Not So Fast: What you need to know before you sign a non-compete agreement.

Selling your closely held business has its perks.  Whether you’re looking to gain cash or stock and diversify your assets, or just simplify family relationships, selling your business can be beneficial. But such benefits are normally burdened with certain restrictive covenants in favor of the buyer, the principal one being a “non-compete” agreement.

Non-compete agreements are extremely popular, yet terribly controversial. Supporters praise these provisions as a way to protect trade secrets and avoid theft of clients. Detractors see them as anti-competitive and heavy-handed.  But whether you’re for or against them is not really the point (they are in our lives regardless).  Rather, business owners and buyers need to know what they’re getting into when they agree to these provisions.  Among other things, non-compete agreements can be considered an acquired intangible asset from the seller and be amortized for cost recovery for federal tax purposes.  Savvy business owners and buyers need to understand these covenants. Below are some questions to keep in mind.

First, what is a non-compete agreement?  

A non-compete usually consists of several covenants which are designed to preserve the buyer’s “benefit of the bargain” that will not, for a certain time period following the closing, be diminished in value due to certain actions of the seller. For example, if you sell me your automotive parts manufacturing company, I might ask you to promise that you won’t turn around and open up another similar manufacturing company close to mine.  Terms of non-competes vary; indeed, I may want you to promise that you won’t open up shop for some number of years, or even within the same county or state.  The penalties for violation can be substantial, and could effectively put the person in violation out of business.

In many business purchase agreements, a portion of the lump sum purchase price is allocated to the covenant not to compete. An experienced business buyer will be keenly aware of how best to allocate the purchase value of the business under consideration and what value portion goes to the non-compete covenant.

How do I determine a non-compete value?

A business buyer needs to define and attempt to quantify how much “damage” the business seller and his key associates could realistically inflect on his new business if there is no non- compete agreement in the purchase transaction to determine a non-compete agreement value. A seasoned business valuation consultant can be instrumental here.  A well-thought-out, comparative, discounted net cash flow analysis over the non-compete agreement time frame is fundamental to determining the fair market value of a given non-compete agreement.

What are the tax implications of a non-compete?

Rules involving the tax treatment of non-compete agreements are simple as long as the parties understand the tax treatments of such covenants and goodwill. Goodwill is considered a capital asset, and the seller is permitted to treat the amount assigned to goodwill at favorable capital gains rates. Unfortunately, the buyer is denied any tax deduction because goodwill is thought to have an indeterminable useful life.

On the other hand, any consideration that the seller receives in return for agreeing not to compete must be treated as ordinary income. The buyer can capitalize the amount of the purchase price allocated to the non-competition covenant and is entitled to a tax deduction for the life of the covenant.

Because of these differing tax treatments, the seller and buyer will have opposite interests when negotiating the sale. If the buyer is to prevail, a reasonable amount of the purchase price must be allocated to the covenant not to compete, and the covenant must be reasonable in all aspects. If an excessive amount is allocated or if the covenant is improperly drafted, that portion of the purchase price will be allocated to goodwill.

Changes in federal tax code have significantly reduced the adverse tax interests of business buyers and sellers, but more IRS scrutiny is put on business purchase price allocations to covenants not to compete because often the business buyer wants an unreasonably large value allocation put on the non-compete agreement to reduce his future tax burden made via higher amortization expenses in future business periods.

It is also important for the business buyer to evaluate non-compete agreement values because the IRS has declared that intangible assets, with few exceptions, must be depreciated over a 15 year period, more than twice as long as most tangible business assets.

Note that non-competes can also conflict with nonqualified deferred compensation plans. This issue is terribly complex, but the penalties for getting it wrong are steep. If a non-compete provision tied to a deferred compensation agreement is found to be in violation of IRC Section 409A, the penalty is a 20% surtax plus a sizeable interest penalty. The IRS position is that a severance payment contingent on a non-compete can violate Section 409A if there is a theoretical possibility the employee can influence the year in which the payment will be made.  

Bottom line?  Non-compete provisions can show up in a number of agreements, and they can have significant tax implications.  

Again, whether you agree or disagree with the value of non-compete clauses, they are a popular tool in American business.  Pay attention to such provisions before creating or signing an agreement.  Seek professional guidance so that you don’t suffer the consequences later.

 

Comments

  1. Cody Brown says:

    Goodwill is amortizable over a 15-year period as prescribed in IRC section 197. It benefits the seller and has the same effect on the buyer. Often the tax savings can be split and results in a lower purchase price and more money kept by the seller.

  2. Tammie Smith says:

    What happens to covenant not to compete if the buyer abandons the business?

    • Adam Boatsman says:

      Hi Tammie,

      If a buyer abandons the business, the business ceases operations and therefore all assets are disposed of, including goodwill and other intangibles like a covenant not to compete. So it’s written off in the year the business ceases operations.

      Thanks for reading!

  3. Is the covenant subject to SE Tax ?

    • Adam Boatsman says:

      It’s generally not, however, to avoid some pitfalls the non-compete agreement should be separately valued from the remaining part of any other agreement (e.g. ongoing consulting, the sale of other business assets).

      Thanks for your question!

  4. If in a sales agreement it reads, goodwill 950,000 and non compete 1,000, does this mean if tje seller violates, theybwill only be liable for 1000.00?

    • Adam Boatsman says:

      Hi Susan,

      Your question is a legal one. The seller could still be liable for damages as a result of the violation. The thousand dollars it is valued at is only one of several data points in terms of what the final damages claim might be. We always counsel buyers and sellers that while their tax advantages to the seller to have a low noncompete value, the unintended consequence is that it might make it damages claim more difficult.

  5. Can the seller attribute a basis to a non-compete agreement to offset the ordinary income realized?

    • Adam Boatsman says:

      Hi Maria,

      Unfortunately, that is not the case. Basis only applies to items that otherwise qualify for capital gains treatment.

      Thanks for the question!

  6. Philip Vickers says:

    If a retiring employee agrees to a 5 yr non compete a a rate of $50k for 5 years can entity he is retiring from amortize the $50k payment over 5 years ?

Speak Your Mind

*