                         T.C. Memo. 1997-313



                       UNITED STATES TAX COURT



                    HOWARD PONTIAC-GMC, INC.,
            D.B.A. BOB HOWARD AUTOMALL, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 4972-95.               Filed July 7, 1997.



     Randall K. Calvert, for petitioner.

     David G. Hendricks and Michael J. O'Brien, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION

     VASQUEZ, Judge:    Respondent determined deficiencies in

petitioner's Federal income tax of $4,689 and $24,367 for the

1990 and 1991 tax years, respectively.   Petitioner purchased the

inventories (parts, accessories, new and used cars) of Dave

Markley Jeep-Eagle, Inc. (seller).   Pursuant to a sales
                                - 2 -

agreement, John David Markley (Mr. Markley), the sole shareholder

and president of seller, terminated his Jeep-Eagle franchise with

Chrysler Corp. (Chrysler) and granted petitioner a covenant not

to compete.   Petitioner acquired the relinquished franchise from

Chrysler.   The sole issue for decision is whether the fair market

value of the covenant not to compete (sometimes referred to as

the covenant) is $490,000, as petitioner contends, $125,000, as

respondent contends, or some other amount.    All section

references are to the Internal Revenue Code in effect for the

years in issue, and all Rule references are to the Tax Court

Rules of Practice and Procedure.

                          FINDINGS OF FACT

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

The stipulation of facts and the attached exhibits are

incorporated herein by this reference.    Petitioner (sometimes

referred to as buyer) is a corporation whose home office and

principal place of business was in Oklahoma City, Oklahoma, at

the time it filed the petition in this case.    Petitioner filed

Forms 1120, U.S. Corporation Income Tax Return, for the taxable

years 1990 and 19911 with the Internal Revenue Service Center,

Austin, Texas.    Petitioner had a calender yearend.

Mr. Markley's Ability to Compete

     Mr. Markley entered the automobile dealership business in

the mid-1960's.    He purchased a Ford dealership in Yukon,

     1
        Unless otherwise indicated, all descriptions pertain to
the years in issue.
                               - 3 -

Oklahoma, in 1968 and a Ford dealership in Dallas, Texas, in

1975.   He was the sole shareholder and dealer of the Yukon and

Dallas dealerships.   Both of these dealerships were successful,

and Mr. Markley enjoyed a good reputation within the industry

with his customers.   As a suburban Oklahoma Ford dealer, Mr.

Markley was a competitor of Oklahoma City dealerships, and was

consistently ranked among the top two or three truck dealers in

the Oklahoma City metro area (out of seven dealerships).     In 1980

and 1981, Mr. Markley sold the Dallas and Yukon dealerships.

     In May 1988, Mr. Markley reentered the automobile dealership

business when Chrysler awarded him a Jeep-Eagle franchise in

Oklahoma City.   He acquired the Jeep-Eagle franchise directly

from Chrysler.   The seller's sales and service agreement with

Chrysler (the franchise) was not transferable and was conditioned

upon the continued performance of day-to-day management duties by

Mr. Markley.

     Mr. Markley was a successful Jeep-Eagle dealer in the

Oklahoma City market.   His overall vehicle sales averages

exceeded his market share responsibility as determined by

Chrysler.   Mr. Markley's name was known in the Oklahoma City

market as a result of his 14 years of advertising as a Ford

dealer in Yukon, Oklahoma (a suburb of Oklahoma City).

     At the time of the sale to petitioner, Mr. Markley intended

to stay in the Oklahoma City area.     He was 49 years old, in good

health, and intended to expand an existing used car and finance

company business in Oklahoma City.
                                - 4 -

Mr. Howard

     At the time of the agreement, Robert E. Howard II, was the

sole shareholder and CEO of petitioner.    He was 43 years old.

Mr. Howard has been in the automobile business all his life.      He

began working in his father's car dealership as a teenager.      In

1971, at age 24, Mr. Howard began working for Bob Moore Cadillac.

Bob Moore is a "mega dealer"2 who has assisted a number of other

individuals in acquiring dealerships, all of whom have been

successful and some of whom have become mega dealers in their own

right.    Mr. Howard worked his way up to the position of sales

manager for Bob Moore Cadillac and in 1973, at the age of 26, was

the youngest metropolitan Cadillac sales manager in the United

States.    In 1973, Mr. Howard was promoted to general manager of a

Chevrolet dealership owned by Mr. Moore.

     In 1978, at age 31, Mr. Howard purchased an interest in a

Pontiac-GMC dealership (petitioner) in Edmond, Oklahoma.    By

1980, Mr. Howard had become the sole shareholder of petitioner.

Bob Howard Automall

     By 1982, petitioner had obtained the rights to represent

Subaru, Mazda, and Yugo.    In 1986, Mr. Howard acquired 10-1/2

acres of land in Oklahoma City (the site).    Mr. Howard

constructed three automobile sales facilities and a parts and

service facility on the site which became known as the Bob Howard

Automall (the automall).    Mr. Howard devoted all of his time to

     2
        The term was used, but not defined, by the parties.      We
use the term to mean a very large automobile dealership.
                               - 5 -

the operations of petitioner from 1978 through 1991.    Mr. Howard

has been president and general manager of petitioner since 1978.

By 1988, petitioner, primarily through the efforts of Mr. Howard,

had become the number 2 volume sales leader for Pontiac and GMC

trucks in the State of Oklahoma.   By 1988, petitioner had also

become the number 1 volume retail sales leader in the State of

Oklahoma for Mazda, Subaru, and Yugo.

     The facilities at the automall were approximately twice as

big as were needed for petitioner's operations.   Petitioner was

very successful with the vehicle lines represented; however, the

overhead expense from the oversized facilities made the

acquisition of other vehicle lines very important to petitioner.

In 1988 and 1989, Mr. Howard was actively seeking additional

automobile lines from other manufacturers for his automall.    Mr.

Howard talked to manufacturers about new dealerships that might

be awarded in the Oklahoma City area.

     Mr. Howard was also looking for dealerships whose assets

could be acquired without the necessity of having to enter into

an agreement to lease or purchase the real estate where the

dealership was located.   In approximately 1988 or 1989,

petitioner became very interested in the possibility of

representing Dodge, Chrysler-Plymouth, or Jeep-Eagle.   Petitioner

could not operate a Jeep-Eagle distributorship without a Jeep-

Eagle franchise.
                                - 6 -

The Sale and the Agreement

     Petitioner wanted to acquire the Jeep-Eagle franchise held

by seller.   Seller's business premises were located approximately

2 miles from petitioner's automall.     In late 1989, Mr. Howard (on

behalf of petitioner) and Mr. Markley (on behalf of seller) began

discussions regarding the possibility of petitioner acquiring

certain assets of seller.    By November 1989, Mr. Howard and Mr.

Markley agreed that petitioner would acquire the inventories (the

new cars, used cars, and parts inventory) of seller.     Petitioner

did not purchase or utilize seller's location in any way.

Petitioner was prohibited from using the Markley name.

     Mr. Howard and Mr. Markley contacted their attorneys, who

had not been involved in the negotiations up to that point, and

asked them to draft an agreement (the agreement) which embodied

the terms on which they had agreed.     At the time they were

memorializing the agreement, the attorneys suggested to the

parties that they should allocate $10,000 to goodwill.

Accordingly, the parties allocated $490,000 to the covenant and

$10,000 to goodwill.

     The final draft of the agreement provided for the purchase

of parts and new vehicle inventories based upon manufacturer's

price lists and invoices and the purchase of used car inventories

based upon the agreed value of each vehicle at date of closing.

Petitioner would not agree to purchase the fixed assets of

seller.   The total consideration paid was approximately $2.5

million, allocated by buyer and seller as follows:
                                - 7 -

            Inventories                 $2,000,000
            Covenant not to compete        490,000
            Goodwill                        10,000
            Total sales price            2,500,000

     Petitioner and seller signed the agreement on November 15,

1989.   The form of the covenant not to compete was attached as

schedule 1 to the agreement.    Section 10 of the agreement

provided:

     The Buyer [petitioner] agrees that Buyer will not use
     Seller's name or location in Buyer's operation. The
     parties acknowledge that any goodwill to be acquired by
     Buyer is nominal and have therefore agreed that the
     Buyer will pay Seller Ten Thousand Dollars ($10,000)
     for Seller's goodwill on the closing date.

     For payment of $500,000 (over and above the agreed upon sale

price of the tangible inventories of seller's Jeep-Eagle

distributorship), petitioner received a number of benefits,

including seller's agreement to terminate its Jeep-Eagle

franchise, and seller's agreement to provide to petitioner all

sales and service records, customer lists, and other information

which might be useful to petitioner.

     Seller's termination of its sales and service agreement with

Chrysler was a condition to the closing of the agreement.

Approval of petitioner's application for a Jeep-Eagle franchise

from Chrysler was also a condition to the closing of the

agreement.    Petitioner could only acquire seller's Jeep-Eagle

franchise if seller would agree to terminate the franchise.

Chrysler's Franchise Policies

     Standard Jeep-Eagle franchises are issued for an indefinite

term.   A Jeep-Eagle franchisee can expect to retain its franchise
                               - 8 -

rights under standard franchise for as long as it meets the terms

of the franchise agreement.   Chrysler reserves the right to

independently evaluate all dealer candidates and accept or reject

candidates based upon its sole discretion.   Success in obtaining

a Jeep-Eagle franchise is not assured, even for an individual

with Mr. Howard's demonstrated abilities.

Mr. Howard's Application for a Chrysler Franchise

     In obtaining approval by Chrysler of Mr. Howard and

petitioner as a dealer candidate, petitioner and Mr. Howard's

credentials and plans were considered on their own merit.

     The procedure for obtaining Chrysler's approval as a new

dealer candidate is a lengthy and detailed one.   When applying as

a dealer candidate, petitioner and Mr. Howard were required to

provide detailed information about their respective backgrounds

in the automobile sales industry, financing information, detailed

dealership plans, and numerous other documents.   Mr. Howard and

the employees and agents of petitioner spent several weeks

preparing the necessary documentation and meeting with Chrysler

representatives.

     Ultimately, Mr. Howard's demonstrated abilities as an

automobile dealership manager and petitioner's demonstrated

performance in representing other manufacturers resulted in

petitioner's approval by Chrysler.

     Petitioner's Jeep-Eagle franchise would terminate by its

nonperformance of the franchise terms, by voluntary termination
                               - 9 -

by the franchisee, by Mr. Howard's death, or by his failure to

materially participate.

Covenant Not to Compete

     The amount paid for the covenant not to compete and the term

of the covenant were negotiated separately from the price of the

other assets.   Prior to negotiating with Mr. Markley, Mr. Howard

intuitively calculated the value of Mr. Markley's agreeing not to

compete with petitioner.   Mr. Howard projected annual gross

profits less variable costs for the Jeep-Eagle dealership at

approximately $1,996,000, as follows:

     New vehicle sales                        $810,000
     Finance and insurance income              351,000
     Used vehicle sales                        222,750
     Parts and service                         612,000
                                             1,995,750

     Mr. Howard believed that Mr. Markley could take 25 percent

of his business if Mr. Markley competed with him.

     At the time of the transaction, petitioner believed that Mr.

Markley was a significant competitive threat because:    (1)

Mr. Markley had very good connections with the Jeep-Eagle factory

personnel; (2) Mr. Markley's name was well known in the Oklahoma

City metropolitan area; (3) Mr. Markley was from Oklahoma City

and was continuing in the automobile business in Oklahoma City

after the sale; (4) Mr. Markley's demonstrated sales ability was

very good; (5) Mr. Markley's age and background made him a

competitive threat; (6) Mr. Markley had good customer relations

in the Oklahoma City metropolitan area; and (7) Mr. Markley had

superior knowledge of Chrysler and Jeep-Eagle product lines.
                              - 10 -

     Petitioner was fearful that Mr. Markley would be a

competitive threat by (1) acquiring a new Jeep-Eagle

franchise in a suburb of Oklahoma City (as he had done when he

was a Ford dealer in Yukon) (2) acquiring an existing Jeep-Eagle

dealership or (3) going to work for an existing competitor.

     The covenant not to compete is for a 3-year term and covers

Oklahoma, Canadian, Logan, Pottawatomie, Lincoln, and Cleveland

Counties.   The covenant not to compete does not preclude seller

and/or Mr. Markley from competing with petitioner in Kingfisher

County, which county is adjacent to Oklahoma County and is less

than 15 miles from petitioner's automall, from competing with

petitioner by working for or with any dealership, including Jeep-

Eagle, for compensation of less than $100,000 per year, or from

competing with petitioner by obtaining any franchise other than

Jeep-Eagle.

Deductions for Amortization

     For the taxable years 1990, 1991, and 1992, petitioner

deducted $163,000, $163,500, and $163,500, respectively, as

amortization of the covenant not to compete.

Respondent's Notice of Deficiency

     In the notice of deficiency dated February 2, 1995, upon

which this case is based, respondent disallowed petitioner's

deduction for amortization of the covenant not to compete for the

taxable years 1990 and 1991 to the extent of $121,330 for each

year.
                               - 11 -

                               OPINION

     Respondent determined that the fair market value of the

covenant not to compete was $125,000.    Petitioner bears the

burden of proof.   Rule 142(a).

     A taxpayer generally may amortize intangible assets over

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

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

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

ascertainable value and a limited useful life, the duration of

which can be ascertained with reasonable accuracy.    Newark

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

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

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

its useful life.   Warsaw Photographic Associates v. Commissioner,

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

467 (1974).

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

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

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

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

parties do not have adverse tax interests because adverse tax

interests deter allocations which lack economic reality.       Wilkof

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

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
                               - 12 -

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

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

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

relationship with business reality so that reasonable persons

might bargain for such an agreement.    Patterson v. Commissioner,

810 F.2d 562, 571 (6th Cir. 1987), affg. T.C. Memo. 1985-53;

Schulz v. Commissioner, 294 F.2d 52, 55 (9th Cir. 1961), affg. 34

T.C. 235 (1960); O'Dell & Co. v. Commissioner, supra at 467-468.

     Respondent, in the notice of deficiency, determined that the

covenant not to compete had a fair market value of $125,000.

Petitioner argues that by placing a value on the covenant not to

compete respondent has, in effect, conceded the existence of

economic reality.    In fact, respondent formally concedes, in the

reply brief, that the covenant was amortizable and had economic

reality; thus the only issue for us to decide is the fair market

value of the covenant not to compete.

Value of the Covenant Not to Compete

     Neither party called an expert witness to opine on the value

of the covenant not to compete.

     a.   Petitioner's Arguments

     Petitioner argues that the covenant was worth well in excess

of the $490,000 paid to Mr. Markley.    Petitioner calculates the

value of the covenant as follows:

     The total   amount of gross profit less variable costs as
     projected   by Mr. Howard was approximately $1,996,000
     per year.   * * * Any reduction in this amount will
     result in   a dollar for dollar reduction in the
                                 - 13 -

     dealership's income (or increase in the dealership's
     loss).

                     *   *   *     *      *   *   *

     Mr. Howard projected that the effect of competition by
     David Markley would be reduction in sales of at least
     twenty-five percent (25 percent). A twenty-five
     percent (25 percent) reduction in sales would equate to
     a loss of $1,497,000 over the term of the covenant
     [$1,996,000 x .25 x 3].

     Petitioner cites the testimony of Stuart Ray,3 who was

allowed to testify under Rule 143(f)(2) as an expert on the

automobile dealership industry's practice of using covenants not

to compete:

     Mr. Ray indicated that based upon his experience,
     practice and industry custom he would estimate lost
     profit [lost sales] due to competition from a seller
     [not petitioner specifically] in an Oklahoma City
     metropolitan dealership such as this one, in the range
     of twenty percent (20 percent) to twenty-five percent
     (25 percent).

     b.   Respondent's Arguments

     Respondent, while admitting that the covenant has some value

($125,000), argues that petitioner has overstated the magnitude

of potential lost sales from Mr. Markley competing with

petitioner, citing petitioner's strong background in auto sales

and established presence in the Oklahoma City market.



     3
        Mr. Ray is a C.P.A. and was a partner in an accounting
and consulting firm whose clientele consisted of about 400
automobile dealers in 30 States. Mr. Ray has negotiated over 40
buy-sell agreements; prepared tax returns and financial
statements for at least 60 automobile dealerships; and has 17
years of experience working exclusively with automobile
dealerships. Mr. Ray, however, had no personal knowledge of
petitioner's transactions and did not opine on the value of the
seller's covenant not to compete.
                              - 14 -

     Respondent also argues that the likelihood of competition

from Mr. Markley is low, citing the "limited market entry" into

the Jeep-Eagle market in Oklahoma City area due to the limited

number of Jeep-Eagle franchises allowed by Chrysler in the

Oklahoma City market; that Mr. Markley showed no intention of

competing and, in fact, left Oklahoma shortly after the sale to

pursue a business opportunity in Houston, Texas; and that the

covenant allows for significant competition since it only covers

the sale of new Jeep-Eagle automobiles and does not cover an

adjacent county.

     Respondent further argues that petitioner's method of

valuing the covenant, in addition to the shortcomings mentioned

above, also fails to:   discount the stream of payments required

under the covenant to reflect the time value of money; and to

factor in the effect that amortizing the covenant would have on

after tax cash flow--the payments under the covenant being

deductible and thus reducing petitioner's income tax liability.

     Finally, respondent argues that any amount paid by

petitioner in excess of $125,000 (of the disputed $490,000

payment) was for Mr. Markley's agreement to terminate his Jeep-

Eagle franchise.   Respondent correctly points out that the sale

was contingent upon Chrysler's awarding petitioner Mr. Markley's

franchise, and petitioner could not obtain Mr. Markley's Jeep-

Eagle franchise unless he informed Chrysler that he wished to

terminate his franchise.
                              - 15 -

Conclusions as to Value

     It is undisputed that petitioner acquired a covenant not to

compete from Mr. Markley that had economic reality.   As to

whether petitioner acquired something else of value, Mr. Markley

testified as follows at trial:

     Q.   And would you have given up this business for
     nothing?

     A.   No.   Would I have given up the business?

     Q.   Would you have given up the business, if someone
     had said, I would like to just take it over, but I am
     sorry, I can't pay you anything for it. Would that
     have been attractive to you?

     A.   No.

     Q.   What would it have taken for you to agree to that
     proposition?

     A.   To sell the business?

     Q.   To turn it over--to sell the business.

     A.   Well, it took $500,000 is what it took.

     Apart from the $500,000, Mr. Markley received payment from

petitioner based on the cost of the new vehicles, the fair market

value of the used cars, and the return value for the spare parts.

Essentially, payment to Mr. Markley for terminating a profitable

business (Markley testified that he personally made a minimum of

$120,000 a year) was included in the $500,000, of which $490,000

was allocated to the noncompetition covenant.   We find that a

part of the $490,000 was to compensate Mr. Markley for

terminating his franchise with Chrysler.
                                - 16 -

     In order to value the covenant, using the methodology

adopted by petitioner, we would need to calculate the potential

lost business from competition by Mr. Markley and then, as

respondent correctly points out, lower that number to reflect the

probability of Mr. Markley competing.    Mr. Howard testified to

the potential for lost sales.    Mr. Howard's testimony was

consistent with Mr. Ray's testimony on this issue.    We realize

that Mr. Ray was not testifying specifically about Mr. Markley's

covenant; however, it adds to Mr. Howard's credibility that his

response was in line with industry norms in the Oklahoma City

area.   We note, however, that lost sales in the first year would

have to reflect the business reality that whatever form of

competition Mr. Markley might engage in, it would take some time

to implement.   Using the lower end of the range, 20 percent, and

factoring a time lag in the first year, the potential for lost

business is approximately $300,000 the first year and $400,000

for each of the following 2 years.

     The analysis does not stop at this point.   The potential

annual lost business needs to be reduced to reflect the

probability of competition taking place during each of the 3

years of the covenant.   See International Multifoods Corp. v.

Commissioner, 108 T.C. 25, 47-48 (1997).    In evaluating the

probability of competition, we take into account that the

covenant was restricted to the sale of new Jeep-Eagle

automobiles, which required a franchise from Chrysler.    The value

ascribed to the covenant must be further reduced to reflect its
                              - 17 -

present value.   See International Multifoods Corp. v.

Commissioner, supra.

     Petitioner has failed to take these factors into account;

therefore we find that the covenant not to compete was worth less

than the $490,000 claimed by petitioners.   Respondent

underestimated the probability that Mr. Markley would compete as

well as the damage that would be caused by such competition.

Consequently, we find that respondent has underestimated the

value of the covenant not to compete.   Based on the record as a

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

that the covenant not to compete had a value of $300,000.

     To reflect the foregoing,

                                         Decision will be entered

                                    under Rule 155.
