                        T.C. Memo. 2000-183



                      UNITED STATES TAX COURT



    HAAS & ASSOCIATES ACCOUNTANCY CORPORATION, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent

       MICHAEL A. HAAS AND ANGELA M. HAAS, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 16486-98, 16487-98.            Filed June 21, 2000.



     William Edward Taggart, Jr., for petitioners.

     Kathryn K. Vetter, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     SWIFT, Judge:   In these consolidated cases, respondent

determined deficiencies in petitioners’ Federal income taxes and

accuracy-related penalties as follows:
                                - 2 -


                                 1993           1994      1995
Michael and Angela Haas

  Deficiency                   $34,416           --        –-

  Sec. 6662(a) Accuracy-
    Related Penalty              6,883           --        --


Haas & Associates
  Accountancy Corp.

  Deficiency                      --          $10,833    $7,457

  Sec. 6662(a) Accuracy-
    Related Penalty               --            2,167     1,491


     Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the years in issue, and

all Rule references are to the Tax Court Rules of Practice and

Procedure.

     The issues for decision involve claimed ordinary deductions

relating to a covenant not to compete and to consulting services,

a claimed exclusion from income of $151,000 relating to receipt

of shares of stock in an accounting firm, and the accuracy-

related penalties.    All references to Haas are to petitioner

Michael Haas.


                           FINDINGS OF FACT

     Some of the facts have been stipulated and are so found.

     When the petitions were filed, petitioners Michael and

Angela Haas resided in Novato, California, and the principal
                                - 3 -

place of business of petitioner Haas & Associates Accountancy

Corp. (Haas & Associates) was located in Novato, California.

Haas & Associates was incorporated in the State of California.

     In 1977, Haas graduated from the University of San Francisco

with a degree in accounting and was employed for 2 years as an

accountant for Ernst & Ernst.

     In August of 1979, Haas began employment as an accountant

for Dean, Hale & Petrie (DHP), a public accounting firm

incorporated in California.   The stock of DHP was owned

predominantly, if not exclusively, by Kurt Petrie (Petrie).    In

1980, Haas became a certified public accountant.

     On March 7, 1983, the name of DHP was changed to Dean,

Petrie, and Haas (DPH), and on June 1, 1984, 10 percent of the

outstanding shares of stock in DPH was transferred to Haas.

Petrie owned the other 90 percent of the DPH stock, and Petrie

served as president and general manager of DPH.

     In 1992, after working together for 13 years, differences of

opinion developed between Haas and Petrie over how DPH should be

managed.   As a result, Haas informed Petrie that he wanted to

leave DPH.   Haas attempted to negotiate an agreement with Petrie

under which he would pay DPH for the right to take over the

accounting services relating to some of DPH’s clients with whom

Haas had developed a strong relationship.   Haas and Petrie failed

to reach an agreement, and in November of 1992 Haas and Petrie
                               - 4 -

hired attorneys to continue the negotiations.    The negotiations

turned acrimonious and resulted in a series of offers and

counteroffers.

     On January 15, 1993, Haas and Petrie signed a contract

under which Haas agreed to make certain payments to DPH in return

for which accounting services relating to approximately

180 clients of DPH were to be turned over to a new corporation to

be owned by Haas.   In prior years, the accounting services

performed by DPH for the 180 clients produced for DPH

approximately $600,000 in annual gross receipts.

     To effect this agreement, on January 25, 1993, Haas &

Associates, a new subsidiary of DPH, was formed, and on

February 25, 1993, the name of DPH was changed to Dean & Petrie

(DP).1   In a March 5, 1993, separation agreement between Haas,

Petrie, and DP, the division between Haas and Petrie of the DP

accounting firm was formalized.    As a first step in the

transaction, Haas received an additional 8.26 percent of the

outstanding shares of DP stock, bringing Haas’ total stock

interest in DP to 18.26 percent.

     Haas’ 18.26-percent stock interest in DP was then redeemed

by DP, and all of the shares of stock in Haas & Associates was

transferred to Haas.   The files relating to the 180 former

clients of DPH were transferred to Haas.    DP and Petrie


1

     Hereinafter, we generally use DP to refer to DPH and to DP.
                              - 5 -

individually agreed, for a period of 36 months, not to compete

with Haas and Haas & Associates (i.e., not to solicit any of the

180 clients transferred to Haas and to Haas & Associates), and DP

and Petrie nominally agreed to provide limited “transitional”

consulting services to Haas and to Haas & Associates relating to

the 180 clients.

     In the separation agreement, the fair market values of DPH

as a corporation (as of December 1, 1992), of Haas’ stock

interests in DP, of the 180 clients transferred to Haas, of the

180 client files, of the covenant not to compete, and of the

right to receive consulting services were indicated as follows:


                      Item                      Value

          DPH as a Corporate Entity          $1,830,079

          8.26% Stock Interest in
            DP Transferred to Haas              151,165

          18.26% Stock Interest in DP
            Transferred by Haas to DP           334,087

          180 Clients Transferred to
            Haas and Haas & Associates          334,087

          180 Client Files                       10,000

          Covenant not to Compete               190,000

          Right to Receive Consulting
            Services                             63,500


     Under the terms of the separation agreement, the receipt by

Haas of the additional 8.26-percent stock interest in DP was to
                               - 6 -

be treated by Haas as representing $151,165 in taxable

compensation and as an ordinary business expense for DP.   Haas’

exchange of his DP stock for the stock in Haas & Associates was

to be treated as a tax-free reorganization under sections 355 and

368(a)(1)(D).

     Under the terms of the separation agreement, the 180 client

files, the covenant not to compete, and the right to receive

consulting services were transferred to Haas individually in

exchange for the payment by Haas to DP of $263,500, the indicated

total value therefor.2

     Until January 1, 1994, Haas carried on two separate

accounting practices--one individually and one through Haas &

Associates.

     On January 1, 1994, Haas transferred all of the assets of

his individual accounting practice to Haas & Associates.

     Haas and his wife Angela timely filed their 1993 joint

Federal income tax return.   On their return, Haas included as

ordinary income the $151,000 reflecting the indicated value for

the shares of stock in DP that Haas had received.3



2
     $10,000 relating to the client files + $190,000 relating to
the covenant not to compete + $63,500 relating to the consulting
services = $263,500.
3
     DP issued to Haas a Form W-2, Wage and Tax Statement, in the
amount of $151,000 relating to the additional 8.26-percent stock
interest in DP that Haas received even though the value indicated
therefor in the separation agreement was $151,165.
                               - 7 -

     For 1993, 1994, and 1995, Haas & Associates timely filed

corporation income tax returns.   On Haas and his wife’s 1993

joint Federal income tax return and on Haas & Associates’ 1994

and 1995 corporation income tax returns, the $190,000 relating to

the covenant not to compete was amortized as an ordinary and

necessary business expense deduction, and the $63,500 relating to

consulting services was deducted in 1993 as an ordinary business

expense as follows:


                               Amortization         Deduction
                              Deduction for        Relating to
                              Covenant not         Consulting
                      Year      to Compete          Services

Haas’ Joint
  Income Tax Return   1993        $58,056           $63,500

Haas & Associates’
  Corporation
  Income Tax Return   1994         63,333              -–
                      1995         63,333              -–


     On audit, respondent disallowed the above deductions

relating to the covenant not to compete and to the consulting

services.   In the alternative only, if these deductions are not

allowed, petitioners claim that the $151,000 relating to the
                                - 8 -

8.26-percent stock interest in DP that Haas received should be

excluded from Haas’ income.4


                               OPINION

$190,000 Relating to Covenant Not To Compete

     Under section 162(a), a taxpayer may deduct all ordinary and

necessary expenses incurred in carrying on a trade or business.

     Generally, amounts paid for covenants not to compete are

amortized over the life of the covenants as current business

expenses.   See Warsaw Photographic Associates, Inc. v.

Commissioner, 84 T.C. 21, 48 (1985).     Amounts paid, however, for

goodwill or for going concern value of a business generally are

treated as nondeductible capital expenditures.    See Fong v.

Commissioner, T.C. Memo. 1984-402, affd. without published

opinion 816 F.2d 684 (9th Cir. 1987).

     To be respected for Federal income tax purposes, covenants

not to compete should reflect economic reality.    See Patterson v.

Commissioner, 810 F.2d 562, 571 (6th Cir. 1987), affg. T.C. Memo.

1985-53; Lemery v. Commissioner, 451 F.2d 173, 174 (9th Cir.

1971), affg. per curiam 52 T.C. 367 (1969).

     The division between Haas and Petrie was acrimonious and

strained, and we are satisfied that Petrie could have made a



4
     Amortization deductions were also claimed for the $10,000
relating to the client records, which respondent did not
disallow.
                               - 9 -

strong effort to compete for the 180 clients that were

transferred to Haas.   Petrie was an experienced and successful

accountant who, after the division, was the president and sole

shareholder of DP.   We believe that the covenant not to compete

to which Petrie and DP agreed and for which Haas paid $190,000

reflects economic substance and that the $190,000 represented a

reasonable amount for the covenant not to compete.    Based on

prior years, the clients protected by the covenant represented

approximately $600,000 in annual gross receipts.    The $190,000

for the 3-year covenant not to compete is properly amortizable as

an ordinary and necessary business expense.


$63,500 Relating to Consulting Services

     Petitioners contend that the $63,500 paid by Haas for the

right to receive consulting services from Petrie and DP was

necessary to aid in the division of the accounting practice.

     Respondent contends that little, if any, consulting services

were provided by Petrie and DP, that petitioners have not

satisfied their burden of establishing Haas’ need for the

consulting services, and that any consulting services that were

provided by Petrie and DP (or its predecessor DPH) occurred

before the division and should be treated as nondeductible

startup expenditures of Haas & Associates.    See sec. 195.   We

agree with respondent.
                                 - 10 -

     The evidence does not establish that the $63,500 payment

relating to the so-called consulting services represented an

ordinary and necessary business expense for Haas or for Haas &

Associates.   See Rule 142(a).    Haas was an experienced accountant

and had good relationships with the clients.    The credible

evidence does not establish the need for any such services.

     Further, any payment relating to consulting services that

Petrie and DPH provided before the division of the DPH accounting

firm is to be treated as a nondeductible startup expenditure of

Haas’ individual accounting practice or of Haas & Associates’

accounting practice.   See sec. 195.


$151,000 Relating to 8.26-Percent Stock
Interest and Section 6662(a) Penalty

     Alternatively, petitioners claim that the $151,000 relating

to Haas’ receipt of the additional 8.26-percent stock interest in

DP should be excluded from their income.

     Under the "strong proof" rule generally followed by this

Court, taxpayers challenging the tax treatment or allocations

reflected in purchase and sale contracts may succeed only by

producing strong proof that the revised allocations better

reflect the actual intent of the parties and the economic

realities.    See Schulz v. Commissioner, 294 F.2d 52, 54 (9th Cir.

1961), affg. 34 T.C. 235 (1960); Meredith Corp. & Sub. v.
                             - 11 -

Commissioner, 102 T.C. 406, 438 (1994); Major v. Commissioner, 76

T.C. 239, 247 (1981).

     We shall, however, apply the Danielson rule5 if the Court of

Appeals to which the case is appealable would do so.   See Lardas

v. Commissioner, 99 T.C. 490, 498 (1992); Golsen v. Commissioner,

54 T.C. 742, 757 (1970), affd. 445 F.2d 985 (10th Cir. 1971);

Lang v. Commissioner, T.C. Memo. 1993-474.   Because the Court of

Appeals for the Ninth Circuit, the Court of Appeals to which this

case is appealable, has not explicitly adopted the Danielson

rule, see Schmitz v. Commissioner, 51 T.C. 306, 315-316 (1968),

affd. sub nom. Throndson v. Commissioner, 457 F.2d 1022, 1025

(9th Cir. 1972), we shall apply the “strong proof” rule.

     The basis for petitioners’ alternative contention is that

the $151,000 reported as income on their 1993 joint Federal

income tax return represented artificial income and should not be

charged to Haas as income.

     Respondent contends that petitioners have not presented

strong proof to overcome the treatment in the separation

agreement by Haas, Petrie, and DP of the $151,000 as ordinary

income to Haas.


5
     Under the Danielson rule, a party may seek to alter the
terms of an agreement only by adducing proof which in an action
between the parties to the agreement would be admissible to alter
the agreement or to show its unenforceability because of mistake,
undue influence, fraud, duress, etc. See Commissioner v.
Danielson, 378 F.2d 771, 775 (3d Cir. 1967), vacating and
remanding 44 T.C. 549 (1965).
                              - 12 -

     No credible evidence refutes the income character of the

$151,000.   Haas received the additional 8.26-percent stock

interest in DP that was valued at $151,000 and treated as

nonemployee compensation.   Haas agreed to report and did report

the $151,000 on his and his wife’s 1993 joint Federal income tax

return as taxable income.   Petitioners have not provided adequate

evidence to support the recharacterization of the $151,000 as

nontaxable income.

     Under section 6662(a), a penalty is imposed equal to 20

percent of the portion of the underpayment that is attributable

to a substantial understatement of income tax (namely, an

understatement for a year in excess of 10 percent of the amount

required to be shown on the Federal income tax return or $5,000).

See sec. 6662(d)(1).   However, if the taxpayer has substantial

authority for the tax return position, the penalty does not

apply.   See sec. 6662(d)(2)(B)(i).    We have disallowed the

$63,500 claimed deduction relating to consulting services

primarily on grounds of petitioners’ burden of proof.     We believe

that petitioners, on the limited facts in evidence relating to

this issue, had a reasonable basis for claiming a current

ordinary deduction for the $63,500 relating to the consulting

services.   We do not sustain the section 6662(a) penalty.
                        - 13 -

To reflect the foregoing,


                                  Decisions will be entered

                             under Rule 155.
