Tax Treatment of a Covenant Not to Compete

A covenant not to compete is a formal agreement established during the sale of a business. In this arrangement, the seller receives compensation in exchange for a promise not to engage in competitive business activities against the new owner. This restriction is defined by a specific time frame and a limited geographic area. The tax consequences of these payments are an important consideration for both the buyer and the seller, as the treatment differs substantially for each party and influences negotiations.

Tax Treatment for the Payer

When a buyer acquires a business, any amount paid for a covenant not to compete is considered the purchase of a specific type of intangible asset. For tax purposes, this asset falls under the category of “Section 197 intangibles.” This classification is important because it dictates how the buyer can recover the cost of the payment over time.

The primary tax mechanism for the payer is amortization. The cost allocated to the covenant must be amortized on a straight-line basis over a period of 15 years. This requirement holds true regardless of the actual duration of the non-compete agreement itself. The fixed 15-year schedule is a mandate under Section 197 of the Internal Revenue Code and does not change even if the covenant is for a much shorter period.

To illustrate, if a buyer pays $150,000 for a covenant that restricts the seller from competing for five years, the tax deduction is not spread over that five-year term. Instead, the buyer must take an annual amortization deduction of $10,000 ($150,000 divided by 15 years) for 15 consecutive years. This extended amortization period can be a point of negotiation, as the buyer’s tax benefit is realized more slowly than the actual term of the competitive restriction.

Tax Treatment for the Recipient

For the seller who receives payment for a covenant not to compete, the tax implications are distinctly different and generally less favorable than other allocations in a business sale. The funds received are treated as ordinary income, not as a capital gain. This distinction is important because ordinary income is taxed at higher rates than long-term capital gains. The IRS views these payments as compensation for the seller’s agreement to refrain from performing services, which is why it falls into the ordinary income category.

This tax treatment creates a conflict during sale negotiations. While the buyer benefits from allocating a portion of the purchase price to the covenant to create an amortizable asset, the seller has an incentive to minimize this allocation. The seller’s preference is to attribute more of the sale price to goodwill, another intangible asset. The sale of goodwill qualifies for capital gains treatment, which results in a lower tax liability for the seller.

The difference in tax rates between ordinary income and capital gains can be substantial, directly impacting the net proceeds the seller retains from the transaction. For example, the highest federal tax rate on ordinary income is significantly greater than the top rate for long-term capital gains. This disparity means that for every dollar allocated to the covenant instead of goodwill, the seller pays more in taxes.

Purchase Price Allocation and Reporting

When a business is sold through an asset acquisition, the buyer and seller are required to formally agree on how the total purchase price is divided among the various assets being transferred. This process, known as purchase price allocation, covers everything from tangible assets like equipment and inventory to intangible assets such as the covenant not to compete and goodwill. This allocation must be reported to the Internal Revenue Service.

The document for this reporting is IRS Form 8594, Asset Acquisition Statement. Both the buyer and the seller must file this form with their respective federal income tax returns for the year in which the sale occurred. A requirement is consistency; the allocations reported by both parties on their individual Form 8594 must be identical. Any discrepancy between the buyer’s and seller’s reported allocations can trigger scrutiny from the IRS.

Form 8594 requires the parties to break down the total purchase price into different asset classes, which are organized in a specific hierarchy. These classes range from cash and cash equivalents (Class I) to tangible assets and, finally, to intangible assets like goodwill and the covenant (Class VII). The form ensures that the allocation is systematic and transparent, providing the IRS with a clear picture of how the values were assigned.

Covenants in an Employment Context

The tax treatment of a covenant not to compete changes when it arises in an employment context, separate from the sale of a business. When an employer pays a current or former employee for a non-compete agreement, the rules governing the transaction are different for both the payer and the recipient.

For the employer making the payment, the amount paid for the covenant is considered a form of compensation. It is deductible as an ordinary and necessary business expense. Unlike the 15-year amortization rule for business acquisitions, these payments can be deducted in the year they are paid or accrued, depending on the employer’s accounting method. This allows for a more immediate tax benefit.

From the employee’s perspective, the payments received for the non-compete agreement are treated as wages. This means the income is subject to standard federal and state income tax withholding. These payments are also subject to payroll taxes, which include Social Security and Medicare taxes (FICA).