By John G. Hodnette
Purchasers of a successful business have the reasonable concern that the prior owners will use their expertise to open a new business across the street that immediately competes with the one they just purchased. Noncompete agreements are key to ensuring that does not happen. How is the consideration paid for the noncompetition agreement treated under the tax law for both the seller and the purchaser?
A seller may expect, particularly in a stock sale, the cash allocated to a noncompetition covenant will be taxed as long-term capital gain, like the proceeds from the sale of stock. However, payments received for a noncompetition agreement are actually taxed as ordinary income. Therefore, the seller will want to allocate as little as possible to the noncompete and instead maximize the allocation to the stock (in the case of a stock sale) or to goodwill (in the case of an asset sale). In both cases, that allocation will generally result in long-term capital gain, which is taxed at lower rates than ordinary income.
In contrast, in the case of a stock sale, the purchaser has an interest in maximizing the allocation to the noncompete because the purchaser can amortize that consideration over 15 years pursuant to Section 197(d)(1)(E). That section states “any covenant not to compete (or other arrangement to the extent such arrangement has substantially the same effect as a covenant not to compete) entered into in connection with an acquisition (directly or indirectly) or an interest in a trade or business or substantial portion thereof [shall be a Section 197 intangible amortizable under this section].” The 15-year amortization may surprise purchasers who expect the noncompete to be deductible over the same period as the restrictive covenant of the noncompete. Noncompetes often have a term of 5 years or less. Purchasers may be disappointed to discover their investment that protected them for 5 years will be recouped for tax purposes over 15 years. Nevertheless, allocating purchase price to a noncompete still provides a tax benefit to the purchaser in a stock sale. In an asset sale, in contrast, an allocation of the residual price to goodwill, which is amortizable over 15 years, does not provide the purchaser a tax advantage over an allocation to a noncompete.
An alternative to a significant noncompete payment is for the seller to provide consulting services to the buyer. The seller’s payment for consulting is ordinary income, like a noncompete payment. For the purchaser, however, the consulting fees are deductible as current expenses rather than amortized over 15 years.
John G. Hodnette is an attorney with Johnston, Allison & Hord in Charlotte.
October 13, 2022 / by TAXhttps://ncbarblogprod.wpengine.com/wp-content/uploads/2018/06/Blog-Header-1-1030x530.png 0 0 TAX https://ncbarblogprod.wpengine.com/wp-content/uploads/2018/06/Blog-Header-1-1030x530.png TAX 2022-10-13 15:30:10 2022-10-13 15:30:10 Taxation of Noncompete Agreements
Copyright 2024 North Carolina Bar Association and NCBarBlog. All Rights Reserved. Views and opinions expressed in articles published herein are the authors’ only and are not to be attributed to the North Carolina Bar Association or any of its sections, divisions or committees unless expressly stated. Authors are responsible for the accuracy of all citations and quotations. Unauthorized use and/or duplication of this material without express and written permission from this site’s author and/or owner is strictly prohibited. Excerpts and links may be used, provided that full and clear credit is given to the author and site with appropriate and specific direction to the original content.
