Handling tax issues related to noncompete agreements.

• Author: Hackett, Trenda B.

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 prc-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-ycar 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...