Tax Treatment For Non Compete Agreements

Taxpayers who sell businesses today should be careful to prove the value of each item allocated to the proceeds of the sale and avoid conflicting elements such as covenants and consulting contracts. Taxpayers must also recognize that Section 197 of the IRC contains covenants as depreciable intangible assets with a 15-year lifespan when acquired as part of a business acquisition. Today, the purchaser may prefer that a large amount be allocated to tangible property with a shorter lifespan rather than an obligation not to compete with buyers and sellers, which penalizes buyers and sellers and that the courts are more inclined to respect the indicated allowances. There are two types of non-competition rules: employment contracts and business purchase contracts. These two types of agreements have many similarities, but some important differences. In both cases, the non-competition clause may be a clause in a stand-alone contract or agreement. The main tax effects related to non-compete rights are presented as follows: when the owner enters into a compensatory non-compete agreement, the consideration received is taxed on the owner at the usual rates of income, whether the transaction is structured in shares or assets. However, if the agreement is concluded only for the realization of the transfer of good, the agreement does not necessarily entail ordinary income for the beneficiary, but can be considered as part of the purchase of the business. In such a situation, the value added to the Covenant may give rise to a capital gains treatment. A business buyer must define and attempt to quantify the amount of “damages” suffered by the business seller and its principal employees realistically in the absence of a non-compete clause in the purchase transaction in order to determine a non-compete value.

An experienced business valuation advisor can be helpful in this regard. A well-designed, comparatively designed analysis of net cash flows over the non-compete period is essential to determine the fair value of a given non-compete clause. Note that non-competitors may also conflict with unqualified compensation plans. This subject is terribly complex, but the sentences imposed on the wrong person are high. If it is found that a non-competition clause bound by a deferral agreement is contrary to IRC Section 409A, the penalty amounts to an additional tax of 20%, plus a significant interest penalty. The IRS`s position is that severance pay subject to a non-compete clause may be contrary to Section 409A if there is a theoretical possibility for the employee to influence the year in which the payment is made. The application of these factors to the case indicated a minimal need on the part of the Confederation. As the court asked: why should the taxpayer sell the largest company in the area just to create a smaller one and try to compete with the business he had sold? In addition, the consulting contract nullified any reasonable competitive intent. The definitive proof that the value attributed to the covenant was overstated was that the parties had not attributed anything to the intangible assets to which the expert had asserted such a value.

As a result, the eighth district confirmed to the financial courts a revaluation of the Confederation at a significantly lower amount. The case-law on a non-competition clause or a similar agreement as capital or, on the contrary, on a contractual agreement in the type of compensation is considerable. Normally, the fulfilment of an obligation not to compete with an employer and an employee does not entail the acquisition or transfer of capital to the employer company (Hamlin`s Trust, 209 F.2d 761 (10th Cir. . .