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LIBERO P. BALDARELLI

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Baldarelli, Shaffer, and Brenner were parties to a total of 11 franchise agreements with H & R Block, Inc., all with respect to operations in California. This sales agreement recognized that Baldarelli owned 60 percent of the partnership and desired to acquire Shaffer's 20percent interest.3

For Shaffer's interest in the partnership Baldarelli agreed to pay $45,000 in annual installments of $11,250. Payment was evidenced by four unsecured promissory notes bearing interest at 5 percent per annum. Had the franchises under which the partnership was operating been lost due to conditions beyond the control of the parties to the sales agreement, the balance due on the promissory notes was to be forgiven. This was the only condition attached to the sales price. No allocation of any sort was made with respect to the sales price.

Shaffer's share of the profits for the year of sale was to be computed after adjustments for numerous contingent claims and withdrawals. Paragraph 5 of the Sale and Purchase of Partnership Interest Agreement signed by the parties provided as follows:

5. COVENANT NOT TO COMPETE: Seller expressly agrees that he shall not hereafter engage, directly or indirectly, actively or inactively, in any phase of the tax service business as such is now generally conducted, or may hereafter be conducted, within the States of California and Nevada, for a period of three (3) years from the date of this agreement, and said proscription shall apply whether Seller be engaged as a partner, as sole proprietor, an officer, director or shareholder of a corporation, or as an employee of any such, or similar, business entity, except that Seller shall have the right to be employed, solely in the status of an employee, in the tax service business hereafter provided, however, he is compensated only upon an hourly or weekly basis for his personal services rendered and that he in no way shares in profits from said business, either directly or indirectly, on a profit sharing or other incentive basis related to profits or efficiency of said tax service business. The continuing partners in said joint venture shall have the exclusive right to utilize the firm name of said partnership and Seller does expressly agree that he shall not, directly or indirectly, utilize or appropriate said name or any other name similar to said name, whether such similarity be in spelling, style or connotation. Rough drafts of the final agreement show significant changes in terms and conditions of the sale. Both of the rough drafts contain a covenant not to compete. The only difference between the two is that the first covenant provides that the seller could not engage in the tax preparation business for 3 years within the States of California and Nevada. The second draft makes explicit the seller's permissible work activities. He could work only as an hourly paid employee of such a

The amendment of Dec. 12, 1962, provided that when profits reached $100,000 both Brenner and Shaffer were to relinquish 50 percent of their holdings to Baldarelli. Although profits had reached this level no such transfer was made. The June 21, 1966, sales agreement provided that Shaffer was selling his 20-percent interest in the joint venture.

tax preparation service and could not receive any distribution of profits from the service.

Shaffer received legal advice throughout the negotiations leading up to the sale of his partnership interest. He was advised that a covenant not to compete would violate California law and was probably void.

Shaffer was selling his interest because of a dispute with his other partners. He was also interested in attending graduate school at the University of California at Berkeley and in fact was admitted for the fall quarter of 1966.

The agreed price for Shaffer's interest in the partnership was $45,000. On his 1966 Federal income tax return (Schedule D) Shaffer reported the transaction as follows:

Installment sale method elected, no downpayment in year of sale.

Percentage of profit=94%

In 1966 Shaffer reported the receipt as income of a partnership distributable share of $29,305. In 1967 Shaffer reported the receipt of $11,250 on the installment basis. Using a 94-percent profit ratio, he computed his long-term capital gain as $10,575.

Shaffer treated the receipt of each payment as long-term capital gain from the sale of goodwill-a capital asset. Baldarelli treated the payments made as amortization of a covenant not to compete and deducted the payments in the years he made them.

OPINION

Two partners who operated a tax preparation service had a falling out and they decided to terminate their relationship. One partner bought the other's interest for $45,000. Their agreement contained a covenant not to compete binding the seller. No specific value was assigned to the covenant. The parties realize that this item has important tax consequences. If the selling partner sold goodwill-a capital assethe is entitled to capital gain treatment. Aaron Michaels, 12 T.C. 17, 19 (1949). If he sold only the right to practice some calling, he has in effect received consideration for his forbearance. Hamlin's Trust v. Commissioner, 209 F. 2d 761 (C.A. 10, 1954). The amount received would be treated and taxed as ordinary income. The buyer, now giving

thought to his actions, has realized that if someone sold a capital asset, he must have bought one. If so, he has bought a special kind of capital asset-one without a determinable useful life and therefore not depreciable. See Thrifticheck Service Corp. v. Commissioner, 287 F. 2d 1 (C.A. 2, 1961), affirming 33 T.C. 1038 (1960); Manhattan Co. of Virginia, Inc., 50 T.C. 78 (1968); Boe v. Commissioner, 307 F. 2d 339 (C.A. 9, 1962), affirming 35 T.C. 720 (1961). If in fact the buyer bought a covenant not to compete, he has in law obligated himself to pay the seller an "amount" not to do something. This amount is a deductible item through the amortization of the covenant over its stated life. See 3B Mertens, Law of Federal Income Taxation, sec. 22.33 (1966 rev.), and numerous cases cited therein.

Our task is to decide just what was bought and what was sold. First, we must look at the legal standard by which the burden of proof must be measured. Respondent, as he has many times before, urges us to formally adopt the rule set forth in Commissioner v. Danielson, 378 F.2d 771, 775 (C.A. 3, 1967), vacating and remanding 44 T.C. 549 (1965), certiorari denied 389 U.S. 858 (1967), rather than the "strong proof" rule of Ullman v. Commissioner, 264 F. 2d 305, 308 (C.A. 2, 1959), affirming 29 T.C. 129 (1957). He contends that the Court of Appeals for the Ninth Circuit requires the Danielson rule. We disagree. None of the cases cited by respondent deal with covenants not to compete. The closest case to the Danielson rule is Brockway's Estate v. Commissioner, 219 F. 2d 400 (C.A. 9, 1954), where the court, citing and quoting Greenwood v. Commissioner, 134 F. 2d 915, 921 (C.A. 9, 1943), states: "In the absence of clear and convincing evidence that the parties had a contrary intent those instruments must be permitted to speak for themselves." This is not equivalent to the standard of proof mandated in the Danielson case by the Third Circuit. The parol evidence rule was invoked because parties to valid agreements were simply trying to vary the terms of their agreements rather than explain an ambiguity.

In view of our opinion in Jack E. Golsen, 54 T.C. 742, 756-758 (1970), affd. 445 F. 2d 985 (C.A. 10, 1971), certiorari denied 404 U.S. 940 (1971), we will apply the Danielson rule in the Third Circuit. However, we will continue to adhere to the "strong proof" rule in circuits which do not follow the Danielson rule.

The Court of Appeals for the Ninth Circuit has not yet found it necessary to reach the merits of the Danielson rule. See Throndson v. Commissioner, 457 F. 2d 1022, 1025–1026 (C.A. 9, 1972), affirming sub nom. J. Leonard Schmitz, 51 T.C. 306 (1968). In Schulz v. Commissioner, 294 F. 2d 52, 55 (C.A. 9, 1961), affirming 34 T.C. 235 (1960),

the Ninth Circuit applied the "strong proof" rule to a party seeking to alter a valid contract.

Respondent urges us to take the last step following what he thinks is our "approach" to the Danielson rule, citing Gordon A. Erickson, 56 T.C. 1112 (1971). In Erickson the agreement contained no ambiguity or uncertainty and clearly negated the hypothesis of one of the parties to the agreement who later sought to attach a different construction to its terms. The reversing bookkeeping entry in Erickson which gave rise to the dispute was not explained by the party making the reversing entry. There was a total failure of proof on that crucial issue. That being so, it is clearly erroneous to read Erickson as applying the Danielson rule. Admittedly the "strong proof" rule approaches, but does not equal, the stricter Danielson rule.

Alternatively, respondent contends that petitioner Baldarelli has failed to adduce the strong proof necessary to vary the terms of the sales contract.

Respondent advances the argument that there was in fact a partnership between petitioners Baldarelli and Shaffer. Without such a finding respondent points out that under section 16600, Cal. Bus. & Prof. Code (West 1964), the covenant here would be void. Section 16602 of the California Business & Professions Code (West 1964) permits the execution of a covenant not to compete upon the dissolution of a partnership. We have found there was a partnership and Baldarelli no longer seriously contends otherwise.

As respondent views it, the testimony of Shaffer that he would not and could not compete with Baldarelli and the subsequent unilateral allocation by Baldarelli of the entire purchase price to the covenant not to compete are so inconsistent that this Court should simply return to the written agreement and follow it. That agreement did not mention any allocation of the purchase price to the covenant not to compete and that should, according to the respondent, answer the question of what was intended.

The intention of the parties at the time of the execution of their agreement generally controls the value to be placed on the covenant.

A similar situation arose in Mills Pharmaceuticals, Inc., 57 T.C. 308, 313 (1971), where no evidence was shown that would indicate the contract should be interpreted in a manner at all inconsistent with its clear terms. Reliance on either the "strong proof" or Danielson rule lead to the same result.

Sec. 16600. Invalidity of contracts. Except as provided in this chapter, every contract by which anyone is restrained from engaging in a lawful profession, trade, or business of any kind is to that extent vold.

Sec. 16602. Partners; dissolution; agreement not to compete. Any partner may, upon or in anticipation of a dissolution of the partnership, agree that he will not carry on a similar business within a specified county or counties, city or cities, or a part thereof, where the partnership business has been transacted, so long as any other member of the partnership, or any person deriving title to the business or its goodwill from any such other member of the partnership, carries on a like business therein.

not to compete. See Annabelle Candy Co. v. Commissioner, 314 F. 2d 1, 7 (C.A. 9, 1962), which states that the failure to assign a value to the covenant not to compete at the time of execution is "pretty good evidence that no such allocation was intended [although] it is not conclusive on the parties as would be the case if there had been an express affirmance or disavowal in the agreement." For such a specific disavowal see Robert G. Tomlinson, 58 T.C. 570, 574 (1972).

We are concerned with whether the failure or refusal to allocate any portion of the purchase price to the covenant bears any "arguable relationship with business reality such that reasonable men, genuinely concerned with their economic future, might bargain for such an agreement." Schulz v. Commissioner, supra at 55.

Both parties to this agreement were reasonably knowledgeable in the field of Federal taxation. After the agreement was consummated both treated the transaction in a manner most favorable to themselves. Baldarelli knew that Shaffer wanted to go to graduate school and withdraw from the tax return preparation business. Shaffer knew how difficult it would be to compete with Baldarelli's franchises in a field where much effort is expended on advertising and maintaining customer goodwill. Whether such goodwill is the tendency of a former customer to consciously opt to return or is merely inertia, it is nonetheless a difficult habit pattern to alter.

In Harry A. Kinney, 58 T.C. 1038 (1972), parties to an agreement failed to allocate any portion of the sales price to the covenant not to compete because they could not agree on an allocation. For various reasons we found in the Kinney case that the covenant had substantial value, not the least of which was the agreement between the parties that it had a value. Consequently, we made an allocation. Conversely, in Rich Hill Insurance Agency, Inc., 58 T.C. 610 (1972), where no allocation was made by the parties, the agreement was not changed. We found that in other insurance agency purchases, where competition was reasonably anticipated, the knowledgeable purchaser in Rich Hill consistently demanded and received a covenant not to compete and allocated 50 percent of the purchase price to such covenants. Since no such competition was expected in Rich Hill and no covenant was sought, we would not imply one. Where no value could reasonably be found to be attributable to the covenant, no allocation is permissible. See Roy W. Johnson, 53 T.C. 414, 425 (1969); Howard Construction, Inc., 43 T.C. 343, 355 (1964); North American Loan & Thrift Co.

See also Rinehart Oil News Co., T.C. Memo. 1965-178, affirmed per curiam 369 F. 2d 692 (C.A. 5, 1966), where the contract agreement contained no allocation of the purchase price to the covenants and consequently no such allocation was made. Both parties were there aware of the covenants and their significance, yet they chose not to ascribe a price to them.