Noncompete agreements are commonly included in business purchase transactions to prevent the seller from competing against the buyer for the term of the noncompete agreement. These arrangements are also sometimes called covenants-not-to-compete or noncompete covenants.
Important: Laws regarding noncompete agreements vary from state to state. For example, courts in California generally reject noncompete agreements because state law makes them unenforceable except in limited circumstances. Because noncompete covenants are generally not allowed in the state, California employers often use confidentiality agreements and other types of contracts to protect trade secrets and other information. Still, in many jurisdictions, noncompete covenants can be enforceable if certain conditions are met.
The Seller’s Perspective
The seller of a business must treat amounts allocated to noncompete payments as ordinary income. Ordinary income tax rates are higher than long-term capital gain tax rates. But there’s a silver lining for the seller: Noncompete payments aren’t subject to the self-employment tax.
With an asset purchase transaction, being required to treat noncompete payments as higher-taxed ordinary income will probably cause the seller to want to allocate less of the sale price to the noncompete agreement and more to lower-taxed capital gain assets (such as buildings and land) and lightly depreciated assets (such as recently acquired furniture and fixtures, equipment, and vehicles).
In a stock transaction, the seller will probably prefer to allocate more of the sale price to the value of the stock and less to the noncompete agreement. That’s because gain from selling stock is treated as lower-taxed long-term capital gain, as long as the stock has been owned for more than one year. In contrast, amounts allocated to noncompete agreements are treated as higher-taxed ordinary income.
Noncompete agreements have important tax implications. Here are the details.
The term of a noncompete is usually no longer than five years. However, as the buyer, you or your business entity, must amortize amounts allocated to a noncompete agreement over 15 years. That’s a longer amortization period than what’s allowed for some other assets. This fact has tax planning implications.
When you buy a business by purchasing its assets, you probably prefer to allocate more of the purchase price to the value of assets that you can write off quickly. Examples include receivables, inventory and fixed assets with short depreciable lives, such as furniture and fixtures, computer gear and software.
You probably prefer to allocate less of the price to assets that you must depreciate over long periods. For example, you must depreciate commercial buildings over 39 years, and land can’t be depreciated at all.
You must amortize purchase price amounts allocated to most intangible assets over 15 years. Examples include customer lists, franchise rights, trademarks and goodwill. Noncompete agreements are amortized over 15 years, too.
Asset purchase treatment automatically applies if you (or your business entity) buy a business that has been operated as a sole proprietorship or as a single-member limited liability company (LLC) that has been treated as a sole proprietorship for federal income tax purposes. In these situations, the business assets are considered to be owned by the proprietor, and you (or your business entity) are considered to purchase them directly from that individual.
Asset purchase treatment also applies if you (or your business entity) buy a business that has been operated as a partnership or as an LLC that has been treated as a partnership for federal income tax purposes. When you (or your business entity) become the sole owner of the purchased business, there’s no longer any partnership for tax purposes, because a partnership must have at least two owners. The same applies to an LLC that has been treated as a partnership for tax purposes. Therefore, you treat the transaction as a purchase of the LLC’s assets.
When you buy an incorporated business by purchasing its stock, you probably prefer to allocate more of the purchase price to any noncompete agreement(s) and less to the value of the stock. Why? You can amortize the amount allocated to noncompete agreements over 15 years.
In contrast, the amount you allocate to the value of purchased stock generally must remain capitalized until the stock is sold. There are no amortization deductions for amounts allocated to the value of the stock.
Stock Purchases Treated as Asset Purchases
Under a favorable tax-law exception, you can treat a qualified stock purchase as a purchase of the target corporation’s assets by making a Section 338 election, a Sec. 338(h)(10) election or a Sec. 336(e) election. Then, you allocate the purchase price to the assets that you’re deemed to have purchased and to any noncompete agreement(s).
In this scenario, you probably want to allocate more of the purchase price to the value of assets that you can write off quickly. Examples include receivables, inventory and fixed assets with short depreciable lives, such as furniture and fixtures, computer gear and software.
As we explained earlier with asset purchases, you probably prefer to allocate less of the price to assets that you must depreciate over long periods. For example, you must depreciate commercial buildings over 39 years, and land can’t be depreciated at all.
As stated earlier, you must amortize purchase price amounts allocated to most intangible assets over 15 years. Examples of these are customer lists, franchise rights, trademarks and goodwill. Noncompete agreements are also amortized over 15 years.
Specifying Payments in Transaction Documents
In the documents for your business purchase transaction, be sure to specify the amount that’s allocated to noncompete payments. Otherwise, your 15-year amortization deductions may be called into question by the IRS.
For the purchase of a group of assets that comprise a business, any allocation of purchase price to a noncompete agreement must be reported to the IRS on Form 8594, “Asset Acquisition Statement Under Section 1060.” This form is filed by both the buyer and seller. Specifically, the maximum amount that can be paid under the noncompete agreement must be reported on the buyer’s and seller’s respective Forms 8594. The IRS can use this information to spot differing allocations by you and the seller, which could trigger an audit.
To avoid unwanted IRS attention, you and the seller should report the same allocations to noncompete payments and purchased assets on your respective Forms 8594. Consider including that as a requirement in the purchase contract.
There’s apparently no Form 8594 filing requirement when a noncompete agreement is entered into in connection with a stock purchase, unless the transaction is treated as an asset purchase for federal income tax purposes pursuant to a Sec. 338 election, a Sec. 338(h)(10) election or a Sec. 336(e) election.
Noncompete agreements have important tax implications for both buyers and sellers. As the buyer, you want to make the most tax-effective purchase price allocations to any noncompete agreement(s) and the value of the business assets or ownership interest(s) that you acquire.
The seller’s tax objectives may conflict with yours. Negotiating a purchase price allocation that’s acceptable to both you and the seller is part of the art of the deal. Your tax advisor can help you work out a deal that’s right for your situation.