Rudie v. Commissioner

Grant T. Rudie, Jr., and Karen Rudie, Petitioner v. Commissioner of Internal Revenue, Respondent Rudie v. Commissioner Docket No. 6032-65 United States Tax Court 49 T.C. 131; 1967 U.S. Tax Ct. LEXIS 15; November 29, 1967, Filed *15 Decision will be entered under Rule 50. Upon the termination of a lease on the building where he operated a drugstore, petitioner purchased the business of his only competitor in a community of 1,500 persons. The purchase price of $ 23,750 included amounts allocated to the business name, land, building, fixtures, prescription file, and a covenant by the owner not to compete for 5 years. After remodeling the building, petitioner moved his business there under his own business name and then operated the only drugstore in the community. Petitioner did not advertise the purchase of the prescription file or directly solicit the business of customers whose names appeared in the file. Held, petitioners failed to established a cost or limited useful life of the prescription file entitling them to amortize its cost over a 3-year period. Held, further, since the covenant not to compete was separately bargained for, the cost was properly amortized over its 5-year life. John R. McDonald, for the petitioners. Gerald P. Moran, for the respondent. Dawson, Judge. DAWSON *131 Respondent determined deficiencies in petitioners' income taxes of $ 113.30 in 1961, $ 543.83 in 1962, and $ 510 in 1963. By amended answer filed after the trial of this case, respondent claims increased deficiencies of $ 55.04 in 1961, $ 285 in 1962, and $ 255 in 1963. Two issues are presented: (1) Whether prescription records obtained by petitioner in the purchase of a drugstore constituted an intangible asset with a value of $ 3,000 and a useful life of 3 years, the cost of which can be depreciated under section 167(a), I.R.C. 1954; 1 and (2) whether a covenant not to compete was a distinct part of the transaction for which separate consideration was received, entitling petitioner to amortize the cost over the 5-year life of the covenant. *17 FINDINGS OF FACT Some of the facts have been stipulated and are found accordingly. Petitioners Grant T. Rudie, Jr. (herein called petitioner), and Karen Rudie, husband and wife, were legal residents of Westby, Wis., when their petition was filed herein. Their joint Federal income tax returns for the calendar years 1961, 1962, and 1963 were filed with the district director of internal revenue at Milwaukee, Wis. In 1948, petitioner, a licensed pharmacist, began working for his father who had operated Rudie's Drugstore (herein called Rudie's) in *132 Westby, Wis., since 1927. In 1949 petitioner became a partner and a few years later purchased his father's interest in the drugstore. Petitioner operated Rudie's as a sole proprietorship through the tax years in issue. The Unseth Rexall Drugstore (herein called Rexall), established in Westby around 1900 and operated by various owners continuously until 1961, was Rudie's sole competition in the drug business from 1927 to 1961. The last owner of Rexall was Larry Day (herein called Day) who purchased the store along with its prescription records in 1956. Day had a good reputation in the Westby area as a pharmacist. In addition to*18 the drug business, Day offered a wide variety of merchandise for sale at Rexall. In contrast, Rudie's was primarily a pharmaceutical dispensing store with only a small gift line, greeting cards, and a fountain. The two drugstores filled about the same number of new prescriptions each year. Generally, a minimum population of between 3,500 and 4,000 is required to support a profitable drugstore. Westby had a population of only 1,500 with a per capita income less than the Wisconsin State average. Vernon County, in which Westby is located, suffered an 8-percent decrease in population between 1950 and 1960 and was considered a poor market area. Petitioner's net profit from the operation of Rudie's was $ 4,739.08 in 1959 and $ 8,662.01 in 1960. During the years 1959 and 1960 the average compensation for Wisconsin druggists in management positions was $ 10,000. On January 1, 1961, petitioner was notified that he would have to vacate the building he was leasing from the Westby Telephone Co. His subsequent attempts to secure a lot in town upon which to build were unsuccessful. After hearing that Day was interested in leaving Westby, petitioner offered to purchase the Rexall building*19 and inventory and Day's home, if necessary. No agreement was reached at that time. Subsequently, Harold Nelson, a newspaperman from Lancaster, Wis., who was interested in inducing Day to open a drugstore in Lancaster, prompted further negotiations between petitioner and Day. On May 20, 1961, the parties agreed to a sales price of $ 23,750 and executed without legal advice a witnessed written agreement, as follows: We, Larry Day and Grant Rudie, Jr., Westby, Wisconsin, do this 20th day of May, 1961, hereby agree: (1) That Grant Rudie, Jr. purchase goodwill of Unseth Rexall Drugs, Westby, for $ 13,750.00 for cash upon presentation of title to building. (2) That Grant Rudie, Jr. purchase Unseth Rexall Drugs building, Westby, for $ 10,000 cash. (3) That Larry Day agrees to move stock and fixtures of Unseth Rexall Drugs out of Westby and cease business on or before September 1, 1961; and that said Larry Day agrees not to enter drug store business in Westby for a period of at least 10 years hence. *133 That this agreement covers a total of $ 23,750.00 for business and building. $ 1 earnest money paid down on this agreement. Dated this 20th day of May, 1961 at Westby, Wis. By mutual*20 agreement, the parties consulted an attorney, Lester D. Skundberg (herein called Skundberg) to "finalize" their previous understanding. Skundberg represented both parties in drafting an agreement to buy and sell which differed from the May 20 agreement only in excluding the term '"goodwill" and including as items of purchase the business name "Unseth Rexall Drug Store," the prescription file, and fixtures on the second floor of the building. Petitioner was given the right to immediate possession of the building though transfer of title was scheduled for September 1, 1961. After Skundberg explained the significance of the 10-year covenant not to compete, petitioner requested that it be retained and Day acquiesced, subject to an oral understanding that it would be changed if Skundberg determined the term unreasonable under State law. As a result of Skundberg's admonition, the parties understood that they would agree later to a reasonable allocation of the purchase price to the separate assets for income tax purposes. Skundberg ascertained the fair market value of the building and land, but he did not advise either party as to applicable tax law. Petitioner met with a certified *21 public accountant between May 22 and August 18, 1961, and made the following allocation of the purchase price: Prescription file $ 3,000 Building 13,000 Fixtures 1,000 Covenant not to compete 3,750 Land 2,000 Goodwill 1,000 23,750 Petitioner did not believe any goodwill was involved in the purchase and made the $ 1,000 allocation to it only upon the accountant's insistence. Petitioner had not examined the prescription file before the valuation was made. He had, however, checked the volume of Rexall's prescription business for several years and knew that Day was filling approximately 6,000 new prescriptions each year. Based upon his own business, which handled about the same volume of new prescriptions, petitioner estimated that Day was refilling about 8,000 or 9,000 prescriptions per year. He also estimated that Day's file contained about 8,000 or 9,000 current and usable prescriptions. Petitioner first examined the prescription file on August 19, 1961, and found that he had purchased 36,000 prescriptions. *134 The $ 3,750 allocation to the covenant not to compete was based on the 10-year period in the buy and sell agreement and constituted the balance of *22 the $ 23,750 total purchase price after allocations had been made to all other assets. Thereafter, at a closing conference on August 18, 1961, the covenant period was reduced by written agreement to 5 years upon the advice of Skundberg. Day was informed of petitioner's allocation at the conference and agreed to it. At that time Day and his wife formally conveyed all the property to petitioner and his wife. Day subsequently moved to Lancaster, Wis., and opened a drugstore which he has continued to operate. Immediately upon his purchase, petitioner closed the Unseth Rexall Drugstore and began renovating the building. None of Day's employees was retained by petitioner. After 6 weeks the store front had been changed, the ceiling lowered, and the interior completely remodeled. On the day after the sale, petitioner transferred the newly purchased prescription file to his leased premises where he continued to do business until October 1, 1961, at which time he moved his entire operation to the renovated building, retaining the business name "Rudie's Drugstore." Petitioner's profits from the operation of Rudie's Drugstore for years material to this controversy were as, follows: Year Gross profit Net profit [1959] $ 58,099.14 $ 4,739.08 [1960] 62,211.06 8,662.01 [1961] 80,191.04 10,929.50 [1962] 137,883.70 23,872.64 [1963] 142,404.37 23,937.85 *23 A prescription normally indicates the name of the licensed prescriber, the name of a drug, the patient's name, the prescribed method of use, the date the prescription was written, and a designation of the number of times the prescription can be filled. Each prescription is stamped according to a consecutive numbering system and is placed in a permanent record or file. Under Wisconsin and Federal law a dangerous or "legend" drug may be obtained only by written prescription and may be refilled only as designated. A prescription may allow no refills, a specific number of refills or, by the designation "PRN" or "ad lib," it may allow refills as needed without limit as to time. Pharmacists commonly suggest that PRN prescriptions be reconfirmed every 6 months or yearly. The American Medical Association does not consider PRN to be a valid authorization for a legend drug. Prescriptions may be copied, but the copy is not valid authorization for a refill at another drugstore. In Wisconsin prescription records must be maintained for at least 5 years. The School of Pharmacy of the University of Wisconsin recommends a period of not less than 6 years. Generally, less than 20 percent of *24 all prescription orders contain renewal authorization. National averages indicate that few prescriptions *135 are refilled after a 1-year period, the number becoming inconsequential after about 5 years. Petitioner estimated that of the 36,000 prescriptions purchased from Day approximately 8,000 or 9,000 (22 to 25 percent) were current with a useful life of 3 years. Petitioner based his estimates, made after he had used the prescription file in his business for over 4 months, upon his own experience and upon the advice of other pharmacists. Petitioner had not previously been involved in the purchase or sale of a prescription file. Using the month of December for 5 years as a representative sample, refills 2 of prescriptions in the file purchased by petitioner were made as follows: December 1962 [108] December 1963 [71] December 1964 [60] December 1965 [57] December 1966 [29] *25 It is customary in the pharmacy profession to advertise once or twice in local newspapers the acquisition of a prescription file, but the file is never used to solicit business by personal contact with previous customers. Petitioner did not publicly advertise that he had acquired the Rexall prescription file, nor did he use the file to solicit customers. Prescription files are often insured under a "valuable documents coverage." The insurable interest consists of the approximate cost in time and effort to reconstruct the file in the event of its loss or destruction. On this basis, the average value placed by insurance companies on a single prescription is between $ 3 and $ 3.50. A somewhat lower figure of $ 2 is frequently recommended in Wisconsin. Petitioner attempted to amortize, on the straight-line method, the cost of both the prescription file and the covenant not to compete over a 3-year period. Petitioner had misinformed his accountant that the covenant period was 3 years instead of 5 years. In his notice of deficiency the respondent disallowed any deduction for the cost of purchasing the prescription file but allowed a decreased deduction for the covenant not to compete*26 on the basis of a 5-year amortization period. OPINION On the first issue, respondent contends that the cost of the prescription file cannot be amortized 3 because the file is a single indivisible *136 capital asset which is not exhausted by the passage of time or is in the nature of goodwill, or, alternatively, because petitioner has failed to establish a cost of $ 3,000 or a useful life of 3 years. Petitioner characterizes the file as an intangible asset, useful in his business for only a limited period, and argues that the allocation was at arm's length and the useful life was estimated with reasonable accuracy. *27 In support of his position that the cost of the prescription file cannot be amortized, respondent draws an analogy to customer and subscription lists. As a general rule, no amortization of such intangible assets has been allowed. Anchor Cleaning Service, Inc., 22 T.C. 1029 (1954); Aaron Michaels, 12 T.C. 17 (1949); The Danville Press, Inc., 1 B.T.A. 1171 (1925). Without question, a prescription file does serve as an inducement for those customers with refillable prescriptions to return to the drugstore which holds the file. In this sense it is in the nature of goodwill. See Rodney B. Horton, 13 T.C. 143 (1949). Statistics show, however, that the average prescription will be refilled for only a limited period of time, either because a specific number of refills was designated or because the person will cease to need the drug. At this point the prescription itself has little or no value as an inducement for customers to return. The same thing may be said of the collection of "unrefillable" prescriptions. A pharmacist, then, is in the unique position, as *28 a result of custom in the pharmacy profession, of being unable to solicit business by directly contacting those persons whose names appear in the prescription file. The only acceptable advertising with respect to a prescription file is a general announcement of its acquisition. This basic difference weakens the analogy drawn by respondent between a customer list and a prescription file. In addition, the peculiar facts in this case do not establish a goodwill element in the prescription file. The file was not purchased to provide a means of contact with Rexall's customers. Petitioner reasonably believed that this would naturally flow from "buying out" his only competitor in an area where it was unlikely that other competition would develop. Accordingly, we think the customer and subscription list cases cited by respondent do not govern the instant case. We conclude, however, that petitioners are not entitled to the claimed depreciation deductions based upon the cost of the prescription file because they have failed to establish a cost or reasonable life of the file. The Commissioner's notice of deficiency is presumptively correct, and the petitioners have the burden of proving*29 it to be wrong. Welch v. Helvering, 290 U.S. 111 (1933). Here the petitioners characterize *137 the value of the prescription file to them merely as a "convenience" and a "time saver" and assert that the $ 3,000 allocation agreed to by the parties establishes its "cost." We cannot agree. The only evidence to support the $ 3,000 allocation was testimony of an insurable interest in a prescription file based upon a value of between $ 2 and $ 3.50 per prescription, which represents the cost in time and effort to reconstruct the file. We believe that under these circumstances the insurance value has no substantial relationship to fair market value, but, assuming the contrary to be true, petitioner has failed to show a computation based upon the insurance value which bears any relationship with the $ 3,000 allocation. Under these particular circumstances we give little weight to petitioner's unilateral allocation, especially since there were no adverse tax interests to assure a fair allocation. "While the amounts allocated to these intangibles were seemingly in fair proportions, by their nature they resist precise appraisal, and rest on wholly*30 subjective considerations. Estimates and crude approximations of losses are not sufficient." Golden State Towel and Linen Service, Ltd. v. United States, 373 F. 2d 938 (Ct. Cl. 1967). Although petitioner had never before participated in a sale or purchase of a prescription file, he contends that his estimate of a 3-year useful life, based upon his own experience and the advice of other pharmacists, was reasonable and sufficient under the statute and regulations. The regulations are clear, however, that "No allowance will be permitted merely because, in the unsupported opinion of the taxpayer, the intangible asset has a limited useful life." Sec. 1.167(a)-3, Income Tax Regs. In support of his opinion, petitioner relies on national averages which show few prescriptions are filled after a 1-year period, with declining numbers thereafter. We attach little significance or probative weight to the evidence of national averages because it is indefinite and inconclusive and because petitioner has failed to establish any relationship between the national averages and the facts of this case. Moreover, the previous effort made by this Court to rely primarily*31 upon statistical data to determine the useful life of an intangible asset met with no success. See Commissioner v. Indiana Broadcasting Corporation, 350 F. 2d 580 (C.A. 7, 1965), reversing 41 T.C. 793 (1964), certiorari denied 382 U.S. 1027. Nor is the pharmacy industry practice a sufficient indication of the prescription file's probable useful life. Cf. Coca-Cola Bottling Co., 6 B.T.A. 1333 (1927). The only other evidence in this case indicating a useful life is the stipulated record of refills of prescriptions purchased from Day during the month of December for the years 1962 to 1966. This record does not include refills of new prescriptions written by a physician for the *138 same drug covered by a still refillable prescription of Rexall. Assuming the record to be accurate and representative, we conclude that it augurs against rather than for a 3-year useful life. In the fourth year after sale the petitioner was refilling more than half as many Rexall prescriptions as he did in the year of sale. In the fifth year the number had dropped to only one-fourth. *32 Under petitioner's theory of the value of the prescription file to him, it is plain that its useful life was greater than 3 years. This record simply does not establish that 3 years was a reasonably accurate estimate of the useful life of the prescription file. Since insufficient evidence was introduced from which we can calculate with "reasonable accuracy" the average useful life of the prescription file or its usual life span, we cannot indulge in surmise and speculation by arbitrarily declaring an average useful life. Consequently, we are constrained to conclude on this record that the petitioner has failed to prove respondent erred in his determination that the prescription file had an indeterminable useful life. By raising in an amended answer the issue of petitioner's right to a ratable deduction for the cost of the covenant not to compete, an issue not relied upon in determining the deficiency, respondent has assumed the burden of proof. Sheldon Tauber, 24 T.C. 179 (1955). We find that respondent has failed to carry that burden. Respondent contends that there was neither economic reality to the covenant not to compete nor separate bargaining*33 with respect to it so as to establish a distinct value. Alternatively, he argues that the amounts allocated to both the covenant and the prescription file represent the capital cost of the elimination of competition over an unlimited period and are thus nondeductible. Petitioner, on the other hand, emphasizes the separate treatment accorded the covenant in the agreements and the specific allocation of $ 3,750 agreed to by the parties, and argues that the facts establish its independent significance. Generally, the purchaser of a covenant not to compete is entitled under section 167 to amortize the price paid for the covenant ratably over the life of the covenant if "severable consideration for it can be shown, and it has some basis in fact or arguable relationship with business reality so that reasonable men might bargain for such an agreement." Benjamin Levinson, 45 T.C. 380, 389 (1966). As a result of the specific exclusion of goodwill as a depreciable asset by section 1.167(a)-3, Income Tax Regs., it is clear that there must be "independent significance" to the covenant apart from merely assuring the effective transfer of goodwill. Ullman v. Commissioner, 264 F. 2d 305, 307*34 (C.A. 2, 1959), affirming 29 T.C. 129 (1957). The choice is not, however, between "goodwill" on one hand and "covenant not to compete" on the other, for the two most often are interrelated, whether *139 or not separate significance can be attributed to the covenant. In the case at hand, the facts establish to our satisfaction that the covenant was a principal asset of the purchase, was separately bargained for, and did, indeed, have independent significance. Day covenanted not to compete with petitioner in each agreement executed by the parties. After his attorney explained the significance of the covenant, petitioner specifically requested its inclusion in the formal buy and sell agreement. A specific allocation of $ 3,750 was made to the covenant by petitioner and was approved by Day. The fact that the allocation was made subsequent to the sales agreement does not alter its efficacy since the parties recognized a value to the covenant by contract provision, leaving specific allocation to later agreement. In addition, the change of the covenant period from 10 to 5 years was within their contemplation since they understood that Skundberg would *35 reduce the 10-year limit if he thought it would not be legally enforceable. At the closing conference the 5-year period and the $ 3,750 allocation were approved by both parties. It is true that once a transaction has crystallized the parties may not manipulate tax consequences by "window dressing" in subsequent contracts. George H. Payne, 22 T.C. 526 (1954). But here the parties did not reach final agreement until the closing conference. Respondent insists that the separate bargaining element is missing because of the lack of negotiation or discussion of price. As we stated in Benjamin Levinson, supra, "The answer to this is that [the seller] apparently never objected to the price attributed to the covenant by the purchasers -- so there was little reason for them to negotiate it." We agree that "the effectiveness taxwise of an agreement is not measured by the amount of preliminary discussion had respecting it. It is enough if parties understand the contract and understandingly enter into it." Hamlin's Trust v. Commissioner, 209 F. 2d 761, 765 (C.A. 10, 1954). The economic condition*36 of the Westby area reveals the real importance of the covenant to petitioner. In view of Wesby's location in a poor market area, it was unlikely that someone would open a new drugstore there when Day left. Thus, with Day's covenant, petitioner was assured a virtual monopoly in the drug business. In this position, petitioner did not need to trade upon the goodwill of Rexall in order to secure new customers. As a matter of fact, petitioner has operated the only drugstore in Westby from 1961 until the present time at a substantial increase in profits. Absent the covenant, Day, who concededly had a good reputation in Westby as a pharmacist, would have been free to relocate there if his enterprise in Lancaster had failed. Thus, there was sufficient "business reality" to induce reasonable men to bargain for such an agreement. In addition, the allocation of *140 $ 3,750 to the covenant, or about one-half of the purchase price attributable to the intangible assets, seems reasonable under the circumstances. Alternatively, respondent characterizes the cost of the covenant as a nondeductible cost of eliminating competition for an indefinite period of time, citing B. T. Babbitt, Inc., 32 B.T.A. 693 (1935).*37 A "cost of eliminating competition" characterization was made in Babbitt, but it was determined that the specific covenant period agreed to established a definite useful life over which the capital asset was exhaustible. While the petitioner may enjoy the benefits of the economic situation in Westby originating with the agreement with Day for a much longer period than 5 years, we think the covenant period is a reasonable measure of the life of the asset purchased from Day. To reflect the conclusions reached herein, Decision will be entered under Rule 50. Footnotes 1. All statutory references herein relate to the Internal Revenue Code of 1954 unless otherwise indicated.↩ 2. Refills under a new prescription written by a physician for the same drug which was covered by a prior and still refillable prescription of Rexall are not included.↩ 3. SEC. 167. DEPRECIATION. (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. Sec. 1.167(a)-3, Income Tax Regs., provides, in pertinent part, as follows: If an intangible asset is known from experience or other factors to be of use in the business or in the production of income for only a limited period, the length of which can be estimated with reasonable accuracy, such an intangible asset may be the subject of a depreciation allowance. Examples are patents and copyrights. An intangible asset, the useful life of which is not limited, is not subject to the allowance for depreciation. No allowance will be permitted merely because, in the unsupported opinion of the taxpayer, the intangible asset has a limited useful life. No deduction for depreciation is allowable with respect to goodwill.↩