Noncompete covenants in mergers and acquisitions: compensation or capital gain?

• Author: Weber, Neal A.

In most acquisitions where the target employee-owner played an integral part in the operation of the acquired business, the acquirer and owner will execute a noncompete covenant in connection with the transaction. This is generally the case regardless of whether the owner has an ongoing relationship with the business. The treatment of the noncompete covenant as either a compensatory arrangement or an integral part of the acquisition of the business goodwill will significantly change the tax treatment to both the owner and acquirer.

Recent changes to the financial reporting of acquisitions and combinations may affect how tax practitioners treat these noncompete arrangements, with potentially significant ramifications for both owner and purchaser. This item attempts to clarify the tax rules surrounding the treatment of noncompete covenants and cautions against overreliance on financial accounting reporting in making tax determinations.

Financial Accounting Changes to Business Combinations

Since the Financial Accounting Standards Board (FASB) issuance of Statement of Financial Accounting Standards 141R (FAS 141R), Business Combinations, applicable to business acquisitions occurring in fiscal years beginning on or after December 15, 2008, as codified in FASB Accounting Standards Codification Topic 805, additional emphasis has been placed on the identification of intangibles separable from goodwill. As a result, significant fair value is often allocated to noncompete covenants. However, FAS 141R appraisals do not determine whether the intent of a noncompete covenant was compensatory or to protect the value of the acquired business goodwill. In fact, it may be fair to say that FAS 141R supports a conclusion that the covenant is part and parcel with the business goodwill, as FAS 141R looks to an allocation of the fair value of the business assets acquired. On the flip side, the FAS 141R valuation does appear to identify the noncompete covenant as an asset separate from goodwill.

Tax Treatment of Noncompete Covenants: Purchaser

Placing all questions as to valuation of a noncompete covenant aside, where the purchaser enters into a compensatory noncompete covenant in connection with the acquisition of a trade or business, the consideration paid creates an amortizable Sec. 197 intangible asset (see Regs. Sec. 1.197-2(b)(9)). This is the case whether the purchaser acquires the trade or business through a stock or via an asset acquisition (id.). As a result, the purchaser has a vested interest in a larger allocation of the consideration to the noncompete covenant in a stock acquisition, as the stock acquisition does not by itself result in a stepped-up tax basis of the target's assets.

Contrast that treatment with a Sec. 338(h)(10) or an asset acquisition, where an allocation to a covenant provides the same tax treatment to the purchaser as would an allocation to goodwill (i.e., 15-year amortization). On the other hand, as discussed below, a noncompete covenant entered into to effectuate a transfer of business goodwill does not necessarily create a separate Sec. 197 intangible.

Tax Treatment of Noncompete Covenants: Owner

Where the owner enters into a compensatory noncompete covenant, the consideration received is taxed to the owner at ordinary income rates, whether the transaction is structured as a stock or asset sale. However, where the covenant is entered into simply to effectuate the transfer of the business goodwill, the covenant does not necessarily result in ordinary income to the recipient, but rather may be considered part and parcel with the purchase of the business. In such a situation, the value attributable to the covenant may result in capital gain treatment.

Covenant: Compensatory, Capital, or Condition of Employment?

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