Non-Compete Agreement Payments Considered
Ordinary Income
The transfer of intangible
assets is commonly part of the sale of a business. However, the income-tax
treatment of these intangibles--generally goodwill and a covenant on the
part of the seller not to compete--can differ significantly. A recent case
illustrates the need to clearly define what is being bargained for when
parties engage in the sale of a business.
General Tax Treatment of Intangibles
A payment made by the buyer of a business to the seller under a covenant not
to compete is generally taxable to the seller as ordinary income (Rev. Rul.
69-643, 1969-2 CB 10). Goodwill is the expectancy that customers will
continue to patronize a specific place of business based on a pre-existing
business relationship. For federal income-tax purposes, goodwill is
considered to be a capital asset (International Multifoods Corp., 108 TC No.
25, 1997). IRC Sec. 197 governs situations where the purchaser of a business
makes payments both for goodwill and pursuant to a non-competition agreement.
In such cases, both types of intangibles must be ratably amortized by the
buyer over a 15-year period.
Muskat v. U.S.
A recent court of appeals case (Muskat v. U.S., CA-1, 1/29/2009) considered
whether payments made under a non-compete agreement could properly be
characterized as having been made for personal goodwill and, as a result, be
taxable as capital gain, not ordinary income. The taxpayer initially
included the payments that he received under the non-compete agreement as
ordinary income. However, the taxpayer thereafter sought to recharacterize
the payments as having been made for personal goodwill. He sought a refund
for the difference between the amount of taxes paid in regard to the
non-compete agreement at ordinary rates and the taxes that would have been
paid if capital gains rates had been applied. The IRS denied his refund
claim, finding that his initial characterization of the non-compete payments
as ordinary income was correct.
A district court rejected the taxpayer’s argument that certain features of
the non-compete agreement (the duration and survivability clause) actually
rendered payments made under it payments for the sale of his personal
goodwill. Instead, the court found that under the express terms of the
agreement, the consideration provided by the buyer was specifically for the
covenant not to compete. Also, no proof was submitted to demonstrate that
personal goodwill was a consideration during the negotiations regarding the
non-compete agreement. Absent “strong proof” that the payments made under the
agreement were actually intended to compensate the seller for his personal
goodwill, the court held they were properly taxable as ordinary income.
On appeal, the circuit court upheld the district court’s ruling and
rationale. The appeals court reiterated the precedent that a taxpayer in
this situation requires strong proof where written contracts exist that
specifically allocate sums for various aspects of the transaction, including
those relating to the non-compete agreement, yet are silent as to personal
goodwill. An express reference to a payment made for the goodwill
of the business in the governing documents, in conjunction with a complete lack of evidence
that personal goodwill was contemplated by the parties during relevant
negotiations, led to the appeals court’s agreement with the lower court’s
ruling.
Conclusion
Intangible assets, especially goodwill, are important business components
and must be completely accounted for during the sale of a business. Payments
received under a non-compete agreement will generally be viewed as ordinary
income, unless compelling proof can show otherwise.
This newsletter is provided by
Somerset for our clients and other interested persons upon request.
Since technical information is presented in generalized fashion, no
final conclusion on these topics should be made without further review.
For additional information on the issues discussed, please contact
Steve Riddle,
Tom
Thieme,
Rex Collins,
Ken
Stalcup or
Doug
Ayres
of our
Litigation, Valuation & Forensic Team.
This document is not intended or written to be used, and cannot be used,
for the purpose of avoiding tax penalties that may be imposed on the
taxpayer.
Somerset CPAs,
P.C.
3925 River Crossing Parkway, Third Floor
Indianapolis, Indiana 46240
317.472.2200 • 800.469.7206 • FAX 317.208.1200
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