a monthly basis over a period of 150 months, scheduled to commence 6 months after November 7, 1984, the closing of the sale of Toyota City. The first six payments were in the amount of $ 7,500 each, and the following 144 payments were in the amount of $ 10,100 each. 2 Thus, although the covenant not to compete covered a period of only 3 years from the sale of Toyota City, the 150 monthly payments, which were to begin 6 months after the sale, would continue for 13 years after the sale. The covenant stated that it was entered into "to compensate Schaefer for Schaefer's agreement not to compete against the [purchaser] Corporation under the terms and conditions hereinafter set forth."
1995 U.S. Tax Ct. LEXIS 51">*54 Petitioner reported the payments under the covenant as passive income on his 1988, 1989, and 1990 income tax returns. Each of these returns included a Form 8275, Disclosure Statement Under Section 6661, stating that petitioner was taking a position contrary to Treasury Department regulations and providing petitioner's reason for doing so.
For the years at issue, petitioner remained the 99-percent shareholder in Nationwide Motor Sales Corporation (Nationwide). Nationwide's principal business was the sale and servicing of 105 T.C. 227">*229 Nissan, Saab, Isuzu, and AMC/Jeep/Renault automobiles in Timonium, Maryland. The parties stipulated that at no time did Toyota City and Nationwide share staff, keep common bank accounts, file common tax returns, share sources of credit, or do business with common manufacturers, distributors, advertisers, or each other. They further stipulated that petitioner has treated Toyota City and Nationwide as separate business activities at all times and in all respects.
Under the provisions of section 469, a taxpayer's right to make use of passive activity losses in any year is limited to the amount of the taxpayer's passive activity income for that year. Sec. 469(a), (d)(1). 1995 U.S. Tax Ct. LEXIS 51">*55 Amounts disallowed may be carried forward to subsequent years. Sec. 469(b). While it has been stated that "Issues arising under section 469 typically focus on whether a
1995 U.S. Tax Ct. LEXIS 51">*56 We begin by noting that a temporary regulation is entitled to the same weight as a final regulation.
105 T.C. 227">*230 Treasury regulations are entitled to a high degree of deference from the courts. A Treasury regulation must be upheld if it "implement[s] the congressional mandate in some reasonable manner".
Section 469 represents the congressional response to the widespread use of tax shelters by some taxpayers to avoid paying tax on unrelated income. See Staff of the Joint Comm. on Taxation, General Explanation of the Tax Reform Act of 1986, at 209-210 (J. Comm. Print 1987). Section 469 provides, as explained above, that passive losses will be allowed only to the extent of passive income.
However, certain types of income are specifically excluded from the computation of passive income. These include so-called1995 U.S. Tax Ct. LEXIS 51">*58 portfolio income, namely, interest, dividends, annuities, or royalties, as well as gain attributable to the disposition of property, and earned income; sec. 469(e). 41995 U.S. Tax Ct. LEXIS 51">*59 Further, 105 T.C. 227">*231 the Secretary is specifically instructed to issue regulations "which provide that certain items of gross income will not be taken into account in determining income or loss from any activity", sec. 469(1)(2). 5
Congress included these exceptions because these income sources "generally are positive income sources that do not bear deductible expenses to the same extent as passive investments. Since taxpayers commonly can rely upon salary and portfolio income to be positive * * * they are susceptible to sheltering by means of investments in activities that predictably give rise to tax losses". Staff of the Joint Comm. on Taxation, General Explanation of the Tax Reform Act of 1986, at 215 (J. Comm. Print 1987). It is with this understanding of the purpose behind section 469, and the specific types of income Congress meant to ensure were not sheltered by losses from passive activities, that we examine
The covenant 1995 U.S. Tax Ct. LEXIS 51">*60 not to compete provided petitioner with a steady stream of income payments for a comparatively long number of years
It is so well established as to not require citation that income from a valid covenant not to compete is ordinary income. However, in the context of determining whether this income is passive income or not, it is instructive to review generally exactly why it has been decided that income from a covenant not to compete is ordinary income.
In
Similarly, this Court has stated that "Importance from the standpoint of the vendor, of course, lies in the treatment of his negative covenant as
These cases are cited to show the long history of viewing payments under a covenant not to compete as similar to types of income
The validity of a regulation is judged under a standard of
Petitioner argues that the covenant not to compete income is sufficiently different from earned income or portfolio income as to render invalid
Petitioner1995 U.S. Tax Ct. LEXIS 51">*63 argues that compensation under a covenant not to compete is the polar opposite of earned income, because 105 T.C. 227">*233 the point of a covenant not to compete is that services will
Petitioner's point is superficially persuasive, but reflection will disclose that it is fallacious. It is fallacious because petitioner assumes that "services actually rendered" must involve some positive action, rather than affirmatively refraining from doing something. And it is that personal deliberate failure to act that the purchaser has bargained for in this case. Such personal refraining to engage in competition traditionally has been equated in the tax law with the rendition of personal services. We quote again what we have quoted above from
Petitioner also points out that income from the covenant is not interest, dividend, annuity, or royalty income, which are dealt with in section 469(e)(1)(A)(i). This is certainly true. However, again, these serve as specific examples of the
The fact that income from the covenant is not exactly the same as any of the specific examples used by Congress is well documented by petitioner. But petitioner attempts to set too narrow a standard. If the regulations were to be limited to income that falls squarely within an example used by Congress, then there would be no need for the regulations. Petitioner's argument proves too much.
Finally, petitioner contends that the grant of authority under section 469(1)(2) cannot be read so broadly as to support1995 U.S. Tax Ct. LEXIS 51">*65 this regulation. To do so, according to petitioner, would mean that Congress provided no intelligible standard for the Secretary in violation of the constitutionally required separation of powers. See
Petitioner has made other arguments. We have considered them and find them to be without merit.
1. Unless otherwise indicated, all section references are to the Internal Revenue Code in effect for the years at issue.↩
2. It may be interesting to note that although the sale price for the entire Toyota City was $ 1,060,000 plus an amount to be agreed upon for the new car inventory and the purchaser undertook to assume the burdens of a lease that was not to expire until some 9 years later, the aggregate amount of the monthly payments by the purchaser for the covenant not to compete was $ 1,499,400.↩
3. This temporary regulation is applicable to the years at issue. See
4. Sec. 469(e) provides in part as follows:
(e) Special Rules for Determining Income or Loss from a Passive Activity.--For purposes of this section-- (1) Certain income not treated as income from passive activity.--In determining the income or loss from any activity-- (A) In general.--There shall not be taken into account-- (i) any-- (I) gross income from interest, dividends, annuities, or royalties not derived in the ordinary course of a trade or business, * * * (ii) gain or loss not derived in the ordinary course of a trade or business which is attributable to the disposition of property-- (I) producing income of a type described in clause (i), or (II) held for investment.
* * *
(3) Compensation for personal services.--Earned income (within the meaning of section 911(d)(2)(A)) shall not be taken into account in computing the income or loss from a passive activity for any taxable year.↩
5. This specific grant of authority qualifies the regulation at issue as a so-called "legislative" regulation, which may be entitled to even greater weight than a regulation issued under the Secretary's general authority found in sec. 7805. See