Don’t Forget Taxes When Negotiating Non-Competes
Get Know How
Stay up-to-date with industry knowledge!
January 27, 2023
Exception to FTC Proposal
Although the Federal Trade Commission (FTC) has proposed a ban on non-compete agreements, the proposal contains an exception in certain business acquisitions where the seller enters into a non-compete agreement as part of the business being sold to the buyer. Even if the FTC’s proposal becomes law, non-competes in business acquisitions will remain popular but will have varying tax consequences.
Tax Treatment of Non-Compete Agreements
Sellers, as compared to buyers, usually have more sensitivity to how non-compete agreements are treated for tax purposes. In general, in a business acquisition, a seller will be taxed at ordinary income tax rates to the extent of the purchase price allocated to a non-compete agreement or provision. Because ordinary income tax rates are almost double long-term capital gain tax rates, sellers often want to minimize this treatment. However, there are times when it may be advantageous for a seller to have some of the purchase price allocated to a non-compete. This primarily occurs to mitigate the dreaded two layers of taxation that sellers incur when selling business assets that operate in the form of a C corporation (or an S corporation subject to built-in gains taxation). If the facts do not support the allocation, however, the IRS may attack this strategy.
For nontax reasons, buyers normally want some of the purchase price allocated to a non-compete to help bolster the non-compete agreement’s enforceability. For tax purposes, a buyer’s views about how much should be allocated to the non-compete varies. Buyers are able to amortize the portion of the purchase price allocated to a non-compete agreement over 15 years. In transactions where a significant portion of the purchase price is allocated to goodwill of the business (which is also amortizable over 15 years), the buyer may be indifferent to how much of the purchase price is allocated to the non-compete. In other scenarios, though, the buyer may wish to have a lesser amount allocated to the non-compete as compared to other assets, which may or may not be aligned with the seller’s goals.
Factors for Consideration
Involving tax advisors early on in a transaction, such as in the letter-of-intent stage, goes a long way in planning for the tax impact of the non-compete to the parties. For example, tax advisors can verify whether the purchase price should be allocated to the non-compete and, if doing so would be beneficial to the seller, whether the facts support such an allocation. Some basic factors for consideration are whether the parties separately negotiated for the non-compete in the business acquisition and whether the non-compete is economically realistic and has independent value apart from the business equity or assets being acquired. Facts and circumstances that drive whether the purchase price must be allocated to a non-compete or whether the facts support doing so include the following: (i) if the business being acquired is a service business and (ii) if the seller has special knowledge of or close relationships with suppliers or customers such that there is a real risk the seller could compete with the business following the sale.
Regardless of the parties’ views on whether and how much of the purchase price should be allocated to a non-compete provision, the parties and their advisors should adopt a reasonable approach. Even if it would be most beneficial for the seller to have nothing allocated to a non-compete provision and the buyer agrees to this approach, the underlying facts may not support it. Taking such an aggressive position would place the parties at risk if taxing authorities were to review the transaction and allocation. There is no cookie-cutter approach to handling the tax impact of non-competes, and non-competes are not going away anytime soon.
For questions about this alert, please contact the author or the Steptoe & Johnson Taxation and Nonprofit Law Team.