                         T.C. Memo. 1997-287



                       UNITED STATES TAX COURT



   CHARLES B. AND TERESA A. THOMPSON, ET AL.,1 Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 5219-95, 5220-95,               Filed June 24, 1997.
                 16787-95, 16945-95,
                 16946-95.



     John B. Turner and Paul Kingsolver, for petitioners.

     Osmun R. Latrobe and Michael J. O'Brien, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     VASQUEZ, Judge:    These cases have been consolidated for

trial, briefing, and opinion.   All section references are to the


     1
        Cases of the following petitioners are consolidated
herewith: State Supply Warehouse Co., Douglas J. Von Allmen, Tax
Matters Person, docket No. 5220-95; Douglas J. and Linda L. Von
Allmen, docket No. 16787-95; Alexa Olson, a Minor, Kimberly
Olson, Legal Conservator, docket No. 16945-95; and Bruce A. and
Kimberly A. Olson, docket No. 16946-95.
                                 - 2 -

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

Rule references are to the Tax Court Rules of Practice and

Procedure, unless otherwise indicated.       In docket No. 5220-95,

respondent issued a notice of final S corporation administrative

adjustment (FSAA) to Douglas J. Von Allmen, tax matters person of

State Supply Warehouse Co. (State Supply), setting forth the

following adjustments with respect to State Supply's 1989 taxable

year:

     Item                  FSAA Adjustment         Amount in Dispute

Sales promotion                   $7,065                   -0-
Covenant not to compete          673,560                $673,560

     During the 1990 tax year, State Supply was an S corporation

not subject to the unified audit and litigation procedures of the

Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), Pub. L.

97-248, sec. 402(a), 96 Stat. 324, 648.       All of respondent's

adjustments to State Supply flowed directly through to its

shareholders' tax returns. Respondent determined the following

deficiencies in, and penalty on, petitioners' Federal income tax:

Charles B. and Teresa A. Thompson--docket No. 5219-95

     Year           Deficiency

     1990             $8,638

Douglas J. and Linda L. Von Allmen--docket No. 16787-95

                                           Accuracy-related Penalty
     Year           Deficiency                   Sec. 6662(a)

     1990             $88,319                      $17,664
                                  - 3 -

Alexa Olson, A Minor, Kimberly Olson, Legal Conservator--docket
No. 16945-95

     Year            Deficiency

     1990              $3,195

Bruce A. and Kimberly A. Olson--docket No. 16946-95

     Year            Deficiency

     1990              $55,679

     Respondent conceded the accuracy-related penalty in docket

No. 16787-95, and petitioner in docket No. 5220-95 has not

argued, and thus conceded, the FSAA adjustment decreasing State

Supply's sales promotion deduction for 1989.      The sole issue for

decision therefore is whether State Supply may amortize $2.5

million, or some lesser amount, for covenants not to compete.

                         FINDINGS OF FACT

     State Supply was incorporated under the laws of the State of

Oklahoma on October 14, 1963.     At the time of the filing of its

petition, State Supply's principal place of business was Tulsa,

Oklahoma.   During the taxable year 1989, State Supply was a

corporation which elected to be taxed for Federal income tax

purposes under the provisions of Subchapter S of the Internal

Revenue Code of 1986, as amended.     For the taxable year 1989,

State Supply is controlled by the TEFRA notice and assessment

procedures provided by sections 6241-6245.      Douglas J. Von Allmen

was the tax matters person for 1989.      During the taxable year

1989, the shareholders of State Supply were Douglas J. and Linda

L. Von Allmen, Bruce A. and Kimberly A. Olson, Charles B. and
                              - 4 -

Teresa A. Thompson, Alexa Olson, Norman B. and Dale M. Cowgill,

Frank J. and Janet F. Andress, and Richard J. and Regina L.

Morrison.

     Petitioners Charles B. and Teresa A. Thompson are husband

and wife and resided in Tulsa, Oklahoma, at the time their

petition was filed in this case.

     Petitioner Alexa Olson, a minor, Kimberly Olson, legal

conservator, is an individual who resided in St. Louis, Missouri,

at the time of the filing of her petition herein.

     Petitioners Douglas J. Von Allmen (hereinafter referred to

as Von Allmen) and Linda L. Von Allmen are husband and wife and

resided in Fort Lauderdale, Florida, at the time their petition

was filed in this case.

     Petitioners Bruce A. Olson and Kimberly A. Olson

(hereinafter referred to as Olson) are husband and wife and

resided in St. Louis, Missouri, at the time their petition was

filed in this case.

State Supply's Business

     State Supply was engaged in the distribution of beauty

supply products in the States of Oklahoma, Arkansas, Missouri,

Kansas, Illinois, Tennessee, Mississippi, Wyoming, Colorado, New

Mexico, and Utah, a territory which covered approximately 11

percent of the U.S. population.2   State Supply, as a master


     2
        Unless otherwise indicated, descriptions pertain to the
years in issue.
                                - 5 -

distributor of beauty supplies, purchased from manufacturers

(hereinafter called suppliers) for sale to subdistributors

(hereinafter called customers) who then sold to beauty salons and

licensed cosmetologists.   In 1987, State Supply was one of four

such master distributors in the country.   At the time of the

acquisition, described infra, there were three principal

suppliers from which State Supply purchased products:    Redken (26

percent of State Supply's sales), Matrix (26 percent of State

Supply's sales), and Lamaur Products (19 percent of State

Supply's sales).   State Supply had distribution agreements with

approximately 77 customers, servicing approximately 20,000 beauty

salons.    Pursuant to distribution agreements between State Supply

and its customers, either party to a distribution agreement could

terminate the agreement, without cause, by giving 90 days' prior

written notice of such termination to the other party.   The

distribution agreements did not prohibit the customers from

buying from other sources.

State Supply's Shareholders

     At the time of the acquisition, State Supply had 75,659.61

shares of common stock issued and outstanding.   At the time of

the acquisition, Robert F. Beaurline, president of State Supply,

owned 12,586 shares directly and 3,060.5 shares through his

participation in the Employee Stock Option Plan (ESOP), for a

total of 15,646.5 shares (approximately 20 percent of all

shares).   Betty Holliday (hereinafter referred to as Holliday),
                                - 6 -

chairman of the board of directors of State Supply, owned with

her husband Clifford E. Holliday 12,586.26 shares directly and

10,776.60 shares through her participation in the ESOP, for a

total of 23,362.86 shares (approximately 30 percent of all

shares).

     At the time of the acquisition, there were 68 shareholders,

including the ESOP, which owned 41,945.35 shares.   The 65

shareholders, other than the ESOP, Holliday, and Beaurline,

collectively owned 8,342 shares.3   Most of these shares were

owned by customers of State Supply.

Prior Covenant Not to Compete

     In December 1984, State Supply purchased the shares held by

its previous president and founder of the company, Jim Lewis, for

$991,000.   They also entered into an agreement and covenant not

to compete, for which Lewis was paid $845,000--in addition to the

$991,000 paid for his stock--over 5 years.

Group One Capital and Its Principals

     Group One Capital, Inc. (Group One), was an investment

company specializing in the acquisition of businesses in

manufacturing, distribution, servicing, and retailing, generally

with sales in the range of $10 to $100 million.   Group One was

controlled by Von Allmen and Olson.

     Von Allmen graduated with an accounting degree from the

University of Kentucky, with honors, in 1965.   He had experience

     3
        The breakdown of shares stipulated to by the parties
totals only 75,459.
                               - 7 -

in public accounting with Peat Marwick & Mitchell and other

accounting firms.   Von Allmen had substantial experience with

purchasing, operating, and selling various types of businesses.

He had no personal contacts or experience in the beauty supply

industry.

     Olson had an undergraduate degree from the University of

Michigan in economics and a master's degree in business from

Columbia University.   Olson worked for the Bank of New York for 9

years, part of the time as a vice president.   She was the primary

person dealing with First National Bank of Cincinnati (the bank)

in obtaining the acquisition loan (described infra).

Group One's Offer to Purchase State Supply

     In early 1987, Von Allmen received a telephone call from a

broker in Springfield, Missouri, advising him that State Supply

was for sale.   Von Allmen and Olson conducted an investigation

and analysis of the financial background of State Supply (the

investigation).   Based on his experience, Von Allmen believed

that the value of State Supply, as a distributor, would be equal

to three to five times "trailing earnings", which means the

earnings in the prior year.   Believing that State Supply was a

high risk company, Von Allmen used a multiple in the range of 3-½

to 4 times earnings in determining a price to offer for the

shares.   Von Allmen learned through the investigation that State

Supply had 1986 pretax earnings of approximately $1.5 million.

On June 2, 1987, Group One offered in writing (the offer) to
                               - 8 -

purchase all of the issued and outstanding stock of State Supply

for $6 million.

     The offer proposed that the stock purchase be accomplished

by a cash merger (the acquisition) with a new corporation to be

organized by Von Allmen and Olson.     There were no provisions for

covenants not to compete (sometimes referred to as noncompete

agreements) in the offer.   The offer provided that State Supply

would permit Group One or its advisers full access to all of its

properties, books, and records as may be reasonably requested.

The acquisition took place on October 29, 1987.

Holliday and Beaurline as Potential Competitors

     During their investigation of State Supply, Von Allmen and

Olson discovered that Holliday had been with State Supply for 26

years, since its inception and had developed extensive

relationships with customers over those 26 years as the "right

arm" of the founder of State Supply, Jim Lewis.    Holliday had

sufficient money to go into competition with State Supply after

the sale of her stock to Group One.

     During the investigation, Von Allmen discovered that

Beaurline had been in the beauty supply business for 36 years,

had been with State Supply for 8 years, knew the suppliers and

customers very well, was well known in the beauty supply

industry, and had served as master of ceremonies for

manufacturers' sales meetings and beauty shows.

     Prior to joining State Supply, Beaurline held positions with

distributors and manufacturers in the beauty supply industry and
                                - 9 -

had owned a distributorship called Reliable Beauty Supply and a

manufacturer's representative business called Robert Beaurline

and Associates.   After joining State Supply, Beaurline was

involved in marketing, including implementing a monthly marketing

publication and an aggressive trade show presence.   He had strong

personal relationships with the customers, vendors, and major

suppliers.   Beaurline had sufficient money to go into competition

with State Supply after the sale of his stock to Group One.

     Before the sale of State Supply, if a customer had a serious

problem, the customer would call Beaurline or Holliday.   Both

Beaurline and Holliday had just bought new houses in the Tulsa

area.

The Acquisition Loan

     Group One submitted a loan proposal to the bank.   The bank

made the acquisition loan in October 1987.

     Steve Kieffner, the vice president in charge of new business

development at the bank in 1987, was involved in underwriting the

acquisition loan.   As a condition of the acquisition loan, the

bank required that Beaurline and Holliday execute noncompete

agreements with State Supply.   On September 29, 1987, the bank

prepared an internal credit memorandum which analyzed the

proposed financing and evaluated the solvency of State Supply

after the sale.

The Noncompete and Employment Agreements

     Von Allmen personally invested $300,000 in cash and Olson

personally invested $200,000 in cash in the acquisition of State
                               - 10 -

Supply.    Both Von Allmen and Olson personally guaranteed $1

million of the acquisition loan of approximately $4,450,000.

After making the offer, Von Allmen and Olson concluded that they

had to have noncompete agreements from Holliday and Beaurline in

order to lower the risk to their investment.    At the time of the

acquisition, Von Allmen was "very concerned about what would

happen if those two people [Beaurline and Holliday] would ever

compete with us, and I felt that I needed strong protection."

     Von Allmen obtained legal advice on Oklahoma law regarding

the enforceability of noncompete agreements.    Von Allmen was

advised that under Oklahoma law a company could not prevent

competition under a noncompete agreement, but instead could

recover the moneys paid for the noncompete agreement.    Von Allmen

believed that the amounts paid for the noncompete agreements

would have to be substantial because that was the only way he

could be confident that Beaurline and Holliday would not compete.

     Von Allmen believed Beaurline and Holliday could compete

with State Supply by setting up another business under another

name.   Von Allmen had previous experience with a company called

Gen-Co Supply Co., where the president and every salesmen quit

and set up their own business in competition with their former

company.    Von Allmen believed that competition from Beaurline and

Holliday after the sale would have put State Supply into

bankruptcy.    Von Allmen determined that "We had absolutely no way

to protect ourselves, except to try to put in front of them

[Beaurline and Holliday] a non-compete that had enough money in
                               - 11 -

it that they thought that they had something to risk on the

money, and it wasn't worth the time."

     On July 13, 1987, Von Allmen wrote identical letters to

Beaurline and Holliday proposing that 1-year employment

agreements and 5-year noncompete agreements be executed by them

concurrently with the purchase of the outstanding shares of State

Supply.    The agreements stated that the purchase price of the

stock was $6 million.    Von Allmen proposed that Beaurline and

Holliday would each be paid $17,540 per month the first 24 months

and $23,040 per month for the last 36 months for a total of

$1,250,000 each for the noncompete agreements.      The attorneys for

the parties to the acquisition, Philip Kaplan (seller's attorney)

and Terry Doverspike (buyer's attorney), negotiated the terms of

the noncompete agreements in correspondence dated July 30, August

12 and 20, and September 25, 1987.      During the course of these

negotiations, Kaplan was able to secure a stock pledge agreement

and reduce the period of the noncompete agreement from 5 years to

3 years.    On October 29, 1987, State Supply and Beaurline and

Holliday executed identical documents entitled "Non-Compete

Agreement."    Under the noncompete agreements, Beaurline and

Holliday agreed (among other things) "not to directly or

indirectly enter into the business of distributing beauty

supplies, or any business or branch of business similar to the

type of business conducted by the Employer [State Supply] at the

date of this Agreement, within the states of Oklahoma, Arkansas,
                               - 12 -

Missouri, Kansas, Illinois, Tennessee, Mississippi, Wyoming,

Colorado, New Mexico or Utah" for the 3-year period commencing

November 1, 1987.    No one other than Beaurline and Holliday was

offered a noncompete agreement.

     Also on October 29, 1987, State Supply executed employment

agreements with Beaurline and Holliday.    Under the employment

agreements, neither Beaurline nor Holliday had the authority or

responsibility without prior approval of the board of directors

to hire or fire employees, determine employee compensation, or

make capital expenditures.    The employment agreements could be

terminated without cause by State Supply, and specifically

acknowledged the existence of the noncompete agreements.    The

employment agreements provided that:

     The Employee shall devote his entire time, attention
     and energies to the Employer's business and shall not
     during the term [one year] of his employment be engaged
     in any other business activity whether or not such
     business activity is pursued for gain, profit, or other
     pecuniary advantage. * * *

State Supply's Deductions for Amortization of Noncompete
Agreements

     State Supply, on its U.S. Income Tax Return for an S

Corporation (Forms 1120S), claimed amortization deductions for

the noncompete agreements as follows:

          Taxable Year               Deduction Claimed

              1987                        $166,667
              1988                         958,333
              1989                         673,560
              1990                         548,560
                                - 13 -

     The Commissioner, in his FSAA Notice for the taxable year

1989, disallowed in full the deductions claimed for amortization

of the noncompete agreements.

     During the taxable year 1990, all individual petitioners

herein owned shares of the outstanding common stock of State

Supply.

     The Commissioner mailed his notices of deficiency to the

individual petitioners for the taxable year 1990, which

disallowed in full the amortization deductions claimed for the

noncompete agreements.

Subsequent Events

     Prior to the acquisition, Beaurline and Holliday were the

president and chairman of the board, respectively, of State

Supply.   They continued in their respective offices for 1 year

after the acquisition of shares.

     Approximately 2 months after the closing, Beaurline

approached Von Allmen to request a change in the noncompete

agreement so that Beaurline could work for a close friend who

owned one of State Supply's major suppliers, Lamaur.   On

December 14, 1987, by letter from Terry Doverspike, the

noncompete agreement with Beaurline was amended in order to allow

him to work for Lamaur.

     On February 26, 1991, Holliday died of a heart attack.
                               - 14 -

                               OPINION

     The sole issue in this case is how much, if any, petitioners

may deduct for the covenants not to compete.   Petitioners bear

the burden of proof.   Rule 142(a).

     A taxpayer generally may amortize intangible assets over

their useful lives.    Sec. 167(a); Citizens & S. Corp. v.

Commissioner, 91 T.C. 463, 479 (1988), affd. 919 F.2d 1492 (11th

Cir. 1990).   To be amortizable, an intangible asset must have an

ascertainable value and a limited useful life, the duration of

which can be ascertained with reasonable accuracy.    Newark

Morning Ledger Co. v. United States, 507 U.S. 546, 556 n.9

(1993).   A covenant not to compete is an intangible asset that

has a limited useful life and, therefore, may be amortized over

its useful life.   Warsaw Photographic Associates v. Commissioner,

84 T.C. 21, 48 (1985); O'Dell & Co. v. Commissioner, 61 T.C. 461,

467 (1974).   We must decide if any of the amount paid for the

covenants not to compete was a disguised payment for State

Supply's stock.

     The amount a taxpayer pays or allocates to a covenant not to

compete is not always controlling for tax purposes.    Lemery v.

Commissioner, 52 T.C. 367, 375 (1969), affd. per curiam 451 F.2d

173 (9th Cir. 1971).    We strictly scrutinize an allocation if the

parties do not have adverse tax interests because adverse tax

interests deter allocations which lack economic reality.       Wilkof

v. Commissioner, 636 F.2d 1139 (6th Cir. 1981), affg. per curiam
                               - 15 -

T.C. Memo. 1978-496; Haber v. Commissioner, 52 T.C. 255, 266

(1969), affd. per curiam 422 F.2d 198 (5th Cir. 1970); Roschuni

v. Commissioner, 29 T.C. 1193, 1202 (1958), affd. 271 F.2d 267

(5th Cir. 1959).   A covenant not to compete must have

"economic reality"; i.e., some independent basis in fact or some

arguable relationship with business reality so that reasonable

persons might bargain for such an agreement.    Patterson v.

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

1985-53; Schulz v. Commissioner, 294 F.2d 52, 55 (9th Cir. 1961),

affg. 34 T.C. 235 (1960); O'Dell & Co. v. Commissioner, supra at

467-468.   We shall first decide, therefore, if the noncompete

agreements had "economic reality".

Economic Reality

     Courts apply numerous factors in evaluating a covenant not

to compete.   These include:   (a) The grantor's (i.e.,

covenantor's) having the business expertise to compete; (b) the

grantor's intent to compete; (c) the grantor's economic

resources; (d) the potential damage to the buyer posed by the

grantor's competition; (e) the grantor's contacts and

relationships with customers, suppliers, and other business

contacts; (f) the duration and geographic scope of the covenant;

(g) enforceability of the covenant not to compete under State

law; (h) the age and health of the grantor; (i) whether payments

for the covenant not to compete are pro rata to the grantor's

stock ownership in the company being sold; (j) whether the

payments under the covenant not to compete cease upon breach of
                               - 16 -

the covenant or upon the death of the grantor; and (k) the

existence of active negotiations over the terms and value of the

covenant not to compete.   Molasky v. Commissioner, 897 F.2d 334,

337 (8th Cir. 1990) affg. in part and revg. in part T.C. Memo.

1988-173; Warsaw Photographic Associates, Inc. v. Commissioner,

84 T.C. 21 (1985); Furman v. United States, 602 F. Supp. 444

(D.S.C. 1984) affd. without published opinion 767 F.2d 911 (4th

Cir. 1985); see Beaver Bolt, Inc. v. Commissioner, T.C. Memo.

1995-549 and cases cited therein.   a.   Grantor's Business

Expertise

     Respondent concedes that Holliday and Beaurline had

considerable experience in the beauty supply business.   The

record is replete with evidence that Holliday and Beaurline had

the business experience necessary to compete effectively.

     b.   Grantor's Intent to Compete

     Beaurline and Holliday discussed whether they should agree

to covenants not to compete.   They decided that noncompete

agreements would be acceptable only if the "price was right" for

removing themselves from the beauty supply business for 5 years.

Beaurline credibly testified that he probably would have gone

back into the beauty supply business after the sale of State

Supply.

     c.   Grantor's Economic Resources to Compete

     Holliday received approximately $1,850,000 and Beaurline

approximately $1,240,000 from their sale of stock in State
                              - 17 -

Supply.   Based upon our review of State Supply's business, its

tax returns, and financial statements, we find that the above

amounts would have been sufficient to enable either Holliday or

Beaurline to compete against State Supply.

     d.   Potential Damage to the Buyer Posed by the Grantor's
          Competition

     Due to the nature of State Supply's business (buying

finished products from a small number of suppliers and reselling

them to an established group of 77 customers without adding

value), strong relationships with the four major suppliers and

the customers were crucial to the company's success.   Holliday

and Beaurline had such relationships, and the buyers did not.

Von Allmen reasonably believed that Holliday and Beaurline could

have put State Supply into bankruptcy had they competed.    We find

that both Holliday and Beaurline possessed the ability to take a

significant portion of State Supply's business.

     e.   Grantor's Contacts and Relationships with Customers,
          Suppliers, and Other Business Contacts

     It would be difficult to imagine grantors with stronger

contacts and relationships with suppliers and customers.    Indeed,

respondent concedes that grantors had good rapport with the

suppliers and subdistributors.

     f.   Duration and Geographic Scope

     Holliday's and Beaurline's covenant applied to competition

in the 11 States where State Supply conducted business for a
                               - 18 -

period of 3 years.   We find that these limits were reasonably

drawn to keep them from competing with State Supply.

     g.   Enforceability Under State Law

     The buyers were told by their attorney that the covenants

would be virtually nonenforceable in equity and that their only

recourse would be to obtain a refund of the moneys paid for the

covenants.   Respondent admits on brief that State law provided

such a remedy.

     h.   Age and Health of Grantors

     Respondent concedes that Holliday and Beaurline had no

apparent health problems.    Their age is not in the record.

     i.   Whether Payments Were Pro Rata to the Grantors' Stock
          Ownership

     Although Holliday owned approximately 50 percent more stock

than Beaurline, she received the same amount under the noncompete

agreements as Beaurline.    These non-pro rata payments indicate

that something other than stock was purchased.

     j.   Whether Payments Cease Upon Breach or Upon the Death of
          a Grantor

     The noncompete agreements called for payments to be made

into escrow in the event of the grantors' breach.    However, the

payments were to be continued upon the death of a grantor.     This

factor supports respondent.

     k.   Active Negotiations Over Terms and Value

     There were active negotiations over the terms of the

covenants; the term was lowered from 5 to 3 years.    The value of
                                - 19 -

the covenant does not appear to have been the subject of

negotiation.

     Based upon the above analysis, we hold that the noncompete

agreements had economic reality; the evidence on this point on

petitioners' behalf is overwhelming.

Value of the Noncompete Agreements

     The parties each called expert witnesses to give their

opinions about the value of the covenants.    As the trier of fact,

we must weigh the evidence presented by the experts in light of

their demonstrated qualifications in addition to all other

credible evidence.   Estate of Christ v. Commissioner, 480 F.2d

171, 174 (9th Cir. 1973), affg. 54 T.C. 493 (1970).    However, we

are not bound by the opinion of any expert witness when that

opinion is contrary to our judgment.     Estate of Kreis v.

Commissioner, 227 F.2d 753, 755 (6th Cir. 1955), affg. T.C. Memo.

1954-139; Chiu v. Commissioner, 84 T.C. 722, 734 (1985).      We may

accept or reject expert testimony as we find appropriate in our

best judgment.   Helvering v. National Grocery Co., 304 U.S. 282,

294-295 (1938); Seagate Tech., Inc. & Consol. Subs. v.

Commissioner, 102 T.C. 149, 186 (1994).

     a.   Respondent's Expert

     Respondent's expert, Paul H. Meade, is a valuation engineer

for the Internal Revenue Service (IRS) and a registered

professional engineer licensed in the State of Oklahoma.      He has
                               - 20 -

a bachelor of science degree in industrial engineering from

Oklahoma State University.

     Mr. Meade concludes that the covenants had, at best, a

nominal value.   Mr. Meade first valued State Supply by using a

discounted future earnings method which calculates the present

value of a base level of earnings.      The starting point for Mr.

Meade's calculation is the base level of earnings of $850,000,

which he took from the initial credit memorandum prepared by the

bank.   The base number is not an historical earnings number but

simply the "base level of return * * * which was required by

financial institution [sic]" in order to make the acquisition

loan to the buyers.   Mr. Meade does not tell us why this number

has any significance or why it should form the basis of his

calculations.    Mr. Meade concludes that State Supply's discounted

future earnings stream is worth $7,208,000.      He then adds to that

number the amount of State Supply's cash or cash equivalents in

excess of the amount deemed needed for this type of business

($1.4 million) and arrives at a rounded value of $8.6 million as

the fair market value of State Supply.      Mr. Meade's entire

analysis of the covenants' value is as follows:

     Consideration of the allocation to the covenants in
     regard to the fair market value of the stock [value of
     State Supply] when the net price paid for both stock
     and covenant[s] is $6.8 million [Mr. Meade's
     calculation of the cash required to purchase the stock
     and the discounted cost of the covenants] leaves, at
     best, a nominal value for allocation to the covenants.
                                - 21 -

     b.   Petitioners' Expert

     Petitioners' expert, Mark L. Mitchell, is a principal in

Business Valuation Services, Inc.    He holds a master of business

administration degree in finance and bachelor of science degrees

in mathematical sciences and economics and systems analysis, all

from Southern Methodist University.      He is a member of the

Association for Investment Management and Research, a member of

the Dallas Association of Investment Analysts, and a senior

member of the American Society of Appraisers.

     Mr. Mitchell utilized a discounted cash-flow model to

determine the value of State Supply assuming the presence of the

noncompete agreements.   He concludes that State Supply is worth

$8,516,931.   Both parties' experts agree on the value of State

Supply with the covenants in place.4

     To value the noncompete agreements, Mr. Mitchell calculated

the value of State Supply without them and subtracted that value

from the previously determined value of State Supply with the

noncompete agreements.   In order to calculate the value of State

Supply without the noncompete agreements, Mr. Mitchell made

assumptions concerning the impact that competition from Holliday

and Beaurline would have and the probability of that competition


     4
        By using the bank's   base level of return number of
$850,000 (a number the bank   calculated assuming the existence of
the noncompete agreements),   respondent's expert has, perhaps
inadvertently, valued State   Supply with the noncompete agreements
in place.
                              - 22 -

taking place in each of the first 3 years after the sale.    The

end result was that Mr. Mitchell valued the noncompete

agreements, in the aggregate, at $2,464,752, which he rounded up

to $2.5 million.

Effect of Employment Agreements on Valuation

     Respondent's main argument5 against the petitioners' expert

valuation of the noncompete agreements is that the employment

agreements entered into by Holliday and Beaurline effectively

prevented any possibility of competition for the year they were

in effect.   Once the possibility of competition is eliminated for

the first year after the sale, respondent argues that even

petitioners' expert calculations would only support a value of

$400,000 for the noncompete agreements (the highest risk of

competition coming in the first year after the sale). Respondent

is mistaken.

     We dealt with this argument in Peterson Mach. Tool, Inc. v.

Commissioner, 79 T.C. 72, 85 (1982) affd. 54 AFTR 2d 84-5407, 84-

2 USTC par. 9885 (10th Cir. 1984):

     The fact that Moses [grantor of the covenant] signed an
     employment contract with Peterson, Inc., for the
     duration of his covenant not to compete is entitled to
     weight, but is not determinative. Maseeh v.
     Commissioner, 52 T.C. 18, 23 (1969). There was always


     5
        Incredibly, respondent argues that petitioners' expert
report should be ignored since it "was prepared for tax purposes
and for this specific litigation." We should hope so. See Rule
143(f). Respondent's expert report was prepared under like
circumstances.
                             - 23 -

     the possibility that Moses or Peterson, Inc., could
     breach the employment contract or that Moses could be
     terminated for cause. In either case he could, absent
     a covenant not to compete, have engaged in competition.
     Furthermore, the fact that the employment contract
     contained its own restrictive covenant is of no moment
     since Moses testified that the employment contract and
     covenant not to compete were both part and parcel of
     the stock-sale transaction.

We find that the noncompete agreements and the employment

agreements, which were entered into at the same time and refer to

each other, are "part and parcel of the stock-sale transaction."

We shall give the existence of the employment contracts some

weight in our considerations but, contrary to respondent's

arguments, they are not determinative in considering the

possibility of competition in the first year.

Conclusions as to Value

     We found respondent's expert report to be of no assistance.

We agree with the criticisms contained in petitioners' expert

rebuttal reports6 that, among other deficiencies, Mr. Meade's

expert report (a) treated the cash equivalents in State Supply

inconsistently, including them for valuation purposes but

excluding them when calculating the net price paid by the buyers;

and (b) contains no analysis of the factors to be considered in

valuation of noncompete covenants, as detailed in respondent's

Rev. Rul. 77-403, 1977-2 C.B. 302.    Moreover, Mr. Meade's


     6
        Mr. Mitchell prepared a rebuttal report as did Wendy E.
Sharon, a manager in the Valuation Services Group at Coopers &
Lybrand L.L.P.
                               - 24 -

"method" of valuing the noncompete agreements, comparing the "net

price paid" for the stock and the noncompete agreements to the

value of State Supply, is highly suspect.      Mr. Meade offers no

explanation or rationale for his methodology, nor can we provide

any.

       Mr. Meade's report, as well as respondent's arguments, that

the noncompete agreements had nominal value, are antithetic to

common sense.    The factors detailed above, when we analyzed

whether the noncompete agreements had economic reality,

overwhelmingly establish a strong need, and a corresponding high

relative value, for the noncompete agreements.

       We found petitioners' expert report to be helpful, as it

used a methodology for valuing the noncompete agreements that was

clear and logical.    See International Multifoods Corp. v.

Commissioner, 108 T.C.       (1997).    More importantly, we believe

the record shows that competition from Beaurline and Holliday

could have destroyed State Supply.      Based on the record as a

whole, considering all of the facts and circumstances, we hold

that petitioners have met their burden of showing that the

noncompete agreements were worth at least $2.5 million.

       To reflect the foregoing,

                                            Decisions will be entered

                                       for petitioners in docket Nos.
- 25 -

     5219-95, 16787-95, 16945-95,

     and 16946-95.

          Decision will be entered

     under Rule 155 in docket No.

     5220-95.
