                  T.C. Memo. 2000-10



                UNITED STATES TAX COURT



     JOHN T. JORGL AND SHARON ILLI, Petitioners v.
      COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket No. 11508-98.          Filed January 11, 2000.



     Ps, husband and wife, operated a child care business of
which P husband was the sole shareholder. P subsequently
established a charitable remainder unitrust and contributed
all of his shares in the child care business to the trust.
The trust later sold the business and received all proceeds
of the sale. The purchase agreement between the trust and
the buyers contained a covenant not to compete, and Ps
signed a separate document entitled “COVENANT NOT TO
COMPETE” at the time of sale. Ps reported no income as a
result of this transaction, and R determined a deficiency
for taxes attributable to the portion of the sale price
allocated to a covenant not to compete.
     Held: Execution of a noncompetition agreement resulted
in taxable income to Ps to the extent of the purchase price
attributable thereto. Although the trust received all
proceeds of the sale, Ps were the true earners of the
income. Commissioner v. Sunnen, 333 U.S. 591, 604 (1948)
and Lucas v. Earl, 281 U.S. 111, 114-115 (1930), applied.
                                - 2 -

     The intentions of the parties involved in the transaction
     and the economic reality of Ps’ covenant render a portion of
     the consideration paid properly allocable to their promise.

          Held, further, Ps, relying upon professional advisers,
     acted reasonably and in good faith with respect to their tax
     treatment of the sale transaction and are not liable for the
     accuracy-related penalty under sec. 6662, I.R.C., for a
     substantial understatement of income tax.



     William J. Mitchell and Kevin P. Courtney, for petitioners.

     Steven Walker, for respondent.



              MEMORANDUM FINDINGS OF FACT AND OPINION

     NIMS, Judge:   Respondent determined a Federal income tax

deficiency for petitioners’ 1993 taxable year in the amount of

$120,439.   Respondent also determined an accuracy-related penalty

of $24,088 for 1993, pursuant to section 6662(a).

     The issues for decision are as follows:

     (1) Whether the sale of a business by a charitable remainder

unitrust resulted in taxable income to petitioners by reason of a

covenant not to compete executed in connection with the sale; and

     (2) whether petitioners are liable for the section 6662(a)

accuracy-related penalty on account of a substantial

understatement of income tax.
                               - 3 -

     Unless otherwise indicated, all section references are to

sections of the Internal Revenue Code in effect for the year in

issue, and all Rule references are to the Tax Court Rules of

Practice and Procedure.

                          FINDINGS OF FACT

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

The stipulations of the parties, with accompanying exhibits, are

incorporated herein by this reference.

     John T. Jorgl and Sharon Illi (petitioners) are married and

resided in Orange Park, Florida, at the time of filing their

petition in this case.

The Business--Little Rascals Child Care Centers, Inc.

     Mr. Jorgl (petitioner) collaborated with Ms. Melanie Biggs

to found a licensed day care center and school in Sunnyvale,

California.   An architect by profession, petitioner designed the

facility.   The business was incorporated under the laws of

California in June of 1980 as Little Rascals Child Care Centers,

Inc. (Little Rascals), and opened the following September.

Petitioner and Ms. Biggs also founded a second child care center

in Milpitas, California, which was sold in 1986 or 1987.

     In 1985, petitioner purchased the stock owned by Ms. Biggs

in Little Rascals and became the sole shareholder.   He maintained

an office on the center’s premises, managed the business

operations of the enterprise, served as president, and was a
                               - 4 -

member of the board of directors.   Petitioner Ms. Illi became

director of the school as well as a corporate officer.      Both were

employees of the corporation and were compensated for their

services.

     Little Rascals provided child care and development services

for children ranging in age from 3 months to school age.      Such

services included direct care and supervision; resource and

referral programs; and instructional programs in academics,

social skills, arts, and athletics.    The center met all

governmental requirements for licensing and had an excellent

reputation in the community as a quality child care center.

Petitioners developed and maintained close interpersonal

relationships with parents, teachers, and staff.    This hands-on

approach engendered a trust and confidence which frequently led

parents to return with their later children.

Transfer of the Business to a Charitable Unitrust

     In November of 1990, petitioners met with attorney Richard

Polse and informed him that they were considering the sale of the

Little Rascals business and were interested in achieving estate

planning and charitable giving goals.    Petitioners were concerned

with establishing an income source for support during retirement

years.   They also desired to contribute to Project Grant a Wish

after witnessing the generosity of the charity toward a child in

their center who had died of leukemia.    Mr. Polse advised
                               - 5 -

petitioners of the way in which a charitable remainder unitrust

could facilitate these aims.   He, as well as petitioners’

accountant, Tim Kehl, also explained the tax consequences of such

an arrangement.

     Petitioners decided to form a charitable remainder unitrust,

and the trust instrument was prepared by Mr. Polse.   Petitioners

were designated as the income beneficiaries of the Jorgl Unitrust

(the trust), and Project Grant a Wish was named the charitable

remainder beneficiary.   For their lifetimes, petitioners were to

receive annual distributions totaling the lesser of the trust

income for the taxable year or 9 percent of the fair market value

of the trust assets.   The trust was irrevocable, and petitioners

were given no rights to or control over trust assets beyond

receipt of the above-specified distributions.   Following their

deaths, the trust would terminate and Project Grant a Wish would

receive the trust corpus.   Cupertino National Bank was named as

the trustee.

     On June 26, 1991, petitioner as grantor and Cupertino

National Bank as trustee executed a “Charitable Remainder

Unitrust Agreement”.   On June 27, 1991, the stock certificate

transferring all of petitioner’s shares in Little Rascals to

Cupertino National Bank as trustee for the Jorgl Unitrust was

signed.   Petitioners continued to serve as employees, officers,

and directors of Little Rascals.
                                 - 6 -

Sale of the Business to the Shahs

     A meeting of the Little Rascals board of directors was held

on June 27, 1991.   The board resolved to proceed with having the

corporation listed for sale with a business broker, subject to

the signing of the listing by the trustee owner.      The brokerage

firm so engaged subsequently prepared an extensive prospectus to

market Little Rascals.   This document erroneously stated that the

center “was established in 1980 by the current owner, an

architect”.   One of the “TERMS” recited in the document was

“COVENANT 5 years 100 miles”.

     In early 1993, this prospectus was presented to Divyesh and

Priti Shah by Art Withop, their business broker.      The Shahs

understood from reading the prospectus that the current owner was

an architect and the founder of the center, and that the covenant

was being offered by him.   The Shahs and their broker met with

petitioners and the listing broker in April of 1993 to discuss

the possible sale of the business.       After a series of offers and

counteroffers passing between the brokers, the Shahs prepared a

“Purchase Agreement for Corporate Stock”.      It was at this time

that they first learned of the existence of the trust.      The

trustee had not been involved in prior meetings or in the

negotiation of the sale price.    On May 24, 1993, Mr. Shah

executed the purchase agreement as “buyer”, and on May 26, 1993,
                               - 7 -

an officer of Cupertino National Bank as trustee for the Jorgl

Unitrust signed as “seller”.   Petitioners were neither named in

nor signatories to this document.

     The purchase agreement designated $650,000 as the “purchase

price of the stock and any covenant not to compete”.     Paragraph

16 then contained the following language regarding a covenant not

to compete:

     COVENANT NOT TO COMPETE: For a period of 5 consecutive
     years from COE [closing of the agreed escrow], seller
     shall not directly or indirectly carry on a similar
     business within a radius of 100 miles of the business
     being sold, nor assist anyone else except the
     corporation and buyer to do so within these limits: nor
     shall seller have any interest, directly or indirectly,
     in such business, except as an employee of the business
     being sold. Paragraph 19 will not prevent injunctive
     relief to enforce this covenant pending arbitration.
     Any part of the purchase price to be allocated to this
     covenant shall be agreed upon by the parties and
     submitted to escrow prior to COE.

In addition, a handwritten amendment stating “and officers” was

inserted by the Shahs’ broker after the first “seller” in the

printed paragraph.

     Mr. Shah subsequently drafted a covenant not to compete for

petitioners and the Shahs to sign.     When Mr. Shah then called

petitioner to inform him that the draft had been prepared,

petitioner requested that the document be sent to his attorney,

Mr. Kehl, for review.   On July 29, 1993, Mr. Kehl received a fax

of a noncompetition agreement “between John Jorgl and Sharon Illi

* * * and Divyesh P. Shah and Priti D. Shah”.     Mr. Kehl advised
                                - 8 -

petitioners not to sign the document in the form presented.    He

told petitioners that “they would be okay with signing it if the

Shahs’ name [sic] were removed”.    Thereafter, in a subsequent

draft, Mr. Shah deleted any reference to himself and his wife.

This latter document provided that instead of not competing with

the Shahs, petitioners would not compete with Little Rascals.

     The closing of the sale took place on July 30, 1993, in San

Jose, California.   Closing documents signed by the Shahs and the

trustee stated:   “Purchase price of stock (pay to Seller):

350,000.00" and “Purchase price of Covenant Not to Compete (pay

to Seller):   300,000.00".   Also at the closing, petitioners alone

signed a separate document entitled “COVENANT NOT TO COMPETE” and

reading in its entirety as follows:

     This agreement is between John Jorgl and Sharon Illi,
     who were officer’s [sic] of Little Rascals Child Care
     Centers, Inc. and Little Rascals Child Care Centers,
     Inc. regarding the sale of Little Rascals Child Care
     Centers signed on the 30th of July, 1993.

     The agreement is as follows:

     1) John Jorgl and Sharon Illi will not compete with
     Little Rascals in the preschool/day care/school age
     children business; nor assist anyone else except the
     corporation and the buyer of Little Rascals within
     limits defined herein; nor have any interest, directly
     or indirectly, in such business except as an employee
     of the business being sold for a total of 5 consecutive
     years within a 100 mile radius of the business (Little
     Rascals).
                               - 9 -

     2) John Jorgl and Sharon Illi are signing this document
     with full understanding that competing with Little
     Rascals would be a breach of contract and both John and
     Sharon could be severly [sic] liable.

     The Shahs discussed their reasons for the above document

during the closing, expressing concern that petitioners might

personally open another child care center, yet all sales

instruments were being signed by the bank on behalf of the trust.

Petitioners had indicated that they were leaving the area to

travel, but the Shahs perceived the possibility of petitioners’

returning and using their reputation to start another center as a

continuing threat.   Petitioners were 50 and 37 years of age and

in good health at the time of the sale.    Although petitioners

viewed the separate covenant as a voluntary accommodation to the

Shahs, they signed in good faith and have never engaged in

proscribed competitive activities.     They departed from California

shortly after the closing and have since resided elsewhere.

     The $300,000 allocated to a covenant not to compete was

never discussed.   Mr. Shah calculated the value and had it

included in the closing documents.     None involved objected, so no

negotiations took place.   Mr. Shah prepared a document basing the

value of the covenant not to compete on tuition that would be

lost if 10 to 15 children left the center due to competition.

His computations resulted in a $600,000 figure which he then

multiplied by a 50-percent “fudge factor”.    He was aware that, as

buyer, allocating value to a covenant not to compete would be
                              - 10 -

advantageous from a tax standpoint.     For reasons undisclosed at

trial, respondent now concedes that the value of the covenant was

$200,000 and not $300,000 as allocated in the closing statements.

The full $650,000 price was deposited directly from escrow into

the trust’s account, and petitioners received no additional

compensation for signing the separate document.

     Following the closing, the Shahs received from petitioners

the business training referenced in the prospectus and the

purchase agreement.   The prospectus had indicated that “TRAINING

2 weeks @ 20 hrs.” was included in the sale price.     Section 15 of

the purchase agreement similarly stated:     “TRAINING:   Seller

shall train buyer in the operation of the business”.      On August

14, 1993, petitioners sent a letter to memorialize completion of

this training which reads in part:     “As of August 13, 1993,

Sharon has completed the training with Priti in accordance with

the requirements of our Purchase Agreement dated May 24, 1993,

Section 15.”

     Petitioners’ Federal income tax return for 1993 did not

reflect any income as a consequence of the above transactions.

                              OPINION

     We must decide whether the sale of a business operated by

petitioners, after petitioner had transferred all stock in the
                              - 11 -

business to a charitable remainder unitrust, resulted in taxable

income to petitioners by reason of a covenant not to compete

executed at the time of the sale.

     Petitioners contend that because ownership of the business

had been irrevocably transferred to the trust, because they were

not parties to the purchase agreement between the trust and the

buyers, and because the trust received the entire proceeds of the

sale, the covenant not to compete contained in such agreement can

have no tax consequences for them.     Petitioners further assert

that the separate document entitled “COVENANT NOT TO COMPETE” was

signed by them only as an accommodation and cannot result in

taxable income because it is without true economic value,

unsupported by consideration, and unenforceable under California

covenant law.

     Conversely, respondent argues that the portion of the

purchase price attributable to a covenant not to compete is

taxable to petitioners.   Respondent contends that because

petitioners executed a personal covenant in conjunction with the

sale of the Little Rascals business and because they, not the

trust, posed the only real threat of competition, they cannot

escape tax on the income apportioned to such a covenant by

anticipatorily assigning that income to the trust.     Respondent
                                - 12 -

also alleges that the covenant has significant economic value, is

supported by consideration, and is enforceable under California

covenant law.

     We conclude that a portion of the consideration paid can

properly be allocated to the promise made by petitioners.      The

intentions of the parties involved in the transaction and the

economic reality of petitioners’ agreement support such an

allocation.   Hence, petitioners must be deemed to have earned

income by agreeing not to compete and to have anticipatorily

assigned such income to the trust.       They therefore are required

to recognize taxable income, to the extent of the value of the

covenant, in connection with the sale of Little Rascals.

Deficiency Issue

     General Rules

     As a general rule, section 61 defines gross income as “all

income from whatever source derived”.      Case law then specifies

that consideration paid for a covenant not to compete is included

within this broad definition.    See, e.g., Sonnleitner v.

Commissioner, 598 F.2d 464, 466 (5th Cir. 1979), affg. T.C. Memo.

1976-249; Montesi v. Commissioner, 340 F.2d 97, 100 (6th Cir.

1965), affg. 40 T.C. 511 (1963).     A charitable remainder

unitrust, however, is not subject to income tax by reason of

section 664(c) unless it has unrelated business income, which is

not the case here.
                              - 13 -

     In the present matter, the parties do not contest these

basic propositions but differ as to whether any portion of the

purchase price received by the trust can be attributed and taxed

to petitioners on the grounds of a covenant not to compete.

Because all payments flowing from the sale of the Little Rascals

business were made directly to the trust, and because respondent

does not contend that the trust failed to satisfy the

requirements set forth in section 664 for the creation of a valid

charitable remainder unitrust, resolution of this question turns

on whether petitioners can be said to have actually earned

income, which they anticipatorily assigned to the trust, by

reason of a promise not to compete.

     The principle that substance should govern over form is well

established in tax law.   See, e.g., Higgins v. Smith, 308 U.S.

473, 477 (1940); Turner Broad. Sys., Inc. & Subs. v.

Commissioner, 111 T.C. 315, 326 (1998); Palmer v. Commissioner,

62 T.C. 684, 691 (1974), affd. 523 F.2d 1308 (8th Cir. 1975).     A

corollary to this principle is the assignment of income theory,

under which mere assignment of a right to receive income is

insufficient to insulate the assignor from tax liability.    See,

e.g., Commissioner v. Sunnen, 333 U.S. 591, 604 (1948); Lucas v.

Earl, 281 U.S. 111, 114-115 (1930); Palmer v. Commissioner, supra

at 692.   The true earner of income must bear the tax

consequences.   See, e.g., Commissioner v. Sunnen, supra at 604;
                               - 14 -

Lucas v. Earl, supra at 114-115; Palmer v. Commissioner, supra at

692.    Thus, if a portion of the consideration paid for Little

Rascals is properly allocable to petitioners’ promise, they will

be deemed to have assigned to the trust income they earned by

agreeing not to compete.

       In determining whether such a “tax-enforceable” allocation

to a covenant has been or should be made, courts have articulated

various standards for evaluating sales agreements.    See Lazisky

v. Commissioner, 72 T.C. 495, 500-502 (1979), affd. sub nom.

Magnolia Surf, Inc. v. Commissioner, 636 F.2d 11 (1st Cir. 1980).

When a written contract specifies the portion of the purchase

price to be allocated to a covenant not to compete and one of the

parties seeks to deviate therefrom, two tests frequently adhered

to in deciding whether such deviation is warranted are the strong

proof rule and the so-called Danielson rule.    See, e.g.,

Commissioner v. Danielson, 378 F.2d 771, 775 (3d Cir. 1967),

vacating and remanding 44 T.C. 549 (1965); Elrod v. Commissioner,

87 T.C. 1046, 1065-1066 (1986); Smith v. Commissioner, 82 T.C.

705, 712-714 (1984); Lazisky v. Commissioner, supra at 500-502.

       Under the strong proof rule, a taxpayer attempting to

challenge a contractual allocation must adduce “strong proof”,

meaning more than a preponderance of the evidence, that the terms

of the written instrument do not reflect the actual intentions of
                               - 15 -

the contracting parties.    See, e.g., Elrod v. Commissioner, supra

at 1066; Smith v. Commissioner, supra at 713 n.8.    Under the more

stringent Danielson rule,

     a party can challenge the tax consequences of his
     agreement as construed by the Commissioner only by
     adducing proof which in an action between the parties
     to the agreement would be admissible to alter that
     construction or to show its unenforceability because of
     mistake, undue influence, fraud, duress, etc. * * *
     [Commissioner v. Danielson, supra at 775.]

     This Court typically applies the strong proof rule but will

apply the Danielson rule when the circuit to which appeal would

normally lie has adopted that test.     See Golsen v. Commissioner,

54 T.C. 742, 756-757 (1970), affd. 445 F.2d 985 (10th Cir. 1971);

see also Elrod v. Commissioner, supra at 1065-1066; Smith v.

Commissioner, supra at 712 n.6.    However, when a contract fails

to make an allocation of purchase price to a covenant not to

compete or does so in an ambiguous manner, neither the strong

proof rule nor the Danielson rule is applicable.    See, e.g.,

Elrod v. Commissioner, supra at 1066; Smith v. Commissioner,

supra at 713-714.   Instead, the taxpayer must establish by a

preponderance of the evidence that respondent’s determination of

a deficiency is erroneous.    See Rule 142(a); Peterson Mach. Tool,

Inc. v. Commissioner, 79 T.C. 72, 81-82 (1982), affd. per order

(10th Cir., April 2, 1984).

     There are two primary elements to which the taxpayer’s

burden of proof relates.    See Peterson Mach. Tool, Inc. v.
                              - 16 -

Commissioner, supra at 81.   The threshold inquiry is whether the

parties mutually intended that an allocation of purchase price be

made to the covenant at issue.   See, e.g., Patterson v.

Commissioner, 810 F.2d 562, 570-571 (6th Cir. 1987), affg. T.C.

Memo. 1985-53; Better Beverages, Inc. v. United States, 619 F.2d

424, 430 (5th Cir. 1980); Peterson Mach. Tool, Inc. v.

Commissioner, supra at 81, 83.   Such mutual intent will typically

be deemed to exist where “the parties considered the covenant as

a valuable part of the entire consideration for the agreement.”

Illinois Cereal Mills, Inc. v. Commissioner, T.C. Memo. 1983-469,

affd. 789 F.2d 1234 (7th Cir. 1986).   Relevant factors for

ascertaining intent include both the language of the contract

itself and the circumstances surrounding its negotiation.     See,

e.g., Patterson v. Commissioner, supra at 570; Peterson Mach.

Tool, Inc. v. Commissioner, supra at 83-84.

     If such mutual intent is found, courts then proceed to

evaluate whether an allocation comports with “economic reality”.

See, e.g., Patterson v. Commissioner, supra at 571; Peterson

Mach. Tool, Inc. v. Commissioner, supra at 84.   Economic reality

is defined as “‘some independent basis in fact or some arguable

relationship with business reality such that reasonable men,

genuinely concerned with their economic future, might bargain for

such an agreement.’”   Patterson v. Commissioner, supra at 571

(quoting Schulz v. Commissioner, 294 F.2d 52, 55 (9th Cir. 1961),
                                - 17 -

affg. 34 T.C. 235 (1960)).   An allocation will generally be given

effect where “the covenants had independent economic significance

such that * * * [the Court] might conclude that they were a

separately bargained-for element of the agreement.”       Peterson

Mach. Tool, Inc. v. Commissioner, supra at 81.

     Application

     The instant case involves two documents purporting to

establish a covenant not to compete:     The purchase agreement and

the separate covenant document.    Paragraph 16 of the purchase

agreement dated May 24, 1993, is labeled “COVENANT NOT TO

COMPETE”.   The printed language of the paragraph states, in

pertinent part, that “seller shall not directly or indirectly

carry on a similar business”.    A handwritten amendment “and

officers” has been added after “seller”.    The parties to the

agreement are the Shahs, designated as “buyer”, and the Jorgl

Unitrust, designated as “seller”.    The agreement was signed by

Mr. Shah and by an officer of Cupertino National Bank as sole

trustee for the Jorgl Unitrust.    It was not signed by

petitioners.

     Petitioners alone also signed a separate document entitled

“COVENANT NOT TO COMPETE” at the closing on July 30, 1993.      This

document states that it is “between John Jorgl and Sharon Illi,

who were officer’s [sic] of Little Rascals Child Care Centers,
                               - 18 -

Inc. and Little Rascals Child Care Centers, Inc.”    It provides

that “John Jorgl and Sharon Illi will not compete with Little

Rascals”.

     The allocation of purchase price at issue here was made in a

second pair of documents.    The BUYER’S CLOSING STATEMENT, signed

by Mr. Shah, and the SELLER’S CLOSING STATEMENT, signed by the

trustee, each state:   “Purchase price of Covenant Not to Compete

(pay to Seller):   300,000.00".   The separate covenant document

signed by petitioners makes no reference to price or payment.

The purchase agreement provides that $650,000 is the “purchase

price of the stock and any covenant not to compete”.

  Applicability of the Danielson Rule or the Strong Proof Rule

     Given this scenario, the first question that must be

addressed is whether either the Danielson rule or the strong

proof rule applies.    We note as a threshold matter that appeal

would normally lie to the Court of Appeals for the Eleventh

Circuit, where decisions handed down by the Court of Appeals for

the Fifth Circuit prior to October 1, 1981, are precedential.

See Bonner v. City of Prichard, 661 F.2d 1206, 1209 (11th Cir.

1981).   Since the Court of Appeals for the Fifth Circuit adopted

the Danielson rule in Spector v. Commissioner, 641 F.2d 376, 384,

386 (5th Cir. 1981), revg. 71 T.C. 1017 (1979), we shall examine
                               - 19 -

the above agreements in light of its dictates to the extent

applicable.   However, we conclude that ambiguities render

adherence to the Danielson standard inappropriate here.

     An allocation of $300,000 to “Covenant Not to Compete” was

made in the closing statements.   Yet documents relating to the

transaction can be read, at least facially, as establishing two

such covenants.    Both petitioners and the trust, an independent

legal entity, signed agreements apparently promising not to

compete.    It is thus unclear from the face of the documents what

part of the price was paid for which promise.    Hence, the

relevant instruments do not evidence an unequivocal allocation of

payment to a specific covenant that would justify application of

the Danielson rule or, in the alternative, the strong proof rule.

Petitioners’ burden is therefore to establish by a preponderance

of the evidence that the parties lacked mutual intent to allocate

any portion of the consideration paid to petitioners’ promise or

that the allocation had no basis in economic reality.

           Existence of Mutual Intent Regarding Allocation

     Having determined the appropriate standard of proof, we next

address the question of whether those involved in the sale

process mutually intended to allocate consideration to the

agreement made by petitioners.    As a threshold matter, it should

be noted that to view the separate document signed by petitioners

as entirely independent from and unrelated to the sales
                              - 20 -

instruments executed by the trust would be to introduce a level

of artificiality warranted neither by the terms of the documents

nor by the attendant circumstances.    Although petitioners urge

such a narrow perspective, a reading of all documents together as

evidencing a single, composite transaction appears to be more

consistent with the parties’ mind-sets at the time of the sale.

     The purchase agreement makes reference to covenants from

“seller” and, through conscious addition by the buyers’ agent,

“officers”.   The agreement further states that $650,000 is the

purchase price for the stock and “any covenant not to compete”

(emphasis added); it does not preclude apportionment to covenants

other than those stated therein.   Moreover, the separate covenant

executed by petitioners then explicitly sets forth that it is an

agreement “regarding the sale of Little Rascals Child Care

Centers signed on the 30th of July, 1993.”    It thus seems

reasonable to construe the separate document as carrying out the

“and officers” annotation in the purchase agreement.

     In addition, the letter written by petitioners to the Shahs

only 2 weeks after the sale reveals that they did not view the

components of the transaction with the degree of isolation for

which they now contend.   The letter reads:   “As of August 13,

1993, Sharon has completed the training with Priti in accordance

with the requirements of our Purchase Agreement dated May 24,

1993, Section 15.”   The use of “our Purchase Agreement”, combined
                              - 21 -

with the fact that section 15 says “TRAINING:   Seller shall train

buyer”, indicates that petitioners saw themselves as material

participants in aspects of the sale other than their separate

agreement not to compete.   They also apparently recognized that,

legal obligations aside, only they could meaningfully act upon

certain provisions in the unique situation where a commercial

bank sells a child care center.   A similar inference can be drawn

from the fact that only petitioners, and not the trustee, were

involved in the meetings and negotiations with the Shahs which

preceded the signing of the purchase agreement.   Hence, in

seeking to ascertain the parties’ intentions with respect to

price allocation, we likewise shall view the various participants

and documents as interrelated parts of an overall transaction.

     Turning then to the substantive issue of mutual intent, we

conclude, again by reference to both written instruments and

attendant circumstances, that neither the documents themselves

nor the surrounding negotiations negate the existence of such

intent.   The language used (1) in the prospectus advertising

Little Rascals for sale, (2) in the purchase agreement, and (3)

in the separate covenant document is in each case consistent with

an understanding that a noncompetition agreement from petitioners

was to form a component of the sales price.   The prospectus

describes the business as “established in 1980 by the current

owner, an architect”, makes no mention of the trust, states the
                              - 22 -

asking price, and lists “COVENANT 5 years 100 miles” under

“TERMS”.   The purchase agreement, as indicated above, has been

amended to make reference to a covenant from “officers” and sets

forth the total price of the stock and “any covenant”.   The

separate covenant document identifies that it is an agreement

“regarding the sale of Little Rascals”.   These three instruments,

collectively, thus cannot sustain petitioners’ burden of proving

that no part of the $300,000 allocated to “Covenant Not to

Compete” in the closing statements was intended as consideration

for petitioners’ promise.

     Furthermore, the surrounding negotiations and circumstances

do not require a different conclusion.    Although the prospectus

was technically erroneous, Mr. Shah testified that he understood

the document to mean that petitioner, as founder and seller, was

offering the covenant.   Petitioners did nothing to correct Mr.

Shah’s understanding throughout the initial negotiations premised

on the prospectus, and the Shahs were not made aware of the

existence of the trust until the purchase agreement was drafted.

Petitioners subsequently did not object to the addition of the

“and officers” language to the purchase agreement.   Their

reference to “our Purchase Agreement dated May 24, 1993, Section

15" in the letter they sent to the Shahs shortly after the sale,

however, shows that they had read the agreement and were aware of

its terms.   They then complied with the Shahs’ request to execute
                              - 23 -

a separate covenant not to compete despite this awareness of the

terms of a purchase agreement which contemplated allocation of

price to the stock and to any covenant.   Moreover, they signed

their covenant at the closing where statements explicitly

allocating $300,000 to a covenant not to compete were executed,

so if they did not in fact read these closing documents, they

certainly had the opportunity to do so.

     In addition, petitioners were aware at the time they signed

that it was their agreement, not the trust’s, upon which the

Shahs placed importance.   Petitioners’ own witness testified that

the Shahs’ concerns about competition from petitioners and

reasons for the separate covenant were discussed at the closing.

Hence, petitioners had reason to realize that any significant

value the Shahs paid for a covenant not to compete would be

attributable to their promise, not to that given by the trust.

In that context, they executed a covenant document.   In these

circumstances, knowledge of a purchase contract which

contemplated an allocation of price to a covenant not to compete,

combined with knowledge that their agreement was the only such

covenant of substantial importance to the buyer, adds up to the

type of objective contractual intent to allocate necessary for an

allocation to be given effect.
                              - 24 -

     The fact that petitioners did not intend to be taxed on

their agreement and sought to avoid that result by refusing to

permit the document they signed to refer to the buyers is

irrelevant.   As explained by this Court:

     What is important in the facts herein is whether the
     sellers intended that the covenants actually be a part
     of the agreement (i.e., whether * * * [the buyer]
     slipped the covenants into the contract without their
     knowledge). The facts unquestionably show that the
     sellers were aware of the terms. Moreover, the sellers
     were represented by counsel who read the contract and
     approved of its contents. That the sellers and/or
     their counsel did not intend, and were not aware of,
     the tax consequences of the disputed language is not
     significant. As stated in Hamlin’s Trust v.
     Commissioner, 209 F.2d 761, 765 (10th Cir. 1954), affg.
     19 T.C. 718 (1953):

          It is true that there was very little
          discussion of the suggested allocation. But
          the effectiveness taxwise of an agreement is
          not measured by the amount of preliminary
          discussion had respecting it. It is enough
          if parties understand the contract and
          understandingly enter into it. * * * where
          parties enter into an agreement with a clear
          understanding of its substance and content,
          they cannot be heard to say later that they
          overlooked possible tax consequences. * * *
     [Peterson Mach. Tool, Inc. v. Commissioner, 79 T.C. 72,
     83-84 (1982).]

     Here, petitioners intended that their covenants be a part of

the overall sale transaction, they understood from the contents

of the documents that they were promising not to compete and that

consideration was being allocated to a covenant not to compete,

and they knew that in substance the buyers attributed importance

to their agreement.   These facts regarding the actions of
                                - 25 -

petitioners and the Shahs convince us that there existed, on the

part of petitioners, either a subjective intent to allocate or,

at the very least, a conscious acquiescence in the allocation

proposed by the Shahs, both of which will support a finding of

objective contractual intent.    We therefore conclude that

petitioners have failed to carry their burden of showing that

those involved in the Little Rascals transaction did not mutually

intend that an allocation of purchase price be made to their

agreement.

                    Economic Reality of Allocation

     The question then becomes whether such an intended

allocation must nonetheless be disregarded because it would lack

economic reality.    However, petitioners’ past performance, their

present ability, and the actual negotiations reveal a separately

bargained-for agreement with a sufficient nexus to prudent

business practice to conclude that their agreement had

independent economic significance.

     As to past performance, petitioner had founded two day care

centers and had approximately 13 years of experience in the

business.    Little Rascals was uncontestedly a successful

enterprise with an excellent reputation.    Petitioners had

developed close interpersonal relationships with parents,

teachers, and staff.    In addition, their hands-on approach to
                              - 26 -

involvement in the child care business had often resulted in

repeat patronage, as parents returned to enroll younger siblings.

     With regard to present ability, petitioners were only 50 and

37 years of age and in good health at the time of the sale.

Furthermore, although petitioners mentioned that they planned to

travel following the sale, they did not indicate a permanent

departure from the geographic area.

     Given these circumstances, a prudent business person might

reasonably perceive competition from petitioners as a threat to

the continued success of Little Rascals, and negotiations related

to the sale reveal that the Shahs did in fact have such a

concern.   Beginning with the conscious addition of the “and

officers” language to the purchase agreement and continuing

through the requests for a separately executed covenant and the

discussion of its importance at the closing, the record bears

repeated evidence of the independent significance placed by the

Shahs on this covenant.   Mr. Shah even testified that he would

not have gone through with the sale absent such an agreement.

Hence, petitioners’ covenant was in fact a critical and

separately bargained-for component of the transaction.    When

faced with the unusual scenario of a bank trustee selling a child

care center, the Shahs prudently sought some form of assurance

from the founder, operators, and true threat of competition.
                              - 27 -

     In contrast, an allocation of price to the covenant entered

by the trust would lack economic reality.   As an officer of the

bank testified, the bank lacked the expertise and credentials to

open a competing child care center.    Moreover, such a move would

likely be otherwise precluded by the bank’s fiduciary duties as

trustee, thus making the agreement superfluous.    Finally, no

facts indicate that the Shahs placed significance on or

separately bargained for a promise from the trust.

     Therefore, of the two potential covenants to which

consideration could be allocated, it appears that only an

apportionment to petitioners’ agreement would have a basis in

economic reality.   It is also to be noted that whether an

agreement is enforceable under State law is not necessarily

determinative of tax consequences when the record shows that the

buyer in fact bargained and paid for a covenant.    See Standard

Lumber & Hardware Co. v. Commissioner, T.C. Memo. 1958-159.      When

faced with a situation where the Commissioner attempted to

disallow a buyer’s deductions taken for payments attributed to a

covenant not to compete, on grounds that the covenant would be

void under State law, this Court responded:

          The Commissioner argues that an oral agreement not
     to compete for 5 years would be void in Colorado. The
     Commissioner cites no authority for his contention that
     the deduction would not be allowable if the agreement
     could not be enforced. * * * The fact is that a large
     sum was actually paid on this arm’s-length agreement
     and the evidence indicates that the agreement was
     carried out. [Id.]
                                - 28 -

     Consequently, we need not reach the parties’ contentions

here regarding the enforceability of a covenant against

petitioners.   In unusual circumstances, such as those present in

this case, seeking even an unenforceable agreement made in good

faith may be consistent with prudent business practice.    This is

particularly true where, as here, the issue of enforceability is

debatable and arguments exist to support both sides.

Furthermore, since the Shahs apparently assumed that petitioners

were bound by their signatures, it is also reasonable to believe

that the Shahs in fact bargained and paid for petitioners’

promise.    We therefore conclude that petitioners have failed to

carry their burden of establishing that an allocation of any

value to their covenant not to compete would be devoid of

economic reality.

                         Amount of Allocation

     Where, as here, an allocation of some value has been found

to comport with economic reality in a general sense, the final

question necessary to resolve a deficiency issue asks what

specific amount of the consideration paid should be allocated to

the subject agreement.    We note that the amount allocated to a

covenant by a taxpayer is not always controlling for tax

purposes.    See Lemery v. Commissioner, 52 T.C. 367, 375 (1969),

affd. 451 F.2d 173 (9th Cir. 1971).
                                - 29 -

     In the matter at hand, closing statements apportioned

$300,000, based on calculations by Mr. Shah, to a covenant not to

compete.   Respondent now concedes on brief that the proper

valuation is $200,000.   Petitioners have offered no evidence by

which a different value may be calculated and have instead merely

contended that the proper value is zero.   Although we agree with

petitioners that the valuations computed by Mr. Shah and

respondent are in some respects arbitrary, we have decided that

allocation of some value to petitioners’ agreement is appropriate

and have not been given sufficient information upon which to base

an alternative measurement.   We therefore sustain the deficiency

based upon the $200,000 value advocated by respondent.

Penalty Issue

     Section 6662(a) and (b)(2) imposes an accuracy-related

penalty in the amount of 20 percent of any underpayment that is

attributable to a substantial understatement of income tax.   A

“substantial understatement” is defined by section 6662(d)(1) to

exist where the amount of the understatement exceeds the greater

of 10 percent of the tax required to be shown on the return for

the taxable year or $5,000.

     An exception to the section 6662(a) penalty is set forth in

section 6664(c)(1) and reads:    “No penalty shall be imposed under

this part with respect to any portion of an underpayment if it is

shown that there was a reasonable cause for such portion and that
                               - 30 -

the taxpayer acted in good faith with respect to such portion.”

The taxpayer bears the burden of establishing that this

reasonable cause exception is applicable, as respondent’s

determination of an accuracy-related penalty is presumed correct.

See Rule 142(a).

       Regulations interpreting section 6664(c) state:

       The determination of whether a taxpayer acted with
       reasonable cause and in good faith is made on a case-
       by-case basis, taking into account all pertinent facts
       and circumstances. * * * Generally, the most important
       factor is the extent of the taxpayer’s effort to assess
       the taxpayer’s proper tax liability. * * * [Sec.
       1.6664-4(b)(1), Income Tax. Regs.]

       Furthermore, reliance upon the advice of a tax professional

may, but does not necessarily, demonstrate reasonable cause and

good faith for purposes of avoiding the section 6662(a) penalty.

See id.; see also Freytag v. Commissioner, 89 T.C. 849, 888

(1987), affd. 904 F.2d 1011 (5th Cir. 1990), affd. 501 U.S. 868

(1991).    Such reliance is not an absolute defense, but it is a

factor to be considered.    See Freytag v. Commissioner, supra at

888.    In order for this factor to be given dispositive weight,

the taxpayer claiming reliance on a tax professional must show,

at minimum, that (1) the adviser was supplied with correct

information and (2) the incorrect return was a result of the

adviser’s error.    See, e.g., Ma-Tran Corp. v. Commissioner, 70
                              - 31 -

T.C. 158, 173 (1978); Pessin v. Commissioner, 59 T.C. 473, 489

(1972); Garcia v. Commissioner, T.C. Memo. 1998-203, affd.

without published opinion 190 F.3d 538 (5th Cir. 1999).

     Applying these principles to the instant case, we conclude

that petitioners have sustained their burden of establishing

reasonable cause and good faith for their failure to report

income related to the Little Rascals transaction.    Petitioners

consulted with both their attorney, Mr. Polse, and their

accountant, Mr. Kehl, regarding tax implications prior to forming

the charitable remainder unitrust.     Furthermore, Mr. Polse

suggested and drafted the trust agreement only after being

apprised by petitioners of their goals and intentions with regard

to the sale of their business.   In addition, petitioners signed

the separate covenant document only after it had been reviewed by

Mr. Kehl and modified to comply with his specifications.

Petitioners were thus clearly relying on professional advisers

throughout the transfer of their business, and these

professionals were supplied both with subjective information such

as financial goals and with objective data such as physical

documentation.   Finally, we note that reported decisions

addressing treatment of noncompetition agreements generally

involve a case-by-case analysis of intentions and offer few

bright lines to guide taxpayers and tax practitioners.     Given
                             - 32 -

these circumstances, we hold that petitioners acted reasonably

and in good faith reliance on their advisers.   Respondent’s

determination of an accuracy-related penalty is denied.


                                        Decision will be entered

                                   under Rule 155.
