Non-Compete Agreements: Tax Treatments

Before, during and after any business acquisition, there are many variables to consider, one of which is the tax implication of the sale from both the buyer’s and seller’s perspective. In this case, we are talking about the treatment of intangible assets.

In a recent U.S. Tax Court case, the owners of a company amortized a non-compete over a twenty four month period, whereas under Section 197 of the tax code, relating to the amortization of certain intangible assets, the tax code states that a non-compete should be amortized over a period of fifteen years when it is “in connection with the acquisition of an interest in a trade or business or substantial portion thereof.” In this case, however, the owners justified their accelerated deductions, because they did not believe that the non-compete was entered into under the above condition.

The U.S. Tax Court, however, ruled against the Company and in favor of the IRS. In so doing, they disallowed deductions made by the owners of the Company nearly ten years earlier.

The situation:

The Company in question was Recovery Group, a turn-around, crisis-management business. In 2002, one of Recovery Group’s founders, who was also a 23% shareholder, informed his president, that he wished to leave the Company and to have his shares bought out. The agreement between him and Recovery Group called for the Company to pay him a total of $805,363.33, in payment of which the Company gave him a $205,363.33 check and a $600,000 promissory note payable over three years, of which $400,000 was payment for a “noncompetition and nonsolicitation agreement” that prohibited him from engaging in competitive activities for one year post closing.

The Tax Court arguments from both the Company and the IRS came down to semantics of the Section 197 code and what the word “thereof” in the above sentence referred to. RGI’s contention was that the rule must be related to a 100% interest transfer, or a substantial portion of an interest. The IRS, however, maintained that the word thereof modified the words trade or business and that in fact a non-compete gets 15-year amortization if it is through the acquisition of any interest.

While it is possible to see a justification from both sides, the Memorandum of facts and findings from the case highlights that as a general rule, the “IRS’s determinations are presumed correct, and the taxpayer has the burden of establishing that the determinations in the notice of deficiency are erroneous. Similarly, the taxpayer bears the burden of proving he is entitled to any disallowed deductions that would reduce his deficiency.” Unfortunately for Recovery in this case, they were unable to do so and had to make the adjustments many years after the disputed deduction.

And if you thought this had made the tax rules clear, that’s not exactly the case. There is more confusion when it comes to a asset sale, rather than a stock sale. When a non-compete is entered into related to a stock acquisition, it constitutes an amortizable intangible under Section 197. However, when it relates to an asset sale, you need to consult a tax expert to determine the appropriate tax treatment and whether the transfer is substantial and as a result could be subject to accelerated deductions.

The case history can be read by clicking here

Additional Source: Article written June 1, 2010 by written by Robert Willens, founder and principal of Robert Willens LLC.