Selling a business: substance and form really do count.

• Author: Beatty, Dawn M.

Three concepts regularly come into play when contemplating the sale of a business: noncompete covenants, consulting agreements, and goodwill. On the surface, the tax treatment of each seems fairly straightforward. However, the wording of the purchase agreement, or the lack thereof, can raise problems and issues. Following is a brief overview of the three concepts and then a discussion of specific areas to consider when crafting agreements, with the hope of providing sellers and buyers with guidance to avoid pitfalls.

* Noncompete covenants are created to protect the buyer's interest in the newly acquired business so that the seller does not reestablish himself or herself in the geographical area or compete with the buyer.

* Consulting agreements are created when the buyer wishes to retain the expertise of the seller for a period of time.

* Goodwill is defined in Regs. Sec. 1.197-2(b)(1) as "the value of a trade or business attributable to the expectancy of continued customer patronage. This expectancy may be due to the name or reputation of a trade or business or any other factor."

The exhibit shows the tax implications of these three concepts for the seller and the buyer.

Competing Interests of Buyer and Seller

Under the current federal tax rates, the seller, other than a C corporation, would prefer to sell goodwill and thus benefit from capital gain tax treatment (if the seller has held the stock for more than one year). The buyer, however, is likely to want to protect his or her investment by ensuring that the seller does not immediately compete with the business and/or to retain the seller's services for a period of time. The buyer has a preference to allocate more of the purchase price to the consulting agreement, which would result in a current deduction, as opposed to the noncompete agreement, which must be amortized over 15 years.

From the seller's perspective, a noncompete agreement is generally preferable to a consulting agreement from a tax standpoint because payments under a consulting agreement will be subject to self-employment tax. Self-employment income, however, does afford the individual taxpayer the ability to establish a variety of tax-saving vehicles, including retirement plans and medical reimbursement plans. These tax-saving vehicles generally need to be established within certain time limits and cannot be established after the fact.

Importance of Substance and Form

If a noncompete covenant and a consulting agreement...