Noncompete covenants in mergers and acquisitions

Compensation or capital gain?

Oct 26, 2017

In most acquisitions where the target employee-owner played an integral part in the operation of the acquired business, the acquirer and owner will execute a noncompete covenant in connection with the transaction. This is generally the case regardless of whether the owner has an ongoing relationship with the business. The treatment of the noncompete covenant as either a compensatory arrangement or an integral part of the acquisition of the business goodwill will significantly change the tax treatment to both the owner and acquirer.

Changes to the financial reporting of acquisitions and combinations may affect how tax practitioners treat these noncompete arrangements, with potentially significant ramifications for both owner and purchaser. This article attempts to clarify the tax rules surrounding the treatment of noncompete covenants and cautions against overreliance on financial accounting reporting in making tax determinations.

Financial accounting changes to business combinations

Since the Financial Accounting Standards Board (FASB) issuance of Statement of Financial Accounting Standards 141R (FAS 141R), Business Combinations, applicable to business acquisitions occurring in fiscal years beginning on or after Dec. 15, 2008, as codified in FASB Accounting Standards Codification Topic 805, additional emphasis has been placed on the identification of intangibles separable from goodwill. As a result, significant fair value is often allocated to noncompete covenants. However, FAS 141R appraisals do not determine whether the intent of a noncompete covenant was compensatory or to protect the value of the acquired business goodwill. In fact, it may be fair to say that FAS 141R supports a conclusion that the covenant is part and parcel with the business goodwill, as FAS 141R looks to an allocation of the fair value of the business assets acquired. On the flip side, the FAS 141R valuation does appear to identify the noncompete covenant as an asset separate from goodwill.

Tax treatment of noncompete covenants: Purchaser

Placing all questions as to valuation of a noncompete covenant aside, where the purchaser enters into a compensatory noncompete covenant in connection with the acquisition of trade or business, the consideration paid creates an amortizable section 197 intangible asset (see Regs. section 1.197-2(b)(9)). This is the case whether the purchaser acquires the trade or business through a stock or via an asset acquisition (same section). As a result, the purchaser has a vested interest in a larger allocation of the consideration to the noncompete covenant in a stock acquisition, as the stock acquisition does not by itself result in a stepped-up tax basis of the target’s assets.

Contrast that treatment with a section 338(h)(10) or an asset acquisition, where an allocation to a covenant provides the same tax treatment to the purchaser as would an allocation to goodwill (i.e., 15-year amortization). On the other hand, as discussed below, a noncompete covenant entered into to effectuate a transfer of business goodwill does not necessarily create a separate section 197 intangible.

Tax treatment of noncompete covenants: Owner

Where the owner enters into a compensatory noncompete covenant, the consideration received is taxed to the owner at ordinary income rates, whether the transaction is structured as a stock or asset sale. However, where the covenant is entered into simply to effectuate the transfer of the business goodwill, the covenant does not necessarily result in ordinary income to the recipient, but rather may be considered part and parcel with the purchase of the business. In such a situation, the value attributable to the covenant may result in capital gain treatment.

Covenant: Compensatory, capital or condition of employment?

In determining whether a covenant is compensatory or capital, it is important to understand the intent of the covenant. The primary purpose of a restrictive covenant executed in connection with a mergers and acquisitions transaction is often to protect the acquirer’s investment in the business. In some situations the acquirer may wish to assign a specific value to the noncompete covenant. There are significant nontax reasons that an acquirer may want an allocation of consideration to a noncompete covenant. For example, the acquirer’s attorneys may want the agreement to recite specific consideration, outside the purchase price paid for the stock or assets, paid for a noncompete covenant under the belief that the covenant has a better chance of being enforced by a court if a dispute arises over the parties’ performance.

The body of case law addressing a noncompete covenant or similar agreement as a capital asset or, to the contrary, a contractual agreement in the nature of compensation is substantial. Normally, the execution of a covenant not to compete between an employer and an employee does not effectuate the acquisition or transfer of a capital asset to the employer corporation.[1]

Where payment is made upon execution of such an agreement in connection with the sale of a trade or business, the amount paid for the covenant may represent compensation income for surrendering future income.[2] However, where execution of the covenant is between an employee-owner and a purchaser and is intended primarily as a way for the purchaser of goodwill to guarantee the ability to recover the value of the goodwill acquired, execution of the covenant represents the creation of a capital asset indistinguishable from goodwill.[3]

In determining whether execution of a covenant not to compete or similar agreement represents the acquisition or transfer of a capital asset indistinguishable from goodwill, or, to the contrary a separate and distinct compensatory agreement, the courts look to the context in which the agreement was executed. In making this determination, the courts often apply an economic reality theory to covenants not to compete.[4] If the economic substance of the transaction supports a determination that execution of a covenant or similar agreement represents a surrender of future income, such determination is respected whether or not the covenant is severable from the sale of goodwill.

In Allison, despite the lack of agreement between the parties as to the value of the covenant, the court considered not whether the covenant was severable from the purchase of goodwill, but rather if the covenant comprised independent significance separate from the acquisition of goodwill. The IRS and the U.S. Tax Court (in a separate proceeding against the buyer) previously determined that the covenant represented “a surrender of [the taxpayer’s] future income rather than the sale of good will.” Based on the acquirer’s testimony, the court agreed with the tax court and the IRS by holding that the covenant was not a transfer of property; rather, the covenant held independent significance apart from the purchase of goodwill and was in fact a surrender of future income—i.e., compensation not to compete during the term of the agreement.

Under different facts, however, courts have treated the covenant as capital in nature. In Ullman, the court stated that where a “covenant is so closely related to a sale of good will that it fails to have any independent significance apart from merely assuring the effective transfer of that good will,” the covenant is not separate from the asset acquired (264 F.2d at 307–308). Similarly, “[i]f an agreement not to compete is necessary to effectuate a transfer of good will, then the payments made under it may be treated as if made for the sale of a capital asset.”[5] Citing Schultz, the court in Allison stated:

In Schultz, both the commissioner and tax court found that the covenant not to compete, although stated separately as to value, was essential to the sale of good will of the business and had no real economic value of its own. The court was unable to find that the covenant had an independent basis in fact to the extent that reasonable men, genuinely concerned with their economic future, might bargain for such an agreement.” 294 F. 2d at 55. In other words, in order for the covenant to be treated as a surrender of future income, it must appear that the potential competition of the seller would pose a substantial economic threat to the buyer such that the covenant was not appended as a mere tax gimmick. [emphasis added]

In Schilbach, T.C. Memo. 1991-556, addressing a transfer of personal goodwill, the court also looked to the intent of the agreement. In that case, the taxpayer lost his malpractice insurance, was physically and emotionally exhausted, and intended to leave his practice and enter a new field of medical practice. Upon the sale of his business, the taxpayer signed a covenant not to compete; however, due to the taxpayer’s intentions and his physical and emotional condition, it was clear that even without the covenant, the taxpayer never intended to and was unable to compete with the buyer. Therefore, the covenant was not intended to compensate the seller for the surrendering of future income. Accordingly, the tax court held that the medical practice had goodwill equal to the value established by the taxpayer as of the date of liquidation.

Execution of covenant as condition of employment

Where the owner-employee enters into a noncompete covenant and continues to provide services to the business, the question also arises whether the covenant represents compensation for surrendering future income or simply a condition of future employment. In general, to the extent that an employee is reasonably compensated for future services, execution of the covenant is not a compensatory event, but rather a condition of employment.

As with the case law discussed above, the regulations consider the economic substance and facts and circumstances surrounding execution of the covenant or similar agreement. Regs. section 1.197-2(b)(9) provides that a covenant not to compete does not create an intangible asset if the covenant is entered into in an arrangement requiring the performance of services, and the amount paid for the services represents reasonable compensation. Similarly, Regs. section 1.263(a)-4(d)(6)(i)(C) states that the execution of a covenant not to compete or similar agreement requiring performance of services does not create an intangible asset to the extent payment for services represents reasonable compensation for the services actually rendered under the agreement. In determining whether compensation for personal services is reasonable, Regs. section 1.162-7 applies a facts-and-circumstances test to the compensation paid.

Applying the authority to covenants in practice

It would help to take a closer look at the tax treatment of a noncompete covenant entered into by the selling owner/employee in a stock purchase and a stock purchase with a joint section 338(h)(10) election.

Example 1: Purchaser P acquires all the stock of target T from individual J for $200 million in cash. T has approximately $20 million of liabilities and assets with a fair market value of approximately $220 million. J is the sole shareholder of T and is a key member of management. As a part of the agreement, J and P execute a five-year noncompete agreement. J will continue as an employee of T following the acquisition under an employment contract that reasonably compensates J. The purchase agreement does not include an agreement as to the value or allocation of the consideration allocated to the noncompete agreement. The appraisal, for FAS 141R purposes, places a $15 million fair value on the noncompete covenant and a $150 million fair value on the business goodwill.

Example 2: The facts are the same as in Example 1, except that T is a subchapter S corporation and P and J agree to a section 338(h)(10) election, which will treat the transaction as a purchase and sale of assets. The purchase agreement states that the parties will agree on a purchase price allocation that is to be prepared by T and reviewed by P. Shortly after the transaction closes, a tax practitioner is asked how to treat the covenant and the corresponding $15 million value ascribed by the appraisal for income tax purposes. Is the entire $15 million fair value taxable to J as compensation? Before concluding that J has $15 million of ordinary income, the practitioner should review the applicable case law that may tell him or her otherwise.

The examples above do not provide enough information to provide a definitive answer. J will continue serving as a key member of management post transaction. This factor cuts both ways, since restricting J from starting up a competing business is a factor that could lead to a determination that the covenant is paid for the surrendering of future income. However, J will continue as a reasonably compensated employee with an employment contract, which could be a favorable factor in concluding that the noncompete covenant lacked economic significance and was necessary to effectuate the purchase of the business goodwill. In addition, goodwill is the primary asset acquired in the transaction, which is a factor supporting treatment of the noncompete covenant as indistinguishable from the acquired goodwill. Understanding the intent and substance of the noncompete covenant is a key aspect that must be understood prior to concluding on the treatment.

How does the value placed on the covenant by the FAS 141R appraisal alter the analysis? In the examples above, the appraisal placed a value on the noncompete covenant of $15 million. Assuming a practitioner was able to conclude that the noncompete covenant was wholly capital in nature or that the compensation related to the covenant was far less than $15 million, how would he or she deal with the fact that there is an appraisal placing a $15 million value on the covenant? Assuming that the first chance to advise on the transaction is after the closing, there are at least two arguments for dealing with the appraised value. First, as addressed in Barran (above), an allocation of value to a noncompete covenant is not controlling where the covenant was necessary to effectuate the transfer of goodwill and lacked significance apart from the acquired goodwill (334 F.2d at 61). As a result, the practitioner may argue that the covenant, without challenging the use of a FAS 141R appraisal, is part and parcel with the acquired goodwill and that the $15 million is additional goodwill from a tax perspective in Example 2 (or additional purchase price for the stock under Example 1).

Second, there is merit in the argument that a FAS 141R appraisal is not a complete analysis of the underlying intent of the agreement and therefore is not determinative for tax purposes. This is somewhat restating the first argument, in that the appraisal is not performed to and does not identify the intent of the covenant as effectuating the transfer of business goodwill or as a surrender of future income. As such, the appraisal does not attempt to identify a compensatory value for the surrender of future income or a value attributable to a covenant that was necessary to effectuate the transfer of goodwill.

Pre-transaction planning for a noncompete covenant

When provided with the opportunity to advise on a covenant issue, there are a number of opportunities to strengthen the owner-employee’s positions that the FAS 141R valuation is not determinative and that the covenant is coterminous with the acquired goodwill, and not compensatory.

1.   The purchase agreement recitals and definitions could be written so as to clarify that the intent of the noncompete covenant is not compensatory in nature but rather to protect the buyer’s significant investment in the acquired business goodwill.

2.   Include language in the purchase agreement that no separate consideration is being paid for the covenant, but rather that the consideration for the noncompete covenant is the overall purchase consideration paid for the business. This further supports the intent that the noncompete covenant is not a separately bargained-for compensatory arrangement, but rather is inseparable from the purchased goodwill.

3.   Agree in the purchase agreement as to a specific value attributable to a compensatory noncompete covenant. While not binding upon the IRS, an agreement by the parties to the transaction as to the consideration being paid for the covenant should be helpful in defending the treatment of the remaining consideration as attributable to the business goodwill.

4.   Separately document the position and authority prior to receipt of the FAS 141R appraisal or IRS challenge. As with so many tax issues, documentation of a taxpayer’s position is very helpful in supporting the desired tax treatment. If the selling shareholder is able to demonstrate that, prior to the receipt of a FAS 141R appraisal, he or she had considered the intent of the covenant (e.g., necessary to effectuate the transfer of goodwill), the likelihood of a FAS 141R appraisal placing a significant value of the covenant, and the reasons why the appraisal does not correspond to the value of a compensatory noncompete arrangement, the likelihood of successfully defending the position will be significantly higher.

A practitioner who is advising a purchaser looking for amortizable purchase price in a stock acquisition, such as in Example 1, has entirely different goals. He or she would gather information supporting the independent significance of the covenant and the intent of the covenant as compensatory to the employee-owner for the surrender of future income.


Taxpayers and advisers alike should pay close attention to, and document the intent of, a noncompete covenant at the time it is being negotiated. Further, it is important to understand the intended uses and methodologies of valuations and appraisals prepared for financial statement purposes before relying upon them for federal tax purposes. This is not to say that such an appraisal does not reflect the value of a particular asset, but rather that the intent and substance of the arrangement should control the tax treatment.

This article originally appeared in the April 2011 issue of The Tax Adviser, reviewed and republished October 2017. 

[1] Hamlin’s Trust, 209 F.2d 761 (10th Cir. 1954); see also Ullman, 264 F.2d 305 (2d Cir. 1959); Barran, 334 F.2d 58 (5th Cir. 1964).

[2] Proulx, 594 F.2d 832 (Ct. Cl. 1979); Gazette Telegraph Co., 209 F.2d 926 (10th Cir. 1954), aff’g 19 T.C. 692 (1953); Estate of Beals, 82 F.2d 268 (2d Cir. 1936), aff’g 31 B.T.A. 966 (1934)).

[3] Michaels, 12 T.C. 17 (1949); Toledo Newspaper Co., 2 T.C. 794 (1943), acq. 1944 C.B. 28.

[4] See Allison, No. 9633 (E.D. Cal. 1970); Schultz, 294 F.2d 52 (9th Cir. 1961).

[5] Barran, 334 F.2d at 61

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  • Nick Gruidl

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