Handling tax issues related to noncompete agreements

A covenant not to compete is a contract in which the seller of a business agrees not to compete with the buyer. Noncompete agreements can be used to protect a company’s interest as long as they are drafted in an appropriate manner. Each state has laws that can render a noncompete agreement useless if it is not drafted properly and does not use reasonable terms.

Conceptually, a covenant not to compete upon the sale of a business is not part of the purchase price but rather a separate agreement on the part of the seller to not compete with the new owner. Covenants not to compete are intangible assets amortized over 15 years (Sec. 197(d)).

Observation: If a covenant is not entered into “in connection with an acquisition (directly or indirectly) of an interest in a trade or business or substantial portion thereof,” it is not a Sec. 197 asset (Sec. 197(d)(1)(E)). What does the “in connection with” language mean if a contracting party is not a former owner? It seems reasonable to conclude that covenants with nonowners, such as former employees, should be amortizable over the term of the agreement, as under pre-Sec. 197 law. However, the IRS could be expected to argue that 15-year amortization is required, even for covenants with nonowners, if they are part of a business acquisition.

In Recovery Group, Inc., 652 F.3d 122 (1st Cir. 2011), the First Circuit affirmed a Tax Court’s decision that a covenant not to compete entered into in connection with a redemption of 23% of an S corporation’s stock was a Sec. 197 intangible. As such, the cost of the covenant had to be amortized over 15 years rather than the one-year term of the covenant’s restrictions (Sec. 197(d)(1)(E)). According to the rationale of the Recovery Group holding, any noncompete payment relating to the purchase or redemption of a stock interest — without regard to the size of the interest — is subject to the Sec. 197 amortization schedule.

Incentives to minimize allocations to covenants

Buyers and sellers may be tempted to allocate more of the purchase price to assets that can be written off or depreciated over less than 15 years. Examples include receivables, inventory, machinery, and equipment. The parties may wish to allocate little or no value to covenants because of the relatively unfavorable 15-year amortization rule under Sec. 197. If the IRS discovers that a covenant has been entered into under such circumstances, the examiner may shift the purchase price allocation away from other assets and toward the covenant.

Payments received for a covenant not to compete are treated as ordinary income rather than capital gain. Therefore, sellers will generally prefer allocating the purchase price to capital assets and Sec. 1231 assets (like goodwill and real estate) rather than to covenants not to compete. If the buyer is indifferent about how the price is allocated, the IRS will look at whether “too little” is allocated to the covenant. For example, the buyer and seller may agree to allocate none of the purchase price to the covenant and allocate more of the purchase price to goodwill. The buyer is indifferent because both covenants and goodwill are amortized over 15 years under Sec. 197. However, the seller prefers goodwill because it is a capital asset.

Incentives to maximize allocations to covenants

Because of the 15-year amortization rule, covenants are relatively unattractive to buyers in stock deals treated as taxable asset purchases under Sec. 338. However, the Sec. 197 15-year amortization rule also applies to covenants entered into in connection with stock sales where no Sec. 338 election applies. In such transactions, the buyer can allocate some of the purchase price to an asset that can be amortized over 15 years, as opposed to allocating 100% to the stock, which cannot be amortized at all.

Establishing a bona fide covenant

Payments for covenants can usually be supported only when the former owner has the actual capacity to compete (in terms of geographic location, age and health, financial resources, business contacts, ability to enter the market without restriction, etc.). Even then, one of the following circumstances normally must also apply:

• The business acquired is service- or knowledge-based as opposed to capital-intensive;
• The former owner possesses special technical knowledge (such as information about formulas or secret processes);
• The former owner has long-standing relationships with suppliers or producers; and/or
• The former owner is a marketing powerhouse or has an outstanding reputation, resulting in many loyal customers.

The enforceability of the noncompete agreement depends on a number of factors, including:

• The length of the agreement, with the courts generally considering a period of two to three years or less to be reasonable;
• The scope of the agreement, which should not be overly broad; and
• The geographic area covered by the agreement, which should be reasonable based on the company’s and the individual’s expected area of operation.

Because of the potential for double taxation on the sale of corporate-owned business assets (the corporation is taxed on the sale and the shareholder is taxed on the distribution of the sale proceeds), it is imperative to determine whether the corporation or the shareholder actually owns intangible assets (e.g., client lists and any associated goodwill). If the shareholder owns these intangibles, double taxation is reduced.

In Norwalk, T.C. Memo. 1998-279, the court determined that the goodwill was not an asset owned by the corporation because it did not have noncompete agreements with the shareholder-employees. Accordingly, the goodwill (in the form of client relationships) attached to the employees individually, and it was not an asset owned by the corporation. This presents a potential planning opportunity for sellers who can document the existence of goodwill (e.g., valuable personal relationships with customers) that belongs to the seller personally rather than to the corporation. In such cases, double taxation may be avoided if a portion of the total sales proceeds paid to the seller can be allocated to the seller’s personal goodwill. Assuming the seller has no basis in the self-created goodwill, the proceeds allocated to his or her goodwill will be taxed once at the maximum long-term capital gain rate of 15% or 20% (depending on the seller’s taxable income).

Observation: Taking the position that a portion of a business’s goodwill should be allocated to the owner personally, rather than the business, will invite IRS scrutiny. When structuring such a sale, it is important to engage a valuation expert with deep experience in valuing and allocating goodwill. It is also important to obtain documentation that the goodwill or other intangibles owned by the owner were never sold, contributed, or otherwise transferred to the business. If the owner is also an employee of the corporation, any employment contracts must also be reviewed to ensure that the employee contract did not create intangible assets in the business. The sales document should also indicate which assets are being sold by the business and which assets are being sold by the owner personally.

In Martin Ice Cream Co., 110 T.C. 189 (1998), the court held that the customer relationships of a shareholder-employee are not corporate assets when the employee does not have a covenant not to compete or employment contract with the corporation and these intangibles were never contributed or otherwise transferred to the corporation. The corporation’s assets were determined to be distribution rights and corporate records, which were valued at a much lower amount. The sale of the customer relationships by the individual then avoided double taxation and was subject to lower capital gains rates.

Using a consulting agreement instead

Amounts attributable to a consulting agreement are deductible over the period the seller is to provide services. To the extent that a portion of the consideration can be legitimately attributed to the consulting agreement, the buyer will be entitled to a deduction at the time of the payment. This will usually result in a much faster recovery of expenditures than the 15 years applicable to covenants. Because payments under a covenant not to compete and a consulting contract are both ordinary income, the only detriment to the seller is the payroll taxation. But if the seller already receives wages or other self-employment income at or above the Federal Insurance Contributions Act limit, the only cost will be the 2.9% Medicare Health Insurance (HI) portion of the self-employment tax and possibly the additional 0.9% Medicare tax on earned income.

The IRS will scrutinize arrangements that provide large consulting services payments and small or no allocations to covenants not to compete, especially if the seller is not actually called upon to render any consulting services or to assist with the transition of the business.

This case study has been adapted from PPC’s Tax Planning Guide — Closely Held Corporations, 33d Edition (March 2020), by Albert L. Grasso, R. Barry Johnson, and Lewis A. Siegel. Published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2020 (800-431-9025; tax.thomsonreuters.com).