                        T.C. Memo. 1999-413



                      UNITED STATES TAX COURT



                 SHAREWELL, INC., Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 2909-95.                 Filed December 21, 1999.



     Jordan H. Mintz and Morris R. Clark, for petitioner.

     Derek B. Matta, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     GALE, Judge:   Respondent determined the following

deficiencies in petitioner's Federal income taxes and the

following accuracy-related penalties:
                                 - 2 -




                                             Accuracy-Related
     Fiscal Year Ended      Deficiency     Penalty Sec. 6662(a)

          March 31, 1991      $8,500              $1,700
          March 31, 1992      34,000               6,800

         Unless otherwise noted, all section references are to the

Internal Revenue Code in effect for the years in issue.

     We must decide the following issues:

     (1) Whether there was a valid covenant not to compete

between petitioner and Thomas Wagner, entitling petitioner to

amortization deductions for the cost of the covenant.      We hold

that there was a valid covenant not to compete and that

petitioner is entitled to amortization deductions.

     (2) Whether petitioner is liable for the accuracy-related

penalties as determined by respondent.     We hold that petitioner

is not liable.

                           FINDINGS OF FACT

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

incorporate by this reference the stipulation of facts, first

supplemental stipulation of facts, and attached exhibits.1     At

the time of filing the petition, petitioner was incorporated

under the laws of Delaware with its principal place of business

in Houston, Texas.


     1
       At trial, respondent withdrew hearsay objections to
several of the exhibits attached to the stipulations.
                               - 3 -


     Prior to and during the years in issue, petitioner sold and

leased guidance instruments that, when attached to drilling

equipment, allow the direction and depth of drilling to be

electronically controlled.   Petitioner’s customers included

companies involved in utilities construction, pipeline river

crossing drilling, and oil and gas well drilling.

     Petitioner was founded in 1984 by Frank C. Forest (Forest)

and Thomas M. Wagner III (Wagner) pursuant to articles of

incorporation naming Forest and Wagner as directors.   Forest

served as president and Wagner as vice president.   Forest and

Wagner each took 40-percent interests in petitioner at

incorporation, and they bought out the remaining shareholders in

September 1990, after which Forest and Wagner each held 50

percent of petitioner.

     Prior to forming petitioner, Forest and Wagner each had

extensive experience in drilling technology in the United States

and overseas, both in engineering and in marketing such

technology to and servicing customers.   The two had previously

worked together for more than 15 years at Sperry Sun Well Survey

Company (Sperry Sun), a subsidiary of Sun Oil Company, Wagner

having started with Sperry Sun in 1960 and Forest in 1966.

Forest left Sperry Sun in late 1982 after the company was

acquired by N.L. Industries.   Forest's departure was influenced

by the fact that he had refused to sign, unless additional
                                - 4 -


compensation were offered, a covenant not to compete sought by

N.L. Industries after it acquired Sperry Sun.    After leaving

Sperry Sun, Forest formed a company involved with drilling

steering tools, which he sold 8 months later.    He then took a job

with Drill Tech International, which he left to form petitioner

in 1984.

     Based on their experience together at Sperry Sun, Forest and

Wagner each respected the other's abilities.    Both saw a niche

market for lower-cost surveying and steering equipment that was

not available at that time, and the two formed petitioner in May

1984 to develop such equipment and exploit that niche market.

Wagner did not leave Sperry Sun until 1985, on an early

retirement package.

     Petitioner's business was a success.    By the late 1980's,

petitioner held 80 percent of market share for the products and

services it supplied to the utilities construction business and

25 to 30 percent of market share for oil and gas drilling, which

was the largest share of any company involved in that field.

Various expressions of interest to purchase petitioner were made.

One approach, made by Castex, Inc. (Castex), in mid-1990 was

considered seriously by Forest and Wagner.    They expended

considerable time and money responding to Castex's interest,

including obtaining financial analyses of petitioner for Castex's

review.    As part of the purchase negotiations, Castex made clear
                                 - 5 -


that it would require both Forest and Wagner to execute covenants

not to compete in connection with the acquisition of petitioner.

Preliminary documents prepared for this transaction proposed a

noncompete period of 5 years.    The contemplated purchase of

petitioner by Castex fell through when Castex was unable to

secure financing.

     By 1990, Wagner had become weary of the rigors of managing

petitioner.   He was anxious to sell out to Castex in mid-1990 and

was disappointed that the deal had fallen through.    After the

negotiations with Castex ceased, Wagner approached Forest in late

1990 with a proposal that he, Wagner, be bought out.    Wagner

offered to accept less for his one-half interest than Castex had

suggested it would pay, provided the purchase could be completed

by yearend.   Wagner was anxious to complete the transaction

before the end of 1990 because he was aware that capital gains

tax rates would increase in 1991.    Forest indicated that he

wanted to be sure that petitioner could carry the burden of

buying out Wagner, and that he would require Wagner to provide a

covenant not to compete as part of the buyout to insure

petitioner's continued viability.    Forest also consulted with

petitioner's banker, Lawrence G. Fraser (Fraser), chairman of

Texas Capital Bank (Bank), regarding financing for petitioner's

purchase of Wagner's interest.    Fraser told Forest that the Bank

would require a covenant not to compete from Wagner as a
                               - 6 -


condition for a loan to finance petitioner's purchase of Wagner's

shares.   It was a customary practice for the Bank to require a

covenant not to compete when it provided financing for the buyout

of a partner in an ongoing business.   Wagner indicated that he

would agree to sign a covenant not to compete.

     Wagner and Forest (on behalf of petitioner) began

negotiations in earnest in late November.   The Bank ultimately

approved a loan to Sharewell of $1 million to finance the buyout

of Wagner.   In connection therewith, Wagner was required by the

Bank to agree to purchase a $300,000 participation in the loan.

Wagner’s participation in the loan was intended to provide the

Bank with additional protection or collateral for the loan.    In

addition, the Bank required collateral from petitioner in the

form of a pledge of petitioner’s accounts receivable, inventory

and equipment, as well as all stock in Sharewell and a life

insurance policy covering Forest.   An internal Bank document,

styled a loan worksheet, dated November 28, 1990 (Loan

Worksheet), listed the foregoing as security for the loan, as

well as Wagner’s $300,000 participation.    The Loan Worksheet did

not make any reference to a covenant not to compete.

     The loan was evidenced by a loan agreement between Sharewell

and the Bank executed on December 12, 1990 (Loan Agreement).     The

Loan Agreement provided for a loan of $1 million and an
                               - 7 -


additional line of credit of $400,000.2   The Loan Agreement did

not refer to a covenant not to compete or to any participation in

the loan by Wagner.   The Loan Agreement contained a formal

integration clause, as follows:

     This written loan agreement represents the final
     agreement between the parties and may not be
     contradicted by evidence of prior[,] contemporaneous,
     or subsequent oral agreements of the parties.

     There are no unwritten oral agreements between parties.

     Although Wagner had initially sought approximately $2

million for the buyout, all in cash, he ultimately agreed to

accept $1 million in cash, the assignment to him of $300,000 of

petitioner's accounts receivable due from Scientific Drilling

International (SDI), and an agreement by petitioner to renew a

$250,000 whole life insurance policy covering him.   Forest and

Wagner handled the negotiations themselves, with some advice from

their accountant.   Forest, in consultation with Wagner and

without professional assistance, drafted a written agreement

(Purchase Agreement) setting out the terms of petitioner's

purchase of Wagner's 50-percent interest.   (The attorney who had

previously handled petitioner's legal matters had been elected to



     2
       The Loan Agreement was executed to govern both a
$1 million term loan and an “existing $400,000.00 line of credit
originally dated May 15, 1990". There is no dispute that the
$1 million term loan was provided for petitioner’s purchase of
Wagner’s stock. There is no further evidence in the record
concerning the $400,000 line of credit.
                               - 8 -


a judgeship in early November 1990 and did not render advice or

assistance in the transaction.)   The Purchase Agreement, executed

on December 20, 1990, between Forest (on behalf of Sharewell) as

buyer and Wagner as seller, provided that Wagner would tender his

4,000 shares, constituting 50 percent of the outstanding shares

of Sharewell, and that Sharewell would pay to Wagner "As

consideration for the tendering of the [4,000] shares" the

$1 million in cash; $300,000 in receivables from SDI; and the

life insurance policy noted above.     The Purchase Agreement made

no mention of a covenant not to compete.

     One day later, on December 21, a Certificate of

Participation evidencing Wagner’s $300,000 participating interest

in the Bank’s loan to Sharewell was executed by Wagner and the

Bank (Certificate of Participation).

     Twelve days subsequent to the execution of the Purchase

Agreement, on January 1, 1991, after Forest had had the

opportunity to examine other noncompete agreements to ascertain

their terms and the Christmas holiday had intervened, Forest (on

behalf of Sharewell) and Wagner executed a letter agreement

denominated a "Non-Compete Agreement" (Noncompete Agreement)

drafted by Forest.   In the Noncompete Agreement, Wagner agreed:

     not to engage or participate, directly or indirectly, in any
     business located on any continent or in any country of the
     world that is in competition with Sharewell. The term of
     this Agreement shall be for a period of three years
     beginning January 1, 1991 and ending January 1, 1994.
                                 - 9 -


The Noncompete Agreement further provided that:

     It is agreed that as consideration for your [Wagner's]
     agreement for non-competition * * * Sharewell, Inc. will
     assign to you $300,000 of the installment receivable from
     Scientific Drilling, Inc. * * *

The $300,000 in accounts receivable from SDI referred to in the

Noncompete Agreement was the same consideration referred to in

the Purchase Agreement.   Forest proposed, and Wagner accepted,

the allocation of $300,000 to the Noncompete Agreement; they did

not negotiate over the dollar amount before agreeing to the

allocation.   Forest proposed the $300,000 figure for two reasons.

First, $300,000 represented the portion of the consideration that

had not been borrowed, but instead was accounts receivable

already owed to Sharewell.   Second, Forest believed that, because

the accounts receivable would be received in installments over

time, he would be in a position to exercise some practical

control over payment to Wagner if the covenant were breached,

unlike the case with the remaining $1 million in cash being paid

out at the time of the buyout.    The parties have stipulated that,

in the event the Court determines that any portion of the $1.3

million paid by petitioner to Wagner is allocable to an

amortizable covenant not to compete, the value of the Noncompete

Agreement is $300,000.

     The transaction between Sharewell and Wagner was originally

recorded on Sharewell's books as a $1.3 million redemption of
                               - 10 -


stock.    This entry was subsequently amended to reflect the

allocation to a covenant not to compete.

     At the time he sold his interest in Sharewell, Wagner wanted

some respite from the rigors of the day-to-day operations of the

company.    Both Forest and Fraser believed that Wagner wanted to

retire.    Wagner was 56 years old and in fair health.    He had been

diagnosed with a muscle disease 14 years earlier in 1976, but

this condition was controlled by medication to the extent that he

had at all times maintained a normal work schedule.      After

leaving Sharewell, Wagner did not experience any significant

decline in health.    Wagner had substantial personal relationships

with important clients of Sharewell, many of whom had been

brought in as customers by Wagner, and extensive contacts

throughout the drilling industry. At least one such customer

indicated he would patronize Wagner if the latter started his own

business.    Wagner did not attempt to re-enter the drilling

business during the period proscribed by the Noncompete

Agreement.

     On his 1990 Federal income tax return, Wagner reported $1.3

million of consideration received from Sharewell, minus basis of

$400, as capital gain.
                              - 11 -


                              OPINION

     The issue in this case is whether petitioner obtained a

covenant not to compete that is valid for Federal income tax

purposes.   A covenant not to compete is an intangible asset that

may be amortized over its useful life.    See Warsaw Photographic

Associates, Inc. v. Commissioner, 84 T.C. 21, 48 (1985).     Seeking

the benefit of amortization deductions, petitioner argues that

$300,000 of the $1.3 million in cash and receivables paid to

Wagner in the buyout is allocable to a covenant not to compete.

Respondent argues that the full $1.3 million was paid to Wagner

in exchange for his Sharewell stock.     For the reasons discussed

below, we agree with petitioner.

Parol Evidence Concerns

     In determining whether petitioner and Wagner entered into a

valid covenant not to compete, we must first decide what evidence

of their agreement incident to the buyout of Wagner we may

consider.   Respondent argues that their agreement is contained in

the four corners of the Purchase Agreement, which makes no

reference to a covenant not to compete, and that the Noncompete

Agreement, which does, is parol or extrinsic evidence that cannot

be considered under the Danielson rule.     In Commissioner v.

Danielson, 378 F.2d 771, 775 (3d Cir. 1967), vacating and

remanding 44 T.C. 549 (1965), the Court of Appeals for the Third

Circuit precluded a taxpayer's use of extrinsic evidence to
                                - 12 -


modify the meaning of his written agreement, except in limited

circumstances, holding:

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

The Danielson rule has been adopted by the Court of Appeals for

the Fifth Circuit, see Spector v. Commissioner, 641 F.2d 376 (5th

Cir. 1981), revg. 71 T.C. 1017 (1979), to which appeal of this

case would lie absent stipulation to the contrary, and so we are

bound to apply the Danielson rule in the instant case, see Golsen

v. Commissioner, 54 T.C. 742, 756-757 (1970), affd. 445 F.2d 985

(10th Cir. 1971).

     Petitioner argues that the Danielson rule would not operate

to exclude extrinsic evidence in this case because such evidence

would tend to show mistake.   We agree.   There is ample evidence

to support the proposition that the failure to include a covenant

not to compete in the Purchase Agreement constituted a mutual

mistake or scrivener’s error.    Cf. Woods v. Commissioner, 92 T.C.

776 (1989); State Pipe & Nipple Corp. v. Commissioner, T.C. Memo.

1983-339.   The record establishes that arrangements for the

buyout were made hurriedly against a yearend deadline, without

the assistance of an attorney who had previously provided

services to petitioner.   Both parties to the agreement testified
                              - 13 -


that they had at all times intended to include a covenant not to

compete from Wagner as part of the buyout, and this testimony is

corroborated by a third party, their banker.   That the terms of

the Purchase Agreement were the product of mutual mistake is

further supported by circumstantial evidence, such as the

insistence on covenants not to compete by a prospective purchaser

a few months prior to the transaction at issue and the parties’

execution of such a covenant some 12 days after the execution of

the Purchase Agreement.   The failure to include the covenant in

the first writing evidencing the agreement between petitioner and

Wagner, i.e., the Purchase Agreement, is consistent with the

informality with which other documentation of the transaction was

executed.   For example, the Loan Agreement was executed on

December 12, the Purchase Agreement on December 20, and Wagner’s

Certificate of Participation on December 21.   Clearly, the

Certificate of Participation functioned as security for the first

two documents, but was not executed until after they were, and

neither of the first two was made expressly conditional upon

execution of the third.   This pattern continued with respect to

the delay in executing the Noncompete Agreement, and we believe

merely reflects that the parties to the buyout, and their banker,

had had extensive prior dealings and trusted each other.

     These facts would constitute mutual mistake supporting the

reformation of a written contract under the standards of this
                              - 14 -


Court, see, e.g., Woods v. Commissioner, supra, the Texas courts,

see, e.g., Wiseman v. Priboth, 310 S.W.2d 600 (Tex. Civ. App.

1958), or the rule in Danielson; cf. State Pipe & Nipple Corp. v.

Commissioner, supra (“The testimony * * * to the extent it was

directed at showing mutual mistake, was thus admissible under any

standard of proof.”).   Thus, consideration of the Noncompete

Agreement, or other evidence extrinsic to the Purchase Agreement,

is not precluded by the Danielson rule because of mutual mistake.

     In addition, under the parol evidence rule as applied by

Texas courts, the Noncompete Agreement would be an admissible

“subsequent agreement”.   The Supreme Court of Texas has described

the parol evidence rule in this way:

          The parol evidence rule is not a rule of evidence
     at all, but a rule of substantive law.

          When parties have concluded a valid integrated
     agreement with respect to a particular subject matter,
     the rule precludes the enforcement of inconsistent
     prior or contemporaneous agreements.

          On the other hand, the rule does not preclude
     enforcement of prior or contemporaneous agreements
     which are collateral to an integrated agreement and
     which are not inconsistent with and do not vary or
     contradict the express or implied terms or obligations
     thereof. [Hubacek v. Ennis State Bank, 317 S.W.2d 30,
     31 (Tex. 1958); citations omitted; emphasis added.]

As construed by Texas courts, the parol evidence rule does not

apply to subsequent agreements.   See Lakeway Co. v. Leon Howard,

Inc., 585 S.W.2d 660 (Tex. 1979); Garcia v. Karam, 276 S.W.2d 255

(Tex. 1955).   The Noncompete Agreement was not entered prior to
                               - 15 -


or contemporaneously with the Purchase Agreement, but subsequent

to it.    Cf. Smith v. Bidwell, 619 S.W.2d 445 (Tex. Civ. App.

1981) (conflicting agreement reached 1 day after entering

original written contract is a subsequent agreement for purposes

of parol evidence rule).    Therefore, the Noncompete Agreement

would be admissible in an action between petitioner and Wagner to

alter the construction of the Purchase Agreement, and thus the

Danielson rule does not operate to preclude our consideration of

it in determining what was agreed to by petitioner and Wagner.

     Respondent also argues, for the first time on reply brief,

that the parol evidence rule applies to the discussions between

Forest and Wagner prior to signing the Purchase Agreement and to

any other evidence extrinsic thereto.   We disagree.   When the

Noncompete Agreement and Purchase Agreement are compared, an

ambiguity in the agreement between petitioner and Wagner emerges.

Each writing purports to designate petitioner’s $300,000 in

accounts receivable from SDI as consideration for a different

item–-for Wagner’s stock in the Purchase Agreement and for

Wagner’s covenant not to compete in the Noncompete Agreement.

The Danielson rule does not preclude consideration of extrinsic

evidence where written agreements are ambiguous.   See Patterson

v. Commissioner, 810 F.2d 562, 572 (6th Cir. 1987), affg. T.C.

Memo. 1985-53; Smith v. Commissioner, 82 T.C. 705, 713-714 & n.9

(1984).
                             - 16 -


     Indeed, as we read the decisions of the Court of Appeals for

the Fifth Circuit, conflicting written agreements as exist in

this case may not even be an appropriate circumstance for

invocation of the Danielson rule.    The instant case is not unlike

Dixie Fin. Co. v. United States, 474 F.2d 501 (5th Cir. 1973),

affg. Empire Mortgage & Inv. Co. v. Commissioner, T.C. Memo.

1971-270, and Stewart v. Commissioner, T.C. Memo. 1971-114, where

the Court of Appeals for the Fifth Circuit considered two

distinct buyout transactions involving covenants not to compete.

The first transaction provided the first occasion for the Court

of Appeals to consider whether it should adopt the Danielson rule

over the “strong proof” rule of its then-existing precedents.

The Court of Appeals found it unnecessary to make the choice.    In

the second transaction, the parties to the buyout had entered

into a written agreement on an arm’s-length basis that made a

substantial allocation to a covenant not to compete but 8 months

later entered into a written modification of the agreement that

allocated only $1 to the covenant.    Notwithstanding its earlier

consideration of the Danielson rule, the Court of Appeals did not

see fit even to mention a parol evidence rule in connection with

its consideration of the two conflicting written agreements.    The

Court of Appeals disregarded the second agreement, not because of

any parol evidence rule, but because the Court concluded, based

upon extrinsic evidence, that the second writing did not reflect
                               - 17 -


the parties’ intent.   See Dixie Fin. Co. v. United States, supra

at 505.

     Because (i) there is evidence of mutual mistake, (ii) the

Noncompete Agreement is a subsequent, not a prior or

contemporaneous agreement, in relation to the Purchase Agreement,

and (iii) the conflicting Purchase Agreement and Noncompete

Agreement are both in writing and read together create an

ambiguity, we reject respondent’s invocation of the Danielson

rule and shall consider all extrinsic evidence in the record in

an effort to determine the intent of the parties to the buyout

agreement.

     Respondent, citing Deshotels v. United States, 450 F.2d 961

(5th Cir. 1971), also argues that petitioner’s deductions in

connection with the covenant must fail because petitioner is

relying on the parol testimony of parties without adverse

interests to vary the clear terms of the Purchase Agreement.    In

Deshotels, the Court of Appeals for the Fifth Circuit held that,

for Federal income tax purposes, a taxpayer cannot establish his

claim to a deduction by seeking to controvert the terms of his

written contract with parol testimony of parties to the contract

that do not have interests adverse to the interpretation being

urged.    Forest and Wagner each testified that it was understood

by both throughout their negotiations that a covenant not to

compete would be required from Wagner as part of the buyout and
                             - 18 -


that they agreed to allocate $300,000 to it.   Concededly this

testimony is self-serving to Forest as petitioner’s sole

shareholder, and Wagner’s position is not tax adverse, because

his gain on the transaction is taxed at the same rate for the

years in issue whether characterized as capital gain from the

sale of stock or ordinary income paid with respect to the

covenant.

     However, the holding in Deshotels was only that parol

testimony of nonadverse parties, standing alone, is insufficient

to vary the clear terms of a written contract.   As the Court of

Appeals stated:

          Perhaps parol evidence would be enough to tip the
     scales toward the taxpayer’s interpretation in a case
     where he had offered substantial corroborating evidence
     in addition to the testimony of the contracting parties
     in support of his position. Parol evidence might be
     sufficient in and of itself if there were strong
     support on the face of the document for the taxpayer’s
     interpretation; here the words themselves are very
     clearly in the Commissioner’s favor. We need not
     decide these questions today. We hold only that the
     taxpayer cannot sustain the burden of proving his right
     to a deduction merely by introducing parol evidence to
     controvert the traditional state law meaning of the
     words of a contract affecting the taxpayer’s federal
     tax liability. [Id. at 967.]

The Court of Appeals has subsequently made clear that such parol

testimony, if substantially corroborated, is indeed sufficient to

change the terms of a written instrument.   See Sellers v. United

States, 615 F.2d 1066, 1067-1068 (5th Cir. 1980).   What

distinguishes this case from Deshotels v. United States, supra,
                              - 19 -


and convinces us to uphold petitioner’s position, is that

petitioner has introduced substantial corroborating evidence

beyond the testimony of Forest and Wagner, the parties to the

agreement who lack adversity with respect to the interpretation

urged in their testimony.   First, the Noncompete Agreement

itself, executed 12 days after the Purchase Agreement, is

properly in evidence and supports petitioner’s contentions.

Second, it is undisputed that only months before the buyout of

Wagner, a third party, Castex, had sought to purchase petitioner;

documentary evidence of that proposed transaction establishes

that Castex had sought covenants not to compete from both Forest

and Wagner of 5 years’ duration in connection with the purchase.

Thus, Forest and Wagner would have been freshly reminded of the

significance of a noncompete covenant, given the nature of

petitioner’s business.   Most significantly, petitioner’s banker,

Fraser, testified that it was the Bank’s customary practice to

require covenants not to compete when providing financing for

transactions of this type, and that he had indicated to Forest

that the Bank would require a covenant not to compete from Wagner

as a condition for providing financing to petitioner.

     Faced with this third-party corroboration of Forest’s and

Wagner’s testimony, respondent contends that Fraser provided

false testimony in claiming that the Bank required a noncompete

covenant as a precondition to financing the buyout.   Respondent
                             - 20 -


bases his contention on the fact that neither the Loan Agreement,

which contained a formal integration clause, nor the Loan

Worksheet makes any reference to a covenant not to compete.

     Respondent’s reliance on the Loan Agreement is unconvincing.

While it is true that the Loan Agreement formally purports to

constitute the entire agreement between the bank and petitioner,

and makes no reference to petitioner’s obtaining a noncompete

covenant, the Loan Agreement also does not mention the $300,000

participation in the loan that was to be purchased by Wagner as a

condition to the financing of the buyout.    We believe Wagner’s

$300,000 participating interest was equally, if not more,

significant to the Bank’s protection as the noncompete covenant,

and yet neither is mentioned in the Loan Agreement.    Thus we are

not persuaded that any negative inference regarding the

truthfulness of Fraser’s testimony concerning the Bank’s

requirement of a noncompete covenant can be drawn from the Loan

Agreement’s failure to mention it.

     Respondent is on firmer ground concerning the Loan

Worksheet, which does mention Wagner’s $300,000 participation in

the loan but not any noncompete agreement.    However, we believe

that the Loan Worksheet’s failure to mention a noncompete

agreement is a slender reed on which to base a claim that Fraser

perjured himself in these proceedings.   We find it credible that,

because obtaining a noncompete agreement was, as Fraser
                               - 21 -


testified, a customary practice in such circumstances, it may

have been too routine to warrant mentioning in the Loan

Worksheet, which itself was an informal, internal document.

Based on all of the relevant evidence, including the plausibility

of his assertions and his demeanor when testifying, we find

Fraser credible and reject respondent’s contention that he gave

false testimony.    Accordingly, Forest’s and Wagner’s testimony

that a covenant not to compete from Wagner was always intended as

part of the buyout agreement is corroborated by Fraser’s

testimony in addition to other evidence.    For that reason, this

case is distinguishable from Deshotels v. United States, 450 F.2d

961 (5th Cir. 1971).

Economic Reality of Allocation to Noncompete Covenant

     Having established that it is appropriate to consider parol

testimony and other extrinsic evidence in construing the

agreement between petitioner and Wagner, we turn to a

consideration of whether petitioner has shown entitlement to the

deductions claimed with respect to a covenant not to compete.      In

connection with the purchase of a business, a taxpayer may

amortize a portion of the purchase price if it was intended as

payment for a covenant not to compete from a departing

shareholder and the amount paid for the covenant reflected

economic reality.    See Patterson v. Commissioner, 810 F.2d at

571; Better Beverages, Inc. v. United States, 619 F.2d 424, 428
                              - 22 -


n.5 (5th Cir. 1980); Throndson v. Commissioner, 457 F.2d 1022,

1024-1025 (9th Cir. 1972), affg. Schmitz v. Commissioner, 51 T.C.

306 (1968); Annabelle Candy Co. v. Commissioner, 314 F.2d 1, 8

(9th Cir. 1962), affg. T.C. Memo. 1961-170; Beaver Bolt, Inc. v.

Commissioner, T.C. Memo. 1995-549.     The instant case raises three

questions under the applicable law:    (1) Did the buyout agreement

between petitioner and Wagner include Wagner’s covenant not to

compete; (2) did the covenant reflect economic reality; and (3)

did the parties to the buyout agreement allocate $300,000 to the

covenant?

Did the Buyout Agreement Include Wagner’s Covenant Not To
Compete?

     We find, for much the same reasons that support the

consideration of extrinsic evidence, that such evidence

convincingly demonstrates that petitioner and Wagner intended

Wagner’s covenant not to compete to be a part of their buyout

agreement when they executed the Purchase Agreement and that the

execution of the Noncompete Agreement 12 days later served to

correct a mutual mistake.   Wagner and Forest both testified that

a covenant was always contemplated in their negotiations for the

buyout, and their banker’s testimony corroborates that it was an

essential part of the buyout agreement.    As discussed in greater

detail in connection with the parol evidence concerns, the

surrounding circumstances strongly support the testimony, because
                              - 23 -


they illustrate the parties’ likely awareness of the importance

of a noncompete agreement.   We think the evidence clearly rebuts

respondent’s contention that the Noncompete Agreement was a mere

“afterthought”, prompted entirely by tax considerations.      Rather,

we think the evidence shows that there were substantial business

reasons for a noncompete agreement from Wagner, and that it would

have been highly unlikely, and imprudent, for petitioner not to

seek one.

Did the Covenant Not To Compete Reflect Economic Reality?

     The requirement that the covenant reflect economic reality

or have economic substance has been articulated as follows:

“[T]he covenant must have some independent basis in fact or some

arguable relationship with business reality such that reasonable

men, genuinely concerned with their economic future, might

bargain for such an agreement.”   Schulz v. Commissioner, 294 F.2d

52, 55 (9th Cir. 1961), affg. 34 T.C. 235 (1960).    Courts

consider a number of factors in determining whether a covenant

has economic substance, including the following:    (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
                              - 24 -


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

of the covenant; (i) enforceability of the covenant not to

compete under State law; (j) the age and health of the seller;

(k) the seller's intent to reside in the same geographical area;

and (l) the existence of active negotiations over the terms and

value of the covenant not to compete.    See Beaver Bolt, Inc. v.

Commissioner, supra, and cases cited therein.

     In stipulating that the Noncompete Agreement had a value of

$300,000, respondent has largely conceded its economic reality,

in our view.   Nevertheless, on brief respondent continues to

insist that the Noncompete Agreement lacked economic substance

because Wagner intended to retire and was constrained in any

event by his $300,000 participation in the loan financing his

buyout.   We are not persuaded.   Petitioner’s customers

represented a highly specialized, niche market, and Wagner was

well known to them.   A prospective purchaser of petitioner in the

same year as Wagner’s buyout had insisted on noncompete

agreements from both Wagner and Forest.    Regardless of whether

Wagner “intended” to retire after the buyout, he was 56, might

have second thoughts, and had received $1 million that could

finance a new venture.   Indeed, if Wagner did not represent a

competitive threat, we wonder why the Bank found it necessary to

require Wagner’s participation in the loan.    Respondent in effect

contends that Wagner’s loan participation made the Noncompete
                              - 25 -


Agreement “unnecessary” and therefore lacking in substance, but

we see nothing remarkable in petitioner’s and the Bank’s “belt

and suspenders” approach of wanting both.   Finally, respondent

argues that the Noncompete Agreement lacked substance because it

was unenforceable under Texas law, due to its overly broad scope.

Petitioner responds, and we agree, that Texas courts would reform

an overly broad covenant.   See Tex. Bus. & Com. Code Ann. sec.

15.51(c) (West 1990); Justin Belt Co. v. Yost, 502 S.W.2d 681

(Tex. 1974).   Thus we conclude the Noncompete Agreement reflected

economic reality.

Did the Parties Allocate $300,000 to the Covenant Not To Compete?

     The final and most difficult question concerns whether

petitioner has shown that petitioner and Wagner agreed to

allocate $300,000 to the Noncompete Agreement.   That Wagner’s

covenant was indispensable to the buyout agreement does not

necessarily prove that the parties agreed to allocate any

specific portion of the consideration to it.   See Better

Beverages, Inc. v. United States, 619 F.2d at 429-430; Delsea

Drive-In Theatres, Inc. v. Commissioner, 379 F.2d 316, 317 (3d

Cir. 1967), affg. per curiam T.C. Memo. 1966-6; Annabelle Candy

Co. v. Commissioner, 314 F.2d at 7.    This might be true even

where the covenant was objectively worth the amount amortized, as

has been stipulated here.   Petitioner must still show that the

parties to the buyout agreed to allocate the specific amount
                                - 26 -


claimed to be amortizable.    “The taxpayer must prove what, if

anything, he actually was required to pay to obtain the item, not

what he would have been willing to pay or even what the market

value of the item was.”     Better Beverages, Inc. v. United States,

supra at 428.   Where, as here, the parties to an agreement are

not tax adverse as to the amount allocated to a covenant not to

compete, such allocation warrants strict scrutiny.    See 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. 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).

     Petitioner concedes that Forest and Wagner did not negotiate

with respect to the allocation of $300,000 to the covenant not to

compete.   Moreover, Wagner reported the entire proceeds from the

transaction as capital gain.    The fact remains, however, that

Forest proposed and Wagner accepted a $300,000 allocation, as

memorialized in the Noncompete Agreement.    The cases relied on by

respondent, Better Beverages, Inc. v. United States, supra;

Annabelle Candy Co. v. Commissioner, supra; Major v.

Commissioner, 76 T.C. 239 (1981); and Delsea Drive-In Theatres,

Inc. v. Commissioner, T.C. Memo. 1966-6, affd. 379 F.2d 316 (3d

Cir. 1967), are thus readily distinguishable.    In those cases, no

express allocation had been made to the covenant; the purchaser
                              - 27 -


made a subsequent, unilateral allocation, without the seller’s

knowledge or consent.

      Based on the record in this case, we think the allocation

was the product of a bargained-for exchange.    We think it is more

likely that Wagner’s reporting position reflected a lack of

awareness of the covenant’s tax significance than a belief that

no amount had been allocated to the covenant.   We find

significant in reaching our conclusion the fact that the

allocation was not just a division of the total consideration; it

was an allocation between cash payable at closing and assigned

accounts receivable to be paid in the future.   Forest testified

that he wished to allocate the $300,000 in accounts receivable

from SDI to the Noncompete Agreement because it was the only

portion of the consideration that was not borrowed and

immediately payable to Wagner, but instead would be paid in

installments in the future–-giving Forest some practical

recourse, in his view, if Wagner subsequently breached the

covenant.   We accept Forest’s explanation and find that it

demonstrates that Wagner had a position adverse to the allocation

agreed to, for nontax reasons.   It would have been somewhat more

advantageous to Wagner to allocate the cash consideration, or a

portion thereof, to the covenant so that in the event Forest were

to consider the covenant breached, Forest would be less likely to

attempt to revoke the assignment of the receivables.   These
                              - 28 -


nontax considerations underlying the particular allocation of

$300,000 to the covenant are probative regarding whether the

allocation should be treated as bargained for by the parties, and

on balance we are persuaded that it should, even under a standard

of strict scrutiny.   Therefore we conclude that petitioner has

shown that an allocation of $300,000 to the covenant not to

compete was intended by the parties.

     Based on the foregoing, we shall not sustain respondent’s

determination disallowing petitioner’s deductions with respect to

a covenant not to compete.

     Accuracy-Related Penalties

     Because we do not sustain respondent’s disallowance of

petitioner’s amortization deductions, there is no underpayment in

this case, and petitioner is not liable for accuracy-related

penalties under section 6662(a).

     To reflect the foregoing,


                                        Decision will be entered

                                   for petitioner.
