Three concepts regularly come into play when contemplating the sale of a business: noncompete covenants, consulting agreements, and goodwill. On the surface, the tax treatment of each seems fairly straightforward. However, the wording of the purchase agreement, or the lack thereof, can raise problems and issues. Following is a brief overview of the three concepts and then a discussion of specific areas to consider when crafting agreements, with the hope of providing sellers and buyers with guidance to avoid pitfalls.
- Noncompete covenants are created to protect the buyer's interest in the newly acquired business so that the seller does not reestablish himself or herself in the geographical area or compete with the buyer.
- Consulting agreements are created when the buyer wishes to retain the expertise of the seller for a period of time.
- Goodwill is defined in Regs. Sec. 1.197-2(b)(1) as "the value of a trade or business attributable to the expectancy of continued customer patronage. This expectancy may be due to the name or reputation of a trade or business or any other factor."
The exhibit shows the tax implications of these three concepts for the seller and the buyer.
Exhibit: Tax implications to the seller and buyer
|Noncompete covenant||Ordinary income not subject to SE tax.||Amortize over 15 years.|
|Consulting agreement||Ordinary income subject to SE tax.||Current deduction.|
|Goodwill||Capital gain, except if amortization has been taken, which is recaptured as ordinary income (Sec. 197(f)(7)).||Capital asset amortized over 15 years.|
Competing Interests of Buyer and SellerUnder the current federal tax rates, the seller, other than a C corporation, would prefer to sell goodwill and thus benefit from capital gain tax treatment (if the seller has held the stock for more than one year). The buyer, however, is likely to want to protect his or her investment by ensuring that the seller does not immediately compete with the business and/or to retain the seller's services for a period of time. The buyer has a preference to allocate more of the purchase price to the consulting agreement, which would result in a current deduction, as opposed to the noncompete agreement, which must be amortized over 15 years.
From the seller's perspective, a noncompete agreement is generally preferable to a consulting agreement from a tax standpoint because payments under a consulting agreement will be subject to self-employment tax. Self-employment income, however, does afford the individual taxpayer the ability to establish a variety of tax-saving vehicles, including retirement plans and medical reimbursement plans. These tax-saving vehicles generally need to be established within certain time limits and cannot be established after the fact.
Importance of Substance and FormIf a noncompete covenant and a consulting agreement are contemplated, it is important that substance and form actually exist to support the respective agreements.
To support a noncompete agreement, the parties need to have competing interests. Furthermore, the noncompete agreement needs to be realistic. It is difficult to argue that a seller will compete if he or she does not have the financial ability, is in poor health, or spends much of his or her time after the sale vacationing.
A clear example of noncompeting interests is provided in Mackey's, Inc., T.C. Memo. 1975-280, in which the seller retained a majority interest in the company. The seller also moved overseas within less than a month of signing the documents. The Tax Court found that this noncompete covenant was invalid because it merely restricted the taxpayer from competing against himself, and the consulting agreement was invalid because the taxpayer did not perform any services. The Tax Court held that both the noncompete payments and the consulting fees were disguised dividends.
Existing agreements should be reviewed to ensure a conflict does not exist. For example, if a fast-food restaurant franchise is being sold, the existing franchise agreement may prevent another store opening within a specified distance. It would be difficult to argue the validity of the noncompete if the distance specified was greater than the distance in an already existing franchise agreement. The noncompete covenant should also have provisions for breach of contract if the seller fails to comply with the terms of the covenant. The IRS may argue that the lack of breach of contract provisions is disguised goodwill.
A consulting agreement by its nature presupposes that the seller will perform some sort of consulting services for the buyer to ensure a smooth transition. In order to have substance, the seller—as the consultant—will need to perform actual and meaningful consulting services.
If both a noncompete and a consulting agreement will be structured, it is important that they be distinguishable. That is, they should provide for specific allocations and avoid ambiguity so the Service does not recharacterize the noncompete agreement as a consulting agreement and thus subject the payments to self-employment tax. Obtaining a valuation report from an independent appraiser that provides an allocation of the various pieces can be a valuable tool to support the allocations.
Congress anticipated the attempt to shift the purchase price away from noncompete covenants, and in the legislative history of Sec. 197 it directed that any arrangement that "requires the former owner of an interest in a trade or business to continue to perform services (or to provide property or the use of property)" is considered to have substantially the same effect as a noncompete covenant where the amount paid to the former owner of the business pursuant to the arrangement exceeds the amount that represents "reasonable compensation for the services actually rendered (or the property or use of property actually provided)" (H.R. Conf. Rep't No. 103-213, 103d Cong., 1st Sess. (1993)).
ConclusionBoth substance and form are important when crafting documents to sell a business. The Service and the courts will look beyond the written word to confirm that the actions support the agreements and, where they do not, will recharacterize the payments. The recharacterization can range from currently deductible to amortizable, from not subject to self-employment tax to subject to self-employment tax, and even to disguised dividends— none of which are favorable outcomes.
Stephen E. Aponte is senior manager at Holtz Rubenstein Reminick LLP, DFK International/USA, in New York, NY.
Unless otherwise noted, contributors are members of or associated with DFK International/USA.
For additional information about these items, contact Mr. Aponte at (212) 792-4813 or firstname.lastname@example.org.