                         T.C. Memo. 1998-281



                       UNITED STATES TAX COURT



              LORVIC HOLDINGS, INC., Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 3408-97, 15611-97.       Filed August 4, 1998.




     John P. Barrie, Dana Lasley, and Elizabeth Ann Smith,

 for petitioner.

     Robert J. Burbank, for respondent.




             MEMORANDUM FINDINGS OF FACT AND OPINION



     HAMBLEN, Judge:    Respondent determined the following

deficiencies in petitioner's Federal income tax:
                               - 2 -


           Taxable Year        Deficiencies

             1992                 $204,000
             1993                  204,420
             1994                  204,321
             1995                  153,329


The issue for consideration is whether, for purposes of section

167, the aggregate fair market value of the 5-year covenant not

to compete and the secrecy agreement is $3 million as claimed by

petitioner on its corporate Federal income tax returns.1     Unless

otherwise indicated, all section references are to the Internal

Revenue Code in effect for the years at issue, and all Rule

references are to the Tax Court Rules of Practice and Procedure.

                          FINDINGS OF FACT

     Petitioner, Lorvic Holdings, Inc., is the parent of the

Lorvic Corp. (New Lorvic), and in turn, New Lorvic is the

corporate successor to certain assets of the Lorvic Corp. (Old

Lorvic).   Petitioner is a Delaware corporation, whose principal

offices are located in Earth City, Missouri.   Old Lorvic was

engaged in the development, design, manufacturing, marketing,

distribution, and sale of a variety of health care products for

the professional dental market.    In general, the company


     1
      The notice of deficiency contains adjustments to
petitioner's environmental tax for the 1993, 1994, and 1995 tax
years. This adjustment is a computational adjustment which rests
on the Court's determination of the foregoing issue in this case.
                                - 3 -


segmented its product offerings into four broad classifications:

(a) Preventive, (b) oral evacuation, (c) infection control, and

(d) miscellaneous.    Old Lorvic offered more than 60 items,

including, but not limited to, fluoride gels, solutions,

prophylaxis paste, applicator trays, aspirator instruments,

sterile tubing, and tofflemire bands.     Old Lorvic supplemented

each product classification with private label business for

several major dental manufacturers.     Many of the company's

products were relatively simple to fabricate and were disposable

in nature.   Moreover, most of the foregoing items were not

patented.    In that regard, the company operated a manufacturing

plant in St. Louis, Missouri.

     Old Lorvic actively pursued and developed specific niche

markets which major dental manufacturers either overlooked or had

not emphasized because the overall size of such markets was not

of sufficient magnitude to make it profitable for the larger

companies to pursue.    On the other hand, Old Lorvic's structure

enabled it to exploit these niches and command high profit

margins.    Old Lorvic utilized a complex network of dental product

dealers to distribute its products to dental professionals.     In

that regard, Old Lorvic's primary sales occurred in the United

States, while Canada comprised the largest foreign market for the

company's products.
                                 - 4 -


     In 1954, Charles Nemanick acquired an interest in Old

Lorvic, and assumed managerial responsibilities.    At some point,

Charles Nemanick and family members acquired a controlling

interest in the company.     In 1979, Old Lorvic acquired

Scientific Associates, Inc. (SAI), a contract testing laboratory

in St. Louis, Missouri, which had been providing a certain amount

of services to Old Lorvic.    SAI was thereafter operated as a

separate stand-alone business.

     In March 1985, R.P. Scherer Corp. (Scherer), an

international developer of drug delivery systems and the world's

largest producer of softgels for the pharmaceutical and

nutritional supplements industries, acquired Old Lorvic.    After

the acquisition, Old Lorvic continued to operate, in practice, as

an autonomous business.    At the time of purchase, Scherer was

diversifying in order to expand its domestic earnings base.      In

the foregoing transaction, Scherer paid approximately $5.8

million for the outstanding stock of Old Lorvic.    Scherer,

however, did not prepare a valuation of the assets it had

acquired through Old Lorvic.

     The Stock Purchase Agreement (1985 Agreement) incorporated a

covenant not to compete from Charles Nemanick and his son,

Richard S. Nemanick (Richard Nemanick).    Specifically, Article

XIV of the 1985 Agreement declared:
                         - 5 -


Section 14.1 Covenant Not to Compete. Each of the
Principal Stockholders covenants and agrees that
commencing with the Effective Date and continuing for a
period of five (5) years or until the expiration of
three (3) years following the termination of any
Employment Agreement between [Scherer] as the surviving
corporation and a Principal Stockholder, whichever is
later, such Principal Stockholder shall not anywhere in
the United States and Canada, directly or indirectly,
by or for themselves or as the agent of another or
through others as their agent:

          (a) promote, sell, license, distribute
     or otherwise deal in products or services
     which are in competition with those of
     [Scherer] or any of its subsidiaries;
          (b) own, manage, operate, be compensated
     by, participate in, render advice to, have
     any right to or interest in any business
     directly or indirectly engaged in the design,
     production, sale or distribution of products
     or services directly competitive with
     [Scherer] or any of its subsidiaries; or
          (c) solicit or accept any business from
     customers of [Scherer] or any of its
     subsidiaries for products or services
     directly competitive with those of [Scherer]
     or any of its subsidiaries, or request,
     induce or advise customers of [Scherer] or
     any of its subsidiaries to withdraw, curtail
     or cancel their business with [Scherer] or
     any of its subsidiaries.
              *   *   *   *   *   *   *

Section 14.4 No Consideration Paid for Covenant. [The
parties] each recognize and agree that the entire
consideration passing to the Stockholders pursuant to
the Merger represents and constitutes the fair market
value of the shares of Lorvic Stock, and that no
portion thereof represents payment for the covenants
not to compete by the Principal Stockholders set forth
in Section 14.1 or in the Employment Agreements
attached hereto * * * For federal and state income tax
purposes neither [of the parties] will treat any
portion of such consideration as representing payment
for said covenants not to compete.
                               - 6 -




The 1985 Agreement also incorporated an unsigned, and undated,

exclusive Employment Agreement with Charles Nemanick, who, at the

date of the 1985 transaction, was the chairman and president of

Old Lorvic.   Scherer, through its new subsidiary, sought to

retain Charles Nemanick "so that the experience and management

ability" would continue to be available to Old Lorvic.

Subsequent to the 1985 acquisition, several employees of Old

Lorvic departed the company and were not, at any point, employed

by Scherer.

     Charles Nemanick managed and operated Old Lorvic until his

death in 1986.   Following Charles Nemanick's death, his son

Richard Nemanick, and Charles' wife assumed the positions of

president and chairman, respectively.   Richard Nemanick possessed

substantial experience with the company.   Specifically, he joined

Old Lorvic in 1969, holding various positions throughout the

company.   In that regard, he was responsible for marketing,

manufacturing, acquisitions, and product development.

     Old Lorvic was one of Scherer's profitable subsidiaries.

In that time frame, Old Lorvic earned, before taxes, annual

profit margins of approximately 40 percent.    In particular, Old

Lorvic's Nyclave product which was a nylon wrap, was one of the

principal products in terms of sales volume.   Old Lorvic
                               - 7 -


controlled approximately 90 percent of the Nyclave market.

Also, Old Lorvic controlled approximately 80 percent of the

market for disposable surgical aspirators, and 40 percent of the

market for oral evacuators and a somewhat lesser percentage for

prophylaxis paste.   In that connection, Old Lorvic's major

distributors accounted for more than 50 percent of its gross

sales.

     Throughout the period, Richard Nemanick provided the

management of Scherer, on a monthly basis, with reports that

detailed Old Lorvic's top 10 products, including the sales

percentage change by month and year to date.    Such reports

included sensitive information which incorporated data on

important customers, competitors, and Government regulations

affecting the market.   In addition, he prepared profit plans

which included projections of future sales.    He also prepared

annual budget reports which detailed its profit margins by

product line and by specific product.   Richard Nemanick conducted

frequent telephone conversations with representatives from

Scherer and participated in company meetings at least twice a

year.

     In late 1989, Scherer was acquired in a leveraged buyout by

Shearson Lehman Hutton Holdings, Inc. (Shearson Lehman).

Subsequently, pursuant to directions from Shearson Lehman,
                                 - 8 -


Scherer contemplated divesting itself of Old Lorvic because of

new strategic objectives and considerations with respect to its

business.

     In an undated Descriptive Memorandum prepared by Shearson

Lehman, it was noted that "Management feels the loyalty of its

customer base is Lorvic's most significant competitive advantage

in a market dominated by large corporate organizations."

Moreover, the Descriptive Memorandum also recognized that "While

[Old Lorvic] utilizes a dealer network for the majority of sales,

senior management has built strong direct relationships with

[Old] Lorvic's old customers."    The Descriptive Memorandum

reported that the management of Old Lorvic projected that

revenues would increase in the short term.    In particular,

revenue was projected to be $4.1 million for the taxable year

ended March 31, 1990.   This figure was a 12.8-percent increase

from the previous year.   For the fiscal year 1992, revenues were

projected to reach $5 million with $2.1 million in operating

income.

     Scherer offered to sell Old Lorvic to Richard Nemanick for

approximately $7.5 million.   At the same time, Chemical Ventures

Capital Associates (Chemical Ventures), a venture capital

company, in conjunction with John I. Kirtley (Kirtley), and P.

Jeffrey Leck (Leck) received the Descriptive Memorandum regarding
                                - 9 -


Old Lorvic, and were interested in pursuing an acquisition of the

company.    Leck performed due diligence research on Old Lorvic

including visiting the corporation on numerous occasions and

holding indepth conversations with the officers and managers.      In

the process, Leck, Kirtley, Chemical Ventures, and Richard

Nemanick formed petitioner and a subsidiary, LC Acquisition, to

facilitate the acquisition of Old Lorvic's assets.    Petitioner

was capitalized as set forth below:


                      Common            Preferred         Total
Purchaser             Stock             Stock             Cost

Chemical Venture      9,895             15,000       $1,509,895.00
Kirtley               2,552.5           105              13,052.50
Leck                  2,552.5           105              13,052.50
Richard Nemanick     10,000             900             100,000.00



     In December 1989, Leck and Kirtley compiled an "Acquisition

Financing Memorandum" (Acquisition Memorandum) regarding the

target corporation, Old Lorvic, which noted that "senior

management", as well as Leck and Kirtley, through Florida Capital

Partners, Inc., had "signed a Letter of Intent to acquire the

Lorvic Corp. * * *, a wholly owned subsidiary of R.P. Scherer

Corp.".2    The Acquisition Memorandum was intended, in part, to




     2
      Kirtley and Leck were two principals and owners of Florida
Capital Partners, Inc.
                             - 10 -


obtain loan amounts from financial institutions for petitioner's

prospective purchase of Old Lorvic.

     The Acquisition Memorandum identified and detailed specific

factors as crucial to Old Lorvic's success in the dental

professional field and related objectives.     Among other things,

the Acquisition Memorandum stated that a great degree of Old

Lorvic's attractiveness as a company for acquisition rested on

increasing yearly revenues, an attractive purchase price, and

significant success in its strategy of marketing to specific

niches in the dental professional field.   The Acquisition

Memorandum stated as factors that supported the assumption of

ownership:

     (3) Strong Management Team. The Nemanick family has
     been managing Lorvic's operations for nearly 35 years.
     Senior management averages more that [sic] 22 years
     with the Company. While the Company utilizes a dealer
     network for the majority of sales, senior management
     has built strong direct relationships with Lorvic's
     direct customers.

             *    *     *     *       *    *      *

     (6) Long Established Customer Base. Lorvic has been
     supplying products to the professional dentistry market
     for over thirty years, and the Company's top ten
     customers have been ordering from Lorvic for an average
     of seventeen years. Management feels the loyalty of
     its customer base is Lorvic's most significant
     competitive advantage in a market dominated by large
     corporate organizations.
                               - 11 -


However, Leck was concerned about what he perceived as potential

weaknesses in Old Lorvic's substantial profit margins.    In order

to protect the new company, Leck insisted on a covenant not to

compete "that had enough teeth in it," and, which would preclude

competition from Scherer.    Also, Leck believed that there was a

distinct possibility that Scherer could disclose sensitive

information that it possessed regarding Old Lorvic's business

operations.   Accordingly, Leck required a secrecy agreement.

Leck would not have purchased the assets of Old Lorvic without

these agreements.

     After consultations with Shearson Lehman, Scherer

established a price of approximately $10 million to $12 million.

Several potential buyers considered purchasing the business.    In

the process of negotiations, Leck reduced his initial offer by $1

million because of concerns that potential competitors would

obtain critical information that was being disseminated by

Shearson Lehman.    Eventually, the only firm offer was that

submitted by petitioner's subsidiary, LC Acquisition, for $6.14

million for the assets of Old Lorvic (inclusive of corporate

cash), and $1 million for a secrecy agreement and $2 million for

a noncompete agreement.
                               - 12 -


     On December 28, 1989, LC Acquisition reached an agreement to

acquire the assets of Old Lorvic.3      The funds utilized for the

acquisition of Old Lorvic originated from petitioner's capital

contributions and third parties related to Chemical Ventures.

The acquisition documents in the foregoing transaction reflect a

purchase price of $5.14 million for the tangible assets.4     The

foregoing transaction was embodied in an Asset Purchase Agreement

(Purchase Agreement).    Concomitantly, petitioner entered into a

5-year noncompete agreement with Old Lorvic, Scherer, and its

affiliates, respectively.   In that regard, pursuant to the

agreements, petitioner paid $2 million for the noncompete

covenant, and $1 million for the secrecy agreement.     The covenant

not to compete stated:


     2. Noncompetition.

          (a) For a period of five (5) years after the
     Closing Date, Scherer and each of the Sellers shall
     not, and shall cause any Affiliate which it Controls,
     directly or indirectly, to not, directly or indirectly,
     enter into, engage in, assist, give or lend funds to or
     otherwise finance, be employed by or consult with, or
     have a financial or other interest in, any business
     which competes with the Business (or any part thereof)


     3
      Specifically, the Purchase Agreement denominated "LC
ACQUISITION CORPORATION," as the "Purchaser," and Scherer and its
affiliates as the "Sellers". See infra p. 13.
     4
      Subsequent to the 1989 transaction, Scherer retained and
continued to operate SAI, a business previously owned by Old
Lorvic.
                             - 13 -


     of the Purchaser within the United States or Canada
     (the "Territory"), whether for or by itself or as an
     independent contractor, agent, stockholder, partner or
     joint venturer for any other Person.

The covenant not to compete also delineated that in the event

that any of the sellers (i.e., Scherer and ancillary affiliates)

possessed a financial or any other interest, in an entity in the

same line of business, the foregoing parties would divest all of

their interest within 60 days.   Furthermore, in the event of a

breach, either actual or anticipatory, LC Acquisitions was

entitled to, among other things, temporary or permanent

injunctive relief.

     In turn, the secrecy agreement described the terms of

confidentiality between the seller and the purchaser.5    The

aforementioned agreement provided that for a period of 5 years

after the transaction Scherer and its affiliates would not

disclose any nonpublic, confidential, or proprietary information

such as "analyses compilation, data, studies, or other documents"

or use such information in any manner without petitioner's

permission.   Additionally, one of the terms of the Purchase

Agreement provided that Scherer and its affiliates were required

to submit "confidential offering memoranda and other sales


     5
      Both the secrecy agreement and the covenant not to compete
utilize and apply essentially the same terms except paragraphs 2
through 6 which refer separately to the terms of the respective
agreements.
                               - 14 -


literature" to petitioner.    Finally, the parties agreed to the

immediate transfer by wire of $2 million and $1 million for the

covenant not to compete and the secrecy agreement, respectively,

to Scherer at the closing date.

     Richard Nemanick simultaneously entered into an exclusive

employment agreement, with LC Acquisition, for a period of 5

years.   He also agreed, during his employment, and for a period

of 3 years thereafter, not to engage in competition with LC

Acquisition or its affiliates.

     After the 1989 transaction, LC Acquisition changed its name

to the Lorvic Corp. (i.e., New Lorvic), the affiliate of Lorvic

Holdings, Inc., petitioner.    The written documentation, however,

that Richard Nemanick frequently submitted to Scherer prior to

the 1989 transaction was not returned to petitioner or its

affiliates pursuant to the Purchase Agreement.

     Subsequently, petitioner retained the accounting firm, Ernst

& Young, to complete a valuation of the assets, tangible and

intangible, acquired from Old Lorvic, as well as the noncompete

and secrecy agreements, respectively.    This evaluation was

undertaken to meet the purchase price allocation rules delineated

in section 1060.

     With respect to the agreements, petitioner claimed the

following amortization expense deductions:
                                 - 15 -



                      Noncompete           Secrecy         Total
Taxable Year          Agreement            Agreement       Deductions

   1990               $100,000              $50,000        $150,000
   1991                400,000              200,000         600,000
   1992                400,000              200,000         600,000
   1993                400,000              200,000         600,000
   1994                400,000              200,000         600,000
   1995                300,000              150,000         450,000

TOTAL                2,000,000            1,000,000       3,000,000

     On June 29, 1990, Scherer filed a Form 10-K, pursuant to

section 13 or 15(d) of the Securities Exchange Act of 1934, with

the Securities and Exchange Commission (SEC), for the 1990

taxable year.    15 U.S.C. secs. 78m(a), 78o(d) (1994).   The Form

10-K specified that, by 1990, Scherer had disposed of all of its

diversified health care products and services businesses, except

one specific company, Paco Pharmaceutical Services, Inc.     Also,

in an undated memorandum entitled "Corporate Development: Status

and Strategy", Scherer delineated its general marketing

strategies.6    Among other things, the aforementioned memorandum

discussed Scherer's goal, in 1990 and beyond, to acquire

companies that contributed a certain amount of money, and

possessed "high growth potential in major market areas".     The

memorandum describes Old Lorvic's acquisition process as part of

its "opportunistic diversification" strategy.


     6
      The record indicates that Richard Nemanick obtained the
memorandum in 1987.
                              - 16 -


     In 1995, petitioner's assets and liabilities were sold to

Young Innovations (Young), an international supplier of dental

products, for approximately $15.2 million.   The acquired assets

included cash in petitioner's possession of $1.7 million and

corresponding liabilities were $2.4 million.    Simultaneously,

Richard Nemanick entered into an employment and noncompetition

agreement with Young.   In the process, he also entered into a

consulting agreement which included a nondisclosure provision.

However, Leck did not execute a noncompete agreement in favor of

Young.

                              OPINION

     In this instance, the dispute here centers on how much, if

any, petitioner may amortize for the covenant not to compete and

the related secrecy agreement.   Stated in a different manner, the

issue for our decision is whether any portion of the $2 million

and $1 million paid to Scherer pursuant to the 1989 transaction

is properly allocable to the covenant not to compete and the

secrecy agreement, respectively.   Respondent asserts that the

payments pursuant to the agreements were, in substance, payments

for the sale of nonamortizable goodwill or going-concern value.

Petitioner argues that such deductions are allowable.   In this

regard, petitioner bears the burden of proof.   Rule 142(a); Welch

v. Helvering, 290 U.S. 111, 115 (1933).
                                - 17 -


     Section 167(a), in general, allows a taxpayer to amortize

intangible assets over their useful lives.7   Citizens & S. Corp.

v. Commissioner, 91 T.C. 463, 470 (1988), affd. per curiam 919

F.2d 1492 (11th Cir. 1990); sec. 1.167(a)-3, Income Tax Regs.

The standard for deciding whether an intangible is depreciable is

that such an asset must have an ascertainable value and a limited

useful life, the duration of which can be determined with

reasonable accuracy.    Newark Morning Ledger Co. v. United States,

507 U.S. 546, 556 n.9 (1993).    A covenant not to compete

constitutes an intangible asset that has a limited useful life

and, therefore, may be amortized over its useful life.       Warsaw

Photographic Associates, Inc. v. Commissioner, 84 T.C. 21, 48

(1985); O'Dell & Co. v. Commissioner, 61 T.C. 461, 467 (1974).

     Conversely, goodwill is the aggregate value of the

relationships and reputation developed by a business with its

present and potential customers and associates over a period of

time.    It has been described as the "'expectancy of continued



     7
        Sec. 167(a), in particular,

          SEC. 167(a). General Rule.--There shall be allowed
     as a depreciation deduction a reasonable allowance for
     the exhaustion, wear and tear (including a reasonable
     allowance for obsolescence)--
               (1) of property used in the trade or
          business, or
               (2) of property held for the
               production of income.
                               - 18 -


patronage'".    Newark Morning Ledger Co. v. United States, supra

at 555-556 (citing Boe v. Commissioner, 307 F.2d 339, 343 (9th

Cir. 1962), affg. 35 T.C. 720 (1961)); Metallics Recycling Co. v.

Commissioner, 79 T.C. 730, 742 (1982), affd. 732 F.2d 523 (6th

Cir. 1984).    However, because goodwill is considered not to have

a limited useful life, no amortization deductions are allowable.

Sec. 1.167(a)-3, Income Tax Regs.8; see also discussion in Newark

Morning Ledger Co. v. United States, supra at 565-566.    Going-

concern value is similar to goodwill in that it reflects "the

additional element of value which attaches to property by reason

of its existence as an integral part of a going concern."    VGS

Corp. v. Commissioner, 68 T.C. 563, 591 (1977).    Consequently, we

must decide whether any of the amount paid for the covenant not

to compete and the secrecy agreement was a disguised payment for

nonamortizable items such as goodwill.



     8
      Sec. 197, which provides for the amortization of certain
acquired assets, such as purchased goodwill, was added to the
Internal Revenue Code by the Omnibus Budget Reconciliation Act of
1993 (OBRA-93), Pub.L. 103-66, sec. 13261(a), (g), 107 Stat. 532,
540, and applies to property acquired after Aug. 10, 1993 (the
date of enactment). Prior to the 1993 Act, acquired goodwill and
going concern value were not amortizable, but other acquired
intangible assets were amortizable if they could be separately
identified and their useful lives determined with reasonable
accuracy. At present, sec. 197 allows taxpayers to amortize
certain acquired intangible assets over 15 years, subject to
certain exceptions. However, sec. 197 does not apply to the
assets in the instant case because they were acquired prior to
the date of enactment.
                               - 19 -


     In deciding the issues presented here, we are guided by the

following principles.   Simply because a particular taxpayer pays

or allocates a specific amount to a covenant not to compete is

not controlling for Federal income 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 it

does not have adverse tax consequences for the parties; 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; O'Dell & Co. v. Commissioner, supra

at 468; 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. per curiam 271 F.2d 267 (5th Cir.

1959); Estate of McDonald v. Commissioner, 28 B.T.A. 64, 66

(1933).   Further, we may go beyond the formalities delineated by

the parties to ascertain if the form reflects the substance of

those dealings.   Yandell v. United States, 315 F.2d 141, 142 (9th

Cir. 1963); Annabelle Candy Co. v. Commissioner, 314 F.2d 1, 5

(9th Cir. 1962), affg. per curiam T.C. Memo. 1961-170.

     In order for the form in which the parties have cast their

transaction to be respected for Federal income tax purposes, the

covenant not to compete and the secrecy agreement must have some

independent basis or an arguable correlation to business reality
                                - 20 -


such that reasonable people might bargain or contract for such an

agreement.     Schulz v. Commissioner, 294 F.2d 52, 55 (9th Cir.

1961), affg. 34 T.C. 235 (1960).     This particular test is

referred to as the "economic reality" test.     Patterson v.

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

1985-53.     An allocation to a covenant not to compete lacks

economic reality in the event that there is no showing that the

seller by refraining from competition stands to lose earnings

comparable to the amount supposedly paid for the covenant or that

the buyer would lose such an amount if the seller were to compete

against it.     Forward Communications Corp. v. United States, 221

Ct. Cl. 582, 608 F.2d 485, 493-494 (1979).

     The 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 others

in the business; (g) the buyer's interest in eliminating

competition; (h) the duration and geographic scope of the

covenant, and (i) the seller's intention to remain in the same

geographic area.     Kalamazoo Oil Co. v. Commissioner, 683 F.2d 618
                              - 21 -


(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.

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

Candy Co. v. Commissioner, supra at 7-8; Schulz v. Commissioner,

supra at 55; Peterson Mach. Tool, Inc. v. Commissioner, 79 T.C.

72, 85 (1982), affd. per curiam 54 AFTR 2d 84-5407, 84-2 USTC

par. 9885 (10th Cir. 1984); Major v. Commissioner, 76 T.C. 239,

251 (1981); O'Dell & Co. v. Commissioner, supra at 468-469; Rudie

v. Commissioner, 49 T.C. 131, 139 (1967); Levinson v.

Commissioner, 45 T.C. 380, 389 (1966).

     Finally, fair market value is a question of fact, and the

trier of fact must weigh all relevant evidence of value and draw

appropriate inferences.   Commissioner v. Scottish Am. Inv. Co.,

323 U.S. 119, 123-125 (1944); Helvering v. National Grocery Co.,

304 U.S. 282, 294 (1938); Symington v. Commissioner, 87 T.C. 892,

896 (1986); Zmuda v. Commissioner, 79 T.C. 714, 726 (1982), affd.

731 F.2d 1417 (9th Cir. 1984).   With respect to the concept of

fair market value, that term is generally defined as the price

which a willing buyer would pay a willing seller, both having

reasonable knowledge of the facts and neither acting under any

compulsion.   See United States v. Cartwright, 411 U.S. 546, 551
                              - 22 -


(1973).   The standard to be applied here is objective, utilizing

a hypothetical willing buyer and seller.   The foregoing analysis

is not, however, a specific standard that focuses on any

particular buyer or seller.   See Propstra v. United States, 680

F.2d 1248, 1251-1252 (9th Cir. 1982).   In addition, the

determination of the fair market value of property is a matter of

sound judgment, rather than of mathematics.   See In re Estate of

Williams, 256 F.2d 217, 220 (9th Cir. 1958), affg. T.C. Memo.

1956-239.   Moreover, since valuation is necessarily an

approximation, it is not required that the value we determine be

one as to which there is specific evidence, provided it is within

the range of figures that properly can be deduced from the

record.   Silverman v. Commissioner, 538 F.2d 927, 933 (2d Cir.

1976), affg.   T.C. Memo. 1974-285; Hamm v. Commissioner, 325 F.2d

934, 939-940 (8th Cir. 1963), affg. T.C. Memo. 1961-347.   Fair

market value is determined on the applicable valuation date,

which, in this case, is the date that Old Lorvic's assets were

acquired by petitioner, and the agreements were implemented.

Pabst Brewing Co. v. Commissioner, T.C. Memo. 1996-506.

     Respondent suggests petitioner possesses an incentive to

allocate a large amount to the covenant not to compete because

petitioner could amortize that amount over the life of the

covenant.   In that vein, respondent asserts that the payments
                              - 23 -


were either goodwill or going-concern value.   In the alternative,

respondent contends that the covenant not to compete does not

have a limited useful life.   Conversely, petitioner argues that

the aggregate payment of $3 million to Scherer was determined by

a willing buyer and a willing seller, and substantiated by its

experts.9

     In the instant case, the parties have relied on the opinions

of experts to support their respective views on the fair market

value of the agreements.   We evaluate the expert opinion evidence

in light of the qualifications of the expert and with proper

regard for all other evidence in the record.   Estate of Christ v.

Commissioner, 480 F.2d 171, 174 (9th Cir. 1973), affg. 54 T.C.

493 (1970); IT&S of Iowa, Inc. v. Commissioner, 97 T.C. 496, 508

(1991); Parker v. Commissioner, 86 T.C. 547, 561 (1986).   We may

accept or reject an expert's opinion in toto, or we may pick and

choose the portions of the opinion which we choose to adopt.

Helvering v. National Grocery Co., supra at 294-295; Estate of

Kreis v. Commissioner, 227 F.2d 753, 755 (6th Cir. 1955), affg.

T.C. Memo. 1954-139; Seagate Tech., Inc. & Consol. Subs. v.

Commissioner, 102 T.C. 149, 186 (1994); Chiu v. Commissioner, 84

T.C. 722, 734 (1985).


     9
      Hereafter, the covenant not to compete and the secrecy
agreements will, collectively, be referred to as, "the
agreements".
                               - 24 -


     We turn to the qualifications and testimony of the three

witnesses whom the Court recognized as experts for purposes of

this proceeding.   First, petitioner presented David P. Schutte,

Ph.D. (Dr. Schutte), a senior associate for Business Valuation

Services (BVS).    Dr. Schutte possesses a Ph.D. in economics from

the University of Minnesota, an M.S. in applied math from the

University of Texas, and a B.A. in economics from the University

of California at Berkeley.   Prior to his tenure with BVS, Dr.

Schutte taught finance at the University of North Texas.    He has

also published articles on economics and finance and authored a

standard reference on business valuation.

     Dr. Schutte reviewed the publicly available information,

such as Scherer's annual report, as well as internal,

confidential documents with respect to Scherer provided by

Nemanick.   He also conducted discussions with Nemanick and Leck.

In calculating the value of the agreements, Dr. Schutte applied

the discounted present value of cash-flow to determine the value

of petitioner with and without the foregoing agreements.    The

starting point of his calculation was his determination that the

value of the business with the agreements was $8,255,049.     In his

report, Dr. Schutte pointed out that his conclusion was

consistent with the parties' valuation of Old Lorvic and the

agreements.   Next, Dr. Schutte calculated the value of the
                               - 25 -


agreements by determining petitioner's value without the

agreements and subtracted that value from the previously

determined value of the business with the agreements.     The

difference in value of the business was held to be directly

attributable to the agreements.

     Dr. Schutte valued petitioner's business without the

agreements to be $4,924,636.   In that vein, he calculated that,

in the aggregate, prior to the consideration of the actual

transaction value, the agreements were worth $3,330,413.     Then,

he divided $3,330,413 by $8,255,049 to reach a figure of 0.4034.

In other words, Dr. Schutte believed that the value of the

agreements was equivalent to 40.34 percent of the purchase price

of $8.14 million.

     Second, petitioner presented Thomas P. Lee (Lee) an

appraiser of business and intangible assets for Arthur Andersen,

L.L.P.   Lee possesses an M.B.A. from New York University.      He

also has an M.S. as well as a B.S. in civil engineering from the

Polytechnic Institute of New York.      Lee is a member of, and has

attended conferences and seminars with, the American Society of

Appraisers.   Prior to his tenure with Arthur Andersen, L.L.P.,

Lee was employed by several accounting and valuation firms

including, among others, Ernst & Young, L.L.P.     Subsequent to the

1989 transaction, while employed with Ernst & Young, L.L.P., Lee
                              - 26 -


prepared a confirming appraisal for petitioner.    The report was

intended to determine the value of the assets for purposes of a

section 1060 allocation.

     In his analysis, Lee applied the discounted cash-flow method

over the 5-year period covered by the agreements.   He calculated

the cash-flow over the 5 years covered by the agreements under

two scenarios: (1) Petitioner was protected by the agreements;

and (2) where petitioner was harmed by the competition and

disclosure of information by Scherer.   Then, he determined the

differences in the cash-flow which would be forgone in the

absence of the agreements.   Lee stated that the discounted

present value of the differential between the cash-flows in the

foregoing scenarios was the fair market value of the agreements.

In this appraisal, Lee assigned a value of $2 million for the

covenant not to compete, and $1 million for the secrecy

agreement.

     Finally, the Court recognized as an expert, Joseph H. Wildt

(Wildt), an engineer with respondent.   He possesses an M.S. in

valuation, and a B.S. in electrical engineering.    He acquired the

master's degree in 1981.   Also, Wildt has attended numerous

courses presented by the American Society of Appraisers regarding

business valuation.   Finally, Wildt had been a senior member of
                              - 27 -


the American Society of Appraisers for approximately 15 years but

is now a member of the Institute of Business Appraisers.

     Wildt's ultimate analysis and conclusion was that the

agreements possessed a value of $1.209 million.     In his report,

Wildt estimated petitioner's cash-flow for the 5-year lives of

the agreements with the assumption that the agreements were in

force and that Scherer did not contest in the same market.

Then, he estimated the cash-flow over the same time period based

on the assumption that Scherer was in direct competition with

petitioner, and the likelihood of that particular factor.

     In his report, Wildt determined that the effect of

competition by Scherer would decrease over the life of the

covenant.   Wildt analyzed 15 factors to determine the extent and

magnitude of competition from Scherer.    Finally, Wildt determined

that petitioner would enjoy tax benefits from the amortization

deductions available for the agreements.

     Here, we do not agree with either party in all respects.     In

that regard, we find that the experts provided some useful,

although limited, help in our examination and appraisal.

Nevertheless, we are not significantly persuaded by any one of

the experts.   The parties' experts, in general, utilized the

discounted cash-flow method in valuing the covenant not to

compete and the secrecy agreement.     In other words, the experts
                              - 28 -


compared petitioner's projected net income with and without the

agreements.   We think, however, that petitioner's expert

witnesses, Dr. Schutte and Lee, overestimated the value of the

covenant not to compete and the secrecy agreement.   Both experts

relied too heavily on unwarranted assumptions.   Both Lee and Dr.

Schutte did not identify with particularity the factor(s) that

would have impelled Scherer to compete.   The only material

factors that Dr. Schutte and Lee could point to were threefold:

(1) Scherer possibly retained an institutional record of

sensitive information regarding Old Lorvic's products, suppliers,

distributors, and marketing data; (2) Scherer was familiar with

the products that were relatively simple to manufacture, and

rendered significant returns on Old Lorvic's initial investment;

and (3) Scherer had the capability of competing with Old Lorvic,

and might, at any given point in time, reassess its initial

decision to leave the specialized dental care market.10


     10
      Also, in the instant case, petitioner relies heavily on
Thompson v. Commissioner, T.C. Memo. 1997-287. We, however, find
the citation to Thompson, to be inapposite. In the foregoing
case, the taxpayers were individuals who had extensive knowledge
and experience of the beauty supply business, as well as
substantial relationships with suppliers and distributors.
Accordingly, the record there "overwhelmingly [established] a
strong need, and a corresponding high relative value," for the
noncompete agreements. Thompson. Here, petitioner, a
corporation, has not demonstrated that there was an overwhelming
need for the noncompete agreements. Further, in Thompson, there
was an ample record of negotiations between the parties regarding
                                                   (continued...)
                               - 29 -


     We found Lee's appraisal report, published under Ernst &

Young's aegis, to be useful and informative in summarizing some

of the facts and issues which are in dispute here.   However, his

report suffers from unexplained assumptions.   For example, in his

report, he concluded that Scherer would not find it difficult to

compete with petitioner.    At trial, Lee conceded that Scherer did

not have a relationship with either the suppliers or distributors

of Old Lorvic's products.   The record manifests that Scherer had

a detached relationship with its affiliate, Old Lorvic, other

than the periodic reports that Nemanick submitted to the parent

company.   Hence, Scherer did not develop business or personal

relationships with the suppliers or distributors.    Moreover, Lee

evidently disregarded the fact that, in essence, Old Lorvic was

managed by the Nemanick family and assumed that Scherer could

have induced petitioner's employees through increased financial

compensation to work for Scherer.   In that connection, we observe

that Scherer did not retain any of Old Lorvic's employees

subsequent to the 1989 purchase.

     Also, in his report, Lee stated that the fair market value

of certain real property was consistent with an appraisal made in



     10
      (...continued)
the noncompete and employment agreements. In contrast,
petitioner here relies heavily on experts and sparse
documentation.
                               - 30 -


1985.   In our opinion, we think that there would have been some

significant increases or, at least, variations in the value of

the real property in the space of 4 years.    Finally, we note that

Lee, in his determination of the value of the secrecy agreement,

did not explicitly state the grounds for valuing the

aforementioned agreement at $1 million.    He appears to have based

that valuation on the fact that the purchasers reduced Old

Lorvic's purchase price by that particular amount upon learning

that Shearson Lehman was circulating the Descriptive Memorandum.

     Next, we are not satisfied with the testimony of Dr.

Schutte.    At the outset, Dr. Schutte submitted a report which was

later revised to correct numerous and substantive mathematical

errors.    We are not certain they were adequately corrected.     We,

therefore, do not have great confidence in the substance of Dr.

Schutte's report and testimony.    In that setting, we scrutinize

Dr. Schutte's report.

     Dr. Schutte conducted discussions with Nemanick and Leck

regarding Old Lorvic's business and reviewed the relevant

financial information appurtenant to the 1989 purchase.     Dr.

Schutte's estimations, however, present us with some difficulty.

Dr. Schutte computed that, in any given year, there was a 30-

percent probability that Scherer would enter the market in

competition with petitioner.    In that vein, Dr. Schutte estimated
                              - 31 -


that once Scherer was in the same business, it would become an

effective competitor over time.    He did not adequately explain

the premises behind the foregoing figure.    Moreover, Dr. Schutte

stated that the most likely scenario involving possible

competition by Scherer was for the company to introduce one or

more competing products in select niche markets.    However, Dr.

Schutte appears to have calculated the possibility of competition

in all of the products.   This, of course, results in an overall

reduction in projected revenues.    We do not think that Dr.

Schutte's assumptions, in this regard, result in a consistent and

accurate computation.

     On the other hand, respondent's expert, Wildt, provided

significant detail and insight in his analysis of the 1989

transaction although there were some problems with his testimony

and report.   For example, he was, in some respects, unfamiliar

with New Lorvic's business or the nature of its operations.    He

did not interview any of the principals or visit New Lorvic's

management and operation facilities in an effort to ascertain the

background and circumstances behind Scherer's sale of Old

Lorvic's assets.   Moreover, Wildt compared the company with

unnamed publicly traded companies in the dental supply market.

However, his report does not indicate the comparable companies,

the date, or sources of information.
                              - 32 -


     We think that Wildt neglected the importance of the

likelihood that Scherer possessed sensitive information

concerning Old Lorvic's business operations such as the

profitability of Lorvic's product lines, and the identities of

the suppliers and distributors.   Richard Nemanick's testimony at

trial established that the monthly reports on Old Lorvic's

operations, which included its top 10 products and its major

customers, were prepared and circulated to Scherer.    Also, the

testimony reflects that Richard Nemanick frequently discussed the

contents of these reports with the Scherer managers.

     Therefore, we do not find the contributions of any of the

experts to be, ultimately, dispositive of the issue before us.

We, consequently, address the issue on the basis of the record

before us.

     At the date of the 1989 transaction, Scherer was actively

engaged in the international research, development, manufacture,

and distribution of drug delivery systems which, in turn, were

marketed through distributor networks.   Scherer possessed

affiliates which were involved in businesses in the health care

field.   It was a large, well-capitalized, multinational

corporation, with production facilities, distribution networks,

and an extensive brand name recognition among health care

professionals.   Accordingly, Scherer with its marketing expertise
                              - 33 -


and manufacturing facilities would not have had to incur

tremendous startup costs or, even, allot significant economic

resources in order to compete effectively with petitioner.

     New Lorvic, however, did not have long-term contracts with

either the business suppliers or distributors subsequent to the

1989 transaction.   In that vein, we note that the customer base

was not bound, contractually or otherwise, to Old Lorvic's

products.   Consequently, the distributors and ultimate customers

were not precluded from testing the effectiveness of other

products.   On the other hand, in Richard Nemanick's estimation,

Old Lorvic did not have a single competitor that designed,

manufactured or distributed a wide range of similar or identical

items.

     The parties evidently agree that most of petitioner's

products were relatively simple to manufacture.   Hence, a

potential competitor would find it elementary to replicate the

majority, if not all, of the products.   Thus, competition from

Scherer or any disclosure to outside individuals or entities of

the proprietary information from petitioner would have had

significant impact on petitioner's bottom line.   For example, Old

Lorvic's top 10 customers constituted more than 50 percent of its

revenues.   Therefore, we believe that any competition by Scherer

would substantially harm petitioner's profit margins.
                               - 34 -


     During Scherer's ownership of Old Lorvic, Richard Nemanick

submitted monthly and annual reports on the top 10 suppliers and

customers.    It is petitioner which concedes that the contractual

requirement that all documentation retained by Scherer was to be

returned was not, in fact, satisfied.    In that regard, we observe

that Leck, at trial, considered any written information that

Scherer retained after the sale, to be "a minor detail."     He

considered it the responsibility of his partner, Richard

Nemanick.    Similarly, Richard Nemanick did not consider the

information to be important.    Furthermore, Richard Nemanick

considered the covenant not to compete as "window dressing".      We

infer, therefore, that the parties were not overly concerned with

the possibility that Scherer would compete with petitioner.

     The parties were sophisticated and engaged in customary and

conventional negotiations regarding the purchase of Old Lorvic's

assets, culminating in the appurtenant agreements.    In that

regard, the record does not indicate that the parties possessed

adverse financial interests in regard to the allocation of $3

million to the agreements.    Furthermore, the agreements

incorporated clauses which provided that petitioner could enforce

the covenant and the appurtenant secrecy agreement in the event

that Scherer did not abide by these terms.    However, we observe

that the subsequent Ernst & Young report did not make an
                              - 35 -


allocation between goodwill or going-concern-value and the

agreements as a whole.   Moreover, the record manifests that the

parties were somewhat cavalier regarding the valuations for

goodwill in 1985 and 1989.

     The secrecy agreement and the covenant not to compete are

comparable, in nature, to the 1985 agreements.   The record

reflects that the parties in the 1985 transaction implemented an

agreement not to compete in Article XIV.   Specifically, Old

Lorvic's "principal stockholders" were precluded from entering

into or financing the entry of others into the business of Old

Lorvic, or any business or branch of business similar to that of

Old Lorvic.   In addition, Richard Nemanick was contractually

bound in his capacity as an executive officer of Old Lorvic by an

exclusive employment agreement.   The record indicates that an

exclusive employment agreement ensued from the 1989 purchase of

Old Lorvic's assets.

     Finally, Scherer's Form 10-K, filed on June 29, 1990, with

the SEC provided that the company intended to concentrate on its

primary business of softgel capsule production and divest itself

of subsidiary businesses affiliated with health care products and

services.   We believe that the aforementioned document simply

evidences Scherer's divestiture plans after it had entered into

the agreements with petitioner.   At the time Scherer filed the
                               - 36 -


Form 10-K with the SEC, the agreements prohibited Scherer from

competing in the professional dental products market.

Consequently, this document possesses little probative evidence

of what Scherer's intentions and designs for the future would

have been in the absence of the agreements.    Furthermore,

Scherer's undated, internal memorandum does not evidence that,

because of "opportunistic diversification", it would, eventually,

compete with petitioner.11   If anything, we think it unlikely

that Scherer would sell the assets of Old Lorvic because it did

not fit its then current marketing strategy, and subsequently,

enter into competition with an entity endowed with significant

advantages such as petitioner.

     In sum, we believe that Scherer had the economic and

industrial potential to compete, the items or products

manufactured by petitioner could be manufactured with significant

profit margins, and Scherer might, at any point in time, decide

to compete.   The record, however, does not manifest that Scherer

had the intent to compete with petitioner.    Scherer possessed a

significant disadvantage in that it did not have relationships

with either the suppliers or distributors.    In particular,


     11
      Petitioner and its expert witnesses suggest Scherer
possessed an economic history of periodically changing its
marketing orientation and strategies. However, petitioner has
not submitted sufficient evidence to prove or disprove this
particular thesis.
                              - 37 -


Richard Nemanick possessed extensive relationships with suppliers

and distributors, and that factor was a significant inducement to

the purchase of Old Lorvic's assets and to the retention of

Nemanick's services, as evidenced in the Distribution and

Acquisition Memoranda compiled by Shearson Lehman and Leck,

respectively.

     In view of what we consider deficiencies and conflicts in

the reports and testimony of the experts for both parties, and

what we consider to be either oversights or deficiencies in the

documentation of the foregoing transactions, we believe and

decide that petitioner has not fulfilled its burden of

persuasion.   For example, had petitioners provided stronger

enforcement provisions for its protection to assure compliance

with the agreements, such as injunctive relief or liquidated

damages for violations, the petitioner's position would be more

credible, especially in light of the substantial dollar amounts

appurtenant to the agreements being paid up front.   Also, we find

it apparent that there was abundant going concern value which was

not adequately addressed by petitioner either in the testimony of

its management or in its experts' reports.   For example, the

retention by petitioner of the seller's existing management is an

obvious reflection of the going concern value and petitioner's

objective to assure its continuance.   However, we believe and
                             - 38 -


determine that the agreements did have value, but not as much as

petitioner asserts or as little as respondent contends.   Using

our best judgment, we shall discount petitioner's claimed value

by a percentage we feel would be appropriate under the

circumstances, i.e., 25 percent, to reflect an appropriate and

approximate cost of enforcement for any ensuing violations and to

recognize the inherent going-concern value.   Consequently, in

light of all the facts and circumstances, we determine and hold

that the fair market values of the covenant not to compete and

the secrecy agreement are $1.5 million and $750,000,

respectively.



                                   Decisions will be entered

                              under Rule 155.
