                          T.C. Memo. 1995-549



                        UNITED STATES TAX COURT



                BEAVER BOLT, INC., Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent




     Docket No. 22087-93.             Filed November 20, 1995.



     Alan M. Spinrad and Merritt S. Yoelin, for petitioners.

     Cheryl B. Harris, for respondent.



                MEMORANDUM FINDINGS OF FACT AND OPINION


     COLVIN, Judge:     Respondent determined deficiencies in

petitioner's Federal income tax and additions to tax as follows:

                                             Additions to Tax
                                    Sec.           Sec.        Sec.
  Year Ended        Deficiency    6653(a)          6659       6662(h)
June 30, 1989        $49,842     $2,492.10      $14,952.60      --
June 30, 1990         49,843        --              --       $19,937
                                 - 2 -


     The issues for decision are:

     (1)   Whether petitioner may amortize $383,400, or some other

amount, for Jane Grecco's covenant not to compete.       We hold that

petitioner may amortize $324,100.

     (2)   Whether petitioner is liable for additions to tax for:

(a) Negligence under section 6653(a) for 1989; (b) valuation

overstatement under section 6659 for 1989; (c) substantial

understatement under section 6661 in the alternative to section

6659 for 1989; and (d) an accuracy related penalty under section

6662(h) for gross valuation misstatement, or, in the alternative,

under section 6662(a).   We hold that it is not.

     Section references are to the Internal Revenue Code in

effect for the years in issue.    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.

1.   Formation of Petitioner and Petitioner's Operations

     Petitioner had its principal place of business in Portland,

Oregon, during the years in issue and when it filed its petition.

Petitioner is in the business of marketing and distributing

bolts, nuts, and other fasteners.

     Jane Grecco (Grecco), James Colbert (Colbert), and Dan Allen

(Allen) formed petitioner in 1979.       They each had experience

distributing bolts, nuts, and other fasteners.       Grecco and
                                - 3 -


Colbert were working for a nuts and bolts distributor, Industrial

Products Co., when they decided to start their own business.

They brought in Allen to make outside sales.     Allen was

president, Grecco was vice president, and Colbert was

secretary/treasurer of petitioner.      They were also petitioner's

directors.

     Grecco, Colbert, and Allen each owned 50 shares of

petitioner's stock.    They each invested $10,000 in petitioner,

consisting of $5,000 for the stock and a $5,000 loan.     Petitioner

later repaid the loans.    Petitioner also borrowed $40,000.

Grecco, Colbert, and Allen did not invest additional funds in

petitioner.

     Petitioner has been profitable since its beginning.     Grecco,

Colbert, and Allen asked customers of their earlier businesses to

switch to petitioner.    Grecco and Colbert brought customers to

petitioner.   For example, Grecco brought Brod & McClung, which

Grecco had supplied at other nuts and bolts distributors for

which she worked.   Grecco was petitioner's principal contact with

suppliers.

     At first, petitioner's only employees were Grecco, Colbert,

and Allen.    Petitioner hired another employee about a year after

it began to operate.

     In 1982 and 1983, Allen redeemed his 50 shares of

petitioner's stock, and Ron Tiedemann (Tiedemann) bought 50
                               - 4 -


shares of petitioner's stock from petitioner.    After these

transactions, Grecco, Colbert, and Tiedemann each owned 50 shares

of petitioner's stock, and Grecco was president, Tiedemann was

vice president, and Colbert was secretary/treasurer.

2.   The Stock Purchase Agreement

     On November 6, 1986, Grecco, Colbert, and Tiedemann signed

a stock purchase agreement with petitioner.    The agreement gave

petitioner the option to repurchase its stock owned by a

terminated employee.   The agreement included a formula that set

the purchase price for the stock.    If petitioner exercised the

option, the employee/stockholder would transfer the stock to

petitioner and would be bound by a covenant not to compete for

3 years.   The agreement provided that payments would be reduced

by 25 percent if a party breached the covenant.

     On February 18, 1988, Grecco transferred her stock in

petitioner to herself, as Trustee of the Grecco Trust, a

revocable living trust.   Colbert, Tiedemann, and petitioner

consented to the transfer.

3.   Grecco's Departure From Petitioner

     In early June 1988, Colbert and Tiedemann told Grecco that

they were concerned about her management style.    They thought

that she lacked the respect of some of the employees, and that

she was habitually late to work.    Colbert thought that she had

become paranoid and was too critical of the other employees.      On
                                 - 5 -


June 14, 1988, Colbert and Tiedemann proposed that Grecco resign

as president, take a 6-month paid leave of absence, and, at the

end of 5 months, decide how to proceed.    Grecco did not accept

the proposal.

     The board of directors met on June 16, 1988.    At the

meeting, the board of directors elected Tiedemann secretary,

removed Grecco as president, and elected Colbert president.

The board of directors voted to end Grecco's employment with

petitioner.    Grecco contended that the covenant not to compete

contained in the 1986 stock purchase agreement was unenforceable

on the grounds that the board of directors had improperly

terminated her.

     Petitioner and Grecco negotiated a financial settlement

for Grecco.1    Grecco wanted to maximize the amount of money she

would receive from petitioner.    The board of directors met on

June 30, 1988.    To maximize her leverage, Grecco said she would

compete with petitioner and argued that petitioner had violated

     1
         Petitioner's June 22, 1988, offer included the following:

          5. The corporation will purchase the stock owned by
     Ms. Grecco pursuant to the price determination as set forth
     in the Stock Purchase Agreement * * * the purchase price
     should be somewhere between $400,000 and $450,000. However,
     there would be an allocation of the total purchase price so
     that the amount determined to be the book value of the stock
     as of June 30, 1988, would be the amount allocated to the
     stock. The balance of the price should be allocated to
     either a covenant not to compete or a consultants type of
     agreement in order that the payments pursuant thereto would
     be deductible to the corporation. * * *
                               - 6 -


its fiduciary duties, corporate laws, and the Employee Retirement

Income Security Act of 1974, Pub. L. 93-406, 88 Stat. 829.     The

parties discussed the general terms for separating Grecco from

petitioner at this meeting.   The board of directors rehired

Grecco retroactive to June 16, 1988, and she resigned from

petitioner effective July 1, 1988.     In exchange, the board of

directors offered Grecco a preliminary settlement package and

proposed to pay her about $125,000 for her stock and about

$300,000 for her agreement not to compete.     The board of

directors approved the payment of bonuses (and retirement

contributions based on 7.326 percent of the bonus) for 1988 to

petitioner's employees:   $73,000 to Colbert, $74,000 to

Tiedemann, and $71,000 to Grecco.

4.   Redemption of Grecco's Stock

     On December 23, 1988, petitioner and Grecco signed a

redemption agreement.   Petitioner agreed to pay the Grecco Trust

$130,000 to redeem the stock owned by the trust.     Petitioner

also agreed to pay to Grecco or on her behalf a $71,000 bonus,

severance pay of $45,000, a retirement plan contribution of

$30,000, and life and medical insurance premiums.     Petitioner

also transferred to Grecco a life insurance policy on her life,

a 1984 BMW, and an athletic club membership in consideration for

her resignation as petitioner's president.     Grecco agreed not to
                               - 7 -


compete with petitioner for 3 years in Oregon and Washington,

beginning July 1, 1988.

     The redemption agreement stated that petitioner paid Grecco

$383,400 for the covenant not to compete.2   Petitioner agreed to

pay Grecco $77,400 on December 23, 1988, with the balance to

be paid in equal monthly installments of $5,100, beginning

January 23, 1989, through December 23, 1993.   Grecco agreed

to pay damages equal to 25 percent of the total payments under

the agreement if she breached the covenant not to compete.

The parties did not negotiate the value to be allocated to

the covenant not to compete.




     2
         The redemption agreement provided in part:

          10. In consideration of the amounts to be paid by
     Corporation to Grecco and the other Agreements of the
     Corporation set forth herein, Grecco covenants and
     agrees that for a period of three (3) years from
     July 1, 1988, within the geographic area of Oregon and
     Washington, Grecco shall not, directly or indirectly,
     on behalf of or in concert with any other person, firm,
     proprietorship, partnership or corporation of which
     Grecco is now or hereafter an employee, agent,
     proprietor, partner, officer, director or shareholder,
     engage in a business which sells, at wholesale or
     retail, products similar to products sold by
     Corporation on July 1, 1988, or proposed to be handled
     by Corporation on July 1, 1988. As compensation for
     this covenant not to compete, Corporation shall pay to
     Grecco a total of THREE HUNDRED EIGHTY THREE THOUSAND
     FOUR HUNDRED ($383,400.00) DOLLARS. * * *
                               - 8 -


5.   Colbert's Departure From Petitioner and Petitioner's
     Prepayment of Amounts It Owed to Grecco Under the
     Redemption Agreement

     In the fall of 1990, Colbert decided to withdraw from

petitioner to begin doing business as Viking Bolt in direct

competition with petitioner.   This was about 2-1/2 years after

Grecco's covenant not to compete was in effect.    Grecco sent

petitioner a letter dated October 26, 1990, stating that she

objected to the redemption of Colbert's stock based on paragraph

14 of the redemption agreement.3

     Petitioner sought to prepay at a discount the amount it

owed on Grecco's covenant not to compete.    By letter dated

November 13, 1990, Grecco said that she would agree to the

prepayment if her obligation not to compete ceased on December 1,

1990, instead of June 30, 1991.    Petitioner did not agree to end

the covenant early.   On February 14, 1991, petitioner prepaid the

entire amount it owed to Grecco and the Grecco Trust, without

discount or early release of the covenant.    About 4-1/2 months

remained on the covenant.




     3
       Under par. 14 of the redemption agreement, until all
payments under the agreement have been made, petitioner must have
Grecco's written consent before taking various actions, including
reorganizing its corporate structure, except in the regular
course of business.
                               - 9 -


6.   The Value of Petitioner's Stock Held by the Grecco Trust

     The parties agree that the fair market value of the Grecco

Trust's 50 shares of petitioner was $189,300 as of June 30, 1988.

7.   Grecco as a Potential Competitor

     In 1988, Grecco was 44 years old, in good health, and had

more than 20 years' (9 with petitioner) experience in the nuts,

bolts, and fasteners distribution business.   Grecco's primary

responsibility before she left petitioner was buying inventory

and dealing with suppliers.   Previously at petitioner and at her

prior jobs in the industry, she had been responsible for buying

inventory and taking telephone orders from customers.

     Grecco knew petitioner's customer base, its pricing, and

materials sources.   She had good rapport with vendors.   She took

some sales orders over the phone, but she was not directly

responsible for sales when she left petitioner.   She also worked

to collect accounts receivable.

     Grecco organized fishing trips for some customers and

attended an annual company open house, but she had little direct

contact with most customers when she left petitioner.

     Grecco substantially contributed to petitioner's success.

She still lives in the Portland area.
                              - 10 -


8.   Grecco's Financial Status

     In 1988, Grecco's annual dividend and interest income was

about $4,000, and she had $30,000 equity in her home, an interest

in a limited partnership, and more than $80,000 in retirement

savings, not including petitioner's 1988 contribution to the

retirement plan and any growth in prior contributions.

     Petitioner paid its directors from 1984 to 1988 as follows:

Fiscal Year Ending June 30, 1984     Salary      Retirement Plan
     Tiedemann                      $90,500         $22,625
     Colbert                         90,500          22,625
     Grecco                          90,500          22,625

Fiscal Year Ending June 30, 1985
     Tiedemann                         166,000       17,610
     Colbert                           166,000       17,610
     Grecco                            166,000       17,610

Fiscal Year Ending June 30, 1986
     Tiedemann                         115,000       14,038
     Colbert                           115,000       14,038
     Grecco                            115,000       14,038

Fiscal Year Ending June 30, 1987
     Tiedemann                         154,000       27,598
     Colbert                           136,000       24,132
     Grecco                            136,000       24,132

Fiscal Year Ending June 30, 1988
     Tiedemann                         244,000       30,000
     Colbert                           238,800       30,000
     Grecco                            236,455       30,000


     Petitioner had paid Grecco a salary of $165,455 in

petitioner's fiscal year 1988 when the parties approved the

redemption agreement.   Grecco estimated that her salary and
                               - 11 -


bonus would have been at least $180,000 per year for each of

the following 3 years if she had stayed at petitioner.

9.   Sue Spencer

     In June 1988, Sue Spencer (Spencer) was one of petitioner's

top two salespeople.    However, Grecco would not have tried to

hire her if Grecco had started a competing business, and Spencer

probably would not have left petitioner to work with Grecco in a

competing business.    Petitioner fired Spencer in 1992, and

Colbert hired her to work at Viking Bolt.

                               OPINION

1.   Covenant Not to Compete

     a.   Background

     The first issue we must decide is how much, if any,

petitioner may deduct for Grecco's covenant not to compete.

Respondent argues that the covenant not to compete lacked

economic significance because the parties did not negotiate the

amount to be allocated to the covenant.    Respondent contends

that the covenant was used primarily to avoid tax.    Respondent

contends that the value of the covenant was $52,669.    Petitioner

argues that the covenant was worth the price petitioner paid

for it under the agreement, $383,400, or, in the alternative,

$324,100, the difference between the total amount it paid Grecco

under the agreement and the value of the stock redeemed.
                                - 12 -


     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. ___, ___, 113 S.

Ct. 1670, 1675, 1676 n.9, 1681-1683 (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 whether any of the amount allocated to the

covenant not to compete was a disguised payment for Grecco's

stock in petitioner.    The amount a taxpayer 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 T.C. Memo. 1978-496; Haber v.

Commissioner, 52 T.C. 255, 266 (1969), affd. without opinion 422

F.2d 198 (5th Cir. 1970); Roschuni v. Commissioner, 29 T.C. 1193,
                              - 13 -


1202 (1958), affd. 271 F.2d 267 (5th Cir. 1959); Baird v.

Commissioner, 25 T.C. 387, 393 (1955); McDonald v. Commissioner,

28 B.T.A. 64, 66 (1933); see O'Dell & Co. v. Commissioner, supra

at 468.   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.

     b.   Petitioner's and Grecco's Lack of Adversarial Tax
          Interests

     Respondent points out that petitioner had an incentive to

allocate a large amount to the covenant not to compete because

petitioner could amortize that amount over the 3-year life of

the covenant.   Respondent also points out that Grecco had no

incentive to minimize the amount allocated to the covenant

because the tax rates for ordinary income and capital gains were

generally the same during the years at issue.    Before Congress

repealed capital gains tax preferences, the grantor of a covenant

not to compete had an incentive to allocate less to the covenant

and more to stock because the payment he or she received for the

covenant was ordinary income, while the amount realized from the

sale of stock might be taxed as capital gains.    See Schulz v.

Commissioner, supra at 55, and Landry v. Commissioner, 86 T.C.
                               - 14 -


1284, 1307-1308 (1986) (both cases uphold an allocation by the

parties that resulted from arm's-length negotiations between

parties with adverse tax interests); O'Dell & Co. v.

Commissioner, supra at 468 (the adverse tax interests of the

parties to a noncompetition agreement deter allocations which

lack economic reality).    Absent adverse tax interests, we

strictly scrutinize allocations to a covenant not to compete.

2.   Effect of the Parties' Stipulation That Grecco's Stock in
     Petitioner Was Worth $189,300

     Petitioner paid Grecco $513,400 to redeem her stock and for

her covenant not to compete for 3 years.    Petitioner and Grecco

allocated $383,400 of that amount to the covenant.

     Respondent and petitioner agree that the value of Grecco's

redeemed stock was $189,300.    The difference between petitioner's

payment to Grecco under the redemption agreement ($513,400) and

the value of the stock ($189,300) is $324,100.

     Petitioner and Grecco did not have adverse tax interests

with respect to the allocation of $383,400 to the covenant.

However, Grecco and petitioner negotiated the total redemption

price at arm's length.    Also, petitioner and respondent

stipulated that the stock was worth $189,300.    Petitioner

contends that the remaining payments were payments for Grecco's

agreement not to compete.

     Respondent misses the point of petitioner's argument by

reiterating that Grecco and petitioner did not have adverse
                              - 15 -


interests as to the allocation to the covenant.   Respondent made

no argument that the difference between petitioner's payment

($513,400) and the agreed value of the stock ($189,300) was

payment for anything other than the covenant not to compete.

These facts suggest that the value of the covenant was $324,100,

the difference between the total amount petitioner paid Grecco

($513,400) and the value of the stock ($189,300).

3.   Economic Reality of the Covenant Not to Compete

     A value of $324,100 for the covenant is entirely supported

by the record in this case.   Courts apply numerous factors in

evaluating a covenant not to compete.   These include:   (a) The

seller's (i.e., covenantor's) ability to compete; (b) the

seller's intent to compete; (c) the seller's economic resources;

(d) the potential damage to the buyer posed by the seller's

competition; (e) the seller's business expertise in the industry;

(f) the seller's contacts and relationships with customers,

suppliers, and other business contacts; (g) the buyer's interest

in eliminating competition; (h) the duration and geographic scope

of the covenant; and (i) the seller's intent to reside in the

same geographic area.   Kalamazoo Oil Co. v. Commissioner, 693

F.2d 618 (6th Cir. 1982), affg. T.C. Memo. 1981-344; Forward

Communications Corp. v. United States, 221 Ct. Cl. 582, 608 F.2d

485, 492 (1979); Sonnleitner v. Commissioner, 598 F.2d 464, 468

(5th Cir. 1979), affg. T.C. Memo. 1976-249; Fulton Container Co.
                               - 16 -


v. United States, 355 F.2d 319, 325 (9th Cir. 1966); Annabelle

Candy Co. v. Commissioner, 314 F.2d 1, 7-8 (9th Cir. 1962),

remanding T.C. Memo. 1961-170; Schulz v. Commissioner, supra at

54; Peterson Machine Tool, Inc. v. Commissioner, 79 T.C. 72, 85

(1982), affd. 84-2 USTC par. 9885, 54 AFTR 2d 84-5407 (10th Cir.

1984); Major v. Commissioner, 76 T.C. 239, 251 (1981); O'Dell &

Co. v. Commissioner, supra; Rudie v. Commissioner, 49 T.C. 131,

139 (1967); Levinson v. Commissioner, 45 T.C. 380, 389 (1966).

     a.   Grecco's Ability to Compete

     Respondent concedes that Grecco had the physical and mental

ability to compete with petitioner.     However, respondent argues

that Grecco would not have been able to take much business from

petitioner if she had competed.

     We disagree.   We think Grecco's past success in cofounding

petitioner shows she has the ability to compete, and that she

knows how to surround herself with the necessary personnel to

establish a successful business.    We conclude that Grecco would

have been a good competitor.    This factor favors petitioner.

     b.   Grantor's Intent to Compete

     If the grantor would likely compete with the buyer, we

are more likely to sustain an allocation to the covenant.

Sonnleitner v. Commissioner, supra (among other factors, grantor

had threatened to compete).    In contrast, if the grantor is

unlikely to compete with the buyer, courts are less likely to
                               - 17 -


sustain an allocation to the covenant not to compete.    Schulz v.

Commissioner, supra (allocation to a covenant not to compete not

sustained because, in addition to other reasons, the covenantor

did not intend to compete); Major v. Commissioner, supra

(covenant had minimal value where the buyer felt he could get his

own customers and the grantor was of advanced age and had health

problems).

     Respondent argues that the covenant had no value because

Grecco did not intend to compete.

     Grecco said during the financial settlement negotiations

that she would compete with petitioner.    She testified at the

trial of this case that in 1988 she did not intend to compete

with petitioner.   However, she also testified that if she had

not received a satisfactory financial settlement, she might

have been forced to compete.   Colbert testified that, without

a covenant not to compete, he thought Grecco might take a job

with a competitor, but he did not think she would start her own

business.    Tiedemann testified that he was concerned that Grecco

would compete with petitioner.

     These various statements of intent and expectation by

Grecco, Tiedemann, and Colbert are less persuasive as to Grecco's

intent than the objective facts.    Grecco would no doubt have

continued to need to work absent her payment from petitioner, and

we expect that she would have stayed in the industry and area she
                                - 18 -


knew best.    Thus, we conclude that Grecco would have competed

with petitioner if she had not received an ample financial

settlement.    This factor favors petitioner.

     c.   The Grantor's Economic Resources

     Respondent concedes that Grecco had the financial resources

required to compete with petitioner.     This factor favors

petitioner.

     d.      Potential Damage to Petitioner Posed by Grecco's
             Competition

     Tiedemann testified that Grecco could take a substantial

amount of business with her.     Colbert did not believe that the

covenant was important.

     Grecco had demonstrated her ability to work in the nuts,

bolts, and fasteners industry.     Also, Grecco probably would have

hurt petitioner's business if she competed because she probably

would have taken clients from petitioner.     She did that when she

left Industrial Products Co. to start petitioner.     This factor

favors petitioner somewhat.

     e.      Grecco's Business Expertise in the Industry

     Respondent concedes that Grecco had extensive expertise in

the nuts and bolts distribution industry.     This factor favors

petitioner.

     f.   Grecco's Contacts and Relationships With Suppliers and
          Customers
     Grecco had much contact with petitioner's suppliers, but she

had little contact with its customers when she left petitioner.

This factor favors petitioner somewhat.
                              - 19 -


     g.    Petitioner's Interest in Eliminating Competition

     It appears from the fact that the 1986 stock purchase

agreement included an agreement not to compete that petitioner

wanted to eliminate competition.   This is confirmed by the fact

that petitioner paid Grecco $513,400 for her stock (which was

worth $189,300) and for the covenant not to compete.    This factor

favors petitioner somewhat.

     h.    Duration and Geographic Scope of the Covenant

     Grecco's covenant applied to competition in Oregon and

Washington for 3 years.   We think these limits were reasonably

drawn to keep Grecco from competing with petitioner.    This factor

favors petitioner.

     i.    Grecco's Intent to Reside in the Same Geographic Area

     Grecco still resides in the Portland area.   This factor

favors petitioner somewhat.

4.   The Liquidated Damages Provision

     Respondent contends that the stock purchase agreement did

not require petitioner to make any payment for the covenant not

to compete.   Respondent argues that petitioner intended that the

entire amount of the formula purchase price was to be payment

for the departing shareholder's stock.   We disagree.

     First, we fail to see why petitioner would pay $513,400 for

stock the parties agree is worth $189,300.   Second, Grecco agreed

to pay a 25-percent penalty if she breached the covenant not to

compete.
                                  - 20 -


5.   Expert Testimony

     The parties each called expert witnesses to give their

opinions about the value of the covenant not to compete.

     Expert witnesses' opinions can aid the Court in

understanding an area requiring specialized training, knowledge,

or judgment.    However, as the trier of fact, the Court is not

bound by the experts' opinions.      Helvering v. National Grocery

Co., 304 U.S. 282, 295 (1938).      The opinions of expert witnesses

are weighed according to their qualifications and other relevant

evidence.    Anderson v. Commissioner, 250 F.2d 242, 249 (5th Cir.

1957), affg. in part, remanding in part T.C. Memo. 1956-178;

Johnson v. Commissioner, 85 T.C. 469, 477 (1985).

     a.     Respondent's Expert

     Respondent's expert, William E. Holmer (Holmer), concluded

that the value of the covenant not to compete was $52,669.

Holmer viewed the 25-percent penalty provision for breach of the

covenant as evidence of what petitioner would pay Grecco for not

competing.    He used $421,346 as the starting value of Grecco's

stock in petitioner (as established by the stock purchase

agreement), 25 percent of which is $105,337.     He weighed the

conflicting positions of petitioner (which was a party to

the stock redemption agreement; that agreement provided for 25

percent of the total purchase price as a penalty for breach of

the covenant) and Grecco (who did not negotiate for payment for

not competing versus payment for the stock), and concluded that
                                  - 21 -


petitioner and Grecco would split the difference; thus, he

estimated that the value of the covenant was $52,669.

     We disagree with Holmer's estimate for several reasons.

First, he should have used as a base amount $513,400 (total

payments to Grecco), not $421,346.         Second, his basis for

reducing 25 percent of the base amount by 50 percent is

speculative.    Third, petitioner and its shareholders agreed to

the liquidated damages percentage 2 years before petitioner

forced Grecco out.    Fourth, the liquidated damages provision

applied to all of petitioner's shareholders, not just Grecco.

Thus, it does not necessarily take into account the value of her

covenant not to compete in particular.         Fifth, the liquidated

damages amount was calculated on the price petitioner paid Grecco

for the stock and the covenant rather than being based solely on

the covenant.    Sixth, the fact that petitioner paid $513,400 for

Grecco's stock (which the parties agree is worth $189,300) and

the covenant, is a much better indicator of the value of the

covenant because it is not subject to the flaws just stated.

     b.     Petitioner's Expert

     Petitioner's appraiser, Gregory A. Gilbert (Gilbert),

concluded that the value of the covenant not to compete was

$666,200.    Gilbert used estimates of lost sales provided by

Tiedemann, based on his estimate of the amount of business

petitioner would lose if Grecco and Spencer competed with

petitioner.     Tiedemann exaggerated the amount of business Grecco
                              - 22 -


would take if she competed with petitioner.    For example, he

estimated, using sales for June 1988, that Grecco might take as

much as 38.5 percent, or $125,165, of petitioner's monthly

business.   Gilbert discounted petitioner's potential lost sales

by 39 percent to take into account the uncertainty of Tiedemann's

estimate.   He considered petitioner's ability to reattract

business and an assumed cost savings from doing less business.

     We think Gilbert greatly overestimated the value of the

covenant not to compete.   Gilbert relied too heavily on

Tiedemann's estimates, and failed to consider the extent to which

Colbert could retain some of the accounts.    Grecco and Colbert

testified that she could not have taken all of those accounts.

Grecco's focus had changed from sales to suppliers.    Finally, we

think Gilbert's assumption that Grecco would hire Spencer, and

obtain Spencer's customers, was incorrect because Spencer said

she probably would not have worked with Grecco if Grecco competed

and Spencer probably could not have taken very much of

petitioner's business.

6.   Conclusion

     Although we have carefully considered the methodologies and

conclusions of the two experts, we think the objective facts

relating to Grecco's ability to compete give a more persuasive

basis for deciding the value of her covenant not to compete.

     Grecco was 44 years old in 1988, healthy, and fully able,

both physically and mentally, to compete.    She had a considerable
                                - 23 -


amount of experience in the nuts, bolts, and fasteners

distribution business.    She had sufficient financial resources to

form a competing firm, either alone or with co-owners.     She had

good relationships with customers and suppliers.     Since in 1988

she worked primarily with suppliers, we believe her competitive

impact would not have been a serious problem for petitioner if

she operated alone.     However, she could probably have offset this

by affiliating with others as she did when she and others formed

petitioner, and continuing to focus on suppliers.     She knew how

to surround herself with the necessary personnel, including

salespeople, to establish a successful business.     Considering the

entire record, we conclude that the value of the covenant not to

compete was $324,100.

7.   Additions to Tax

     a.   Negligence

     Respondent determined that petitioner is liable for the

addition to tax for negligence under section 6653(a) for its tax

year ended June 30, 1989.     Petitioner has the burden of proving

that it was not negligent.     Neely v. Commissioner, 85 T.C. 934,

947 (1985).

     Section 6653(a) imposes an addition to tax equal to 5

percent of the underpayment of tax if any part of the

underpayment is due to negligence or intentional disregard of

rules or regulations.     Negligence includes a failure to make a

reasonable attempt to comply with the provisions of the Internal
                                - 24 -


Revenue laws or to exercise ordinary and reasonable care in that

respect.   Sec. 6662(c).   Negligence is a lack of due care or

failure to do what a reasonable and ordinarily prudent person

would do under the circumstances.    Zmuda v. Commissioner, 731

F.2d 1417, 1422 (9th Cir. 1984), affg. 79 T.C. 714 (1982); Neely

v. Commissioner, supra.

     We found that the covenant had economic significance, and

that the value of the covenant was $324,100, nearly 85 percent of

the $383,400 value petitioner claimed on its return.    Given the

inexact science of valuation, we conclude that petitioner is not

liable for the addition to tax for negligence.

     b.    Valuation Overstatement

     Respondent determined that petitioner overstated the value

of the covenant by more than 250 percent and asserted the 30

percent addition to tax under section 6659(b) for petitioner's

tax year ended June 30, 1989.    A valuation overstatement occurs

where the value or adjusted basis of property reported on a tax

return is 150 percent or more of the value or adjusted basis that

is "determined to be the correct amount".    Sec. 6659(c).

     We conclude that the section 6659 addition to tax does not

apply to petitioner because 150 percent of the correct value of

the covenant ($324,100) is $468,150, and petitioner reported a

value of $383,400.
                              - 25 -


     c.   Substantial Understatement

     As an alternative to the addition to tax under section

6659, respondent determined an addition to tax for substantial

understatement of income tax under section 6661.

     Section 6661(a) provides for an addition to tax in

the amount of 25 percent of the amount of any underpayment

attributable to a substantial understatement of income tax.

An understatement is the amount by which the correct tax

exceeds the tax reported on the return.   Sec. 6661(b)(2)(A).

An understatement is substantial if it exceeds the greater

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

or $5,000.   Sec. 6661(b)(1)(A).

     If a taxpayer has substantial authority for the

tax treatment of any item on the return, the understatement

is reduced by the amount attributable to it.   Sec.

6661(b)(2)(B)(i).   Similarly, the amount of the understatement

is reduced for any item adequately disclosed either on the

taxpayer's return or in a statement attached to the return.

Sec. 6661(b)(2)(B)(ii).

     Petitioner argues that it had substantial authority for its

position, and that it reasonably relied on its tax advisers for

the tax treatment of the covenant not to compete.     Petitioner

further argues that respondent should have waived the additions

to tax under section 6661.   Vorsheck v. Commissioner, 933 F.2d

757, 759 (9th Cir. 1991).
                                 - 26 -


       We think the amount petitioner allocated to Grecco's

covenant not to compete was reasonable and that petitioner acted

in good faith.     Thus, we find that respondent should have waived

the addition to tax for a substantial understatement of income

tax.    Id.    Accordingly, we do not sustain respondent's

alternative determination as to the addition to tax.

       d.     Section 6662(h)

       With respect to tax returns due after December 31, 1989,

taxpayers are liable for a penalty equal to 20 percent of the

part of an underpayment attributable to a substantial valuation

misstatement.      Sec. 6662(b)(3).   A substantial valuation

misstatement occurs when the value of property claimed on the

return is 200 percent or more of the amount determined to be the

correct value.      Sec. 6662(e)(1)(A).   Taxpayers are liable for a

penalty equal to 40 percent of the part of the underpayment

attributable to a gross valuation misstatement.       Sec. 6662(a),

(b)(3), (h)(1).      A gross valuation misstatement occurs when the

value of property claimed on the return is 400 percent or more of

the amount determined to be the correct value.       Sec.

6662(e)(1)(A), (h)(2).

       The section 6662(h) penalty does not apply to petitioner for

its tax year ending June 30, 1990, because 400 percent of the

correct value of the covenant ($324,100) is $1,296,400, and

petitioner reported a value of $383,400.
                                - 27 -


     Respondent determined, in the alternative, that the section

6662(a) penalty applies.   Taxpayers are liable for a penalty

equal to 20 percent of the part of the underpayment to which

section 6662 applies.   Sec. 6662(a).    Section 6662 applies to

an underpayment attributable to a substantial understatement

of income tax.   Sec. 6662(b)(2).    A substantial understatement

of income tax occurs when the amount of the understatement for

a taxable year exceeds the greater of 10 percent of the tax

required to be shown or $5,000.     Sec. 6662(d)(1)(A).

     Petitioner bears the burden of proving that it is

not liable for the accuracy related penalty.     Rule 142(a).

      The accuracy related penalty under section 6662(a) does not

apply to any portion of an underpayment if the taxpayer shows

that there was reasonable cause for such portion and that the

taxpayer acted in good faith.    Sec. 6664(c)(1).   We consider

whether the taxpayer acted with reasonable cause and in good

faith based on the facts and circumstances.     Sec. 6664(c)(1).

     We conclude that petitioner is not liable for the accuracy

related penalty under section 6662(a), because as stated above,

petitioner's allocation to the covenant not to compete was

reasonable, and petitioner acted in good faith.

     To reflect the foregoing,


                                          Decision will be entered

                                     under Rule 155.
