Can you amortize covenant not to compete

The IRS denied the claim and Frontier sued. For the IRS. Section provides for the amortization of intangible assets over a year period. Included in the covered intangibles is a covenant not to compete that a taxpayer enters into in connection with the direct or indirect acquisition of a trade or business. Frontier argued the transaction was not covered by section because it was a stock redemption—not a purchase from an outsider—and it was not a business acquisition because the corporation engaged in the same activities after the redemption as before.

The definition of acquisition is gaining control. Treasury regulations section 1. Therefore, this transaction was an acquisition of a trade or business, and the covenant not to compete was a section asset. The amortization, thus, should be over 15 years rather than over the life of the payments. In the future, taxpayers should remember this expansive definition of acquisition of a business when agreeing to a covenant not to compete.

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In determining whether a covenant is compensatory or capital, it is important to understand the intent of the covenant. 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. 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.

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. 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. 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. Under different facts, however, courts have treated the covenant as capital in nature.

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. 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.

In Schilbach , T. 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. 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. 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. Similarly, Regs. In determining whether compensation for personal services is reasonable, Regs. 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. 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 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. The examples above do not provide enough information to provide a definitive answer.