Because of these different tax treatments, sellers and buyers have opposing interests in negotiating the sale. For the buyer to prevail, a reasonable amount of the purchase price must be allocated to the obligation not to compete, and the agreement must be reasonable in all its aspects. If an excessive amount is allocated or if the covenant is poorly formulated, this part of the purchase price will be allocated to goodwill. If the owner enters into a compensatory non-compete agreement, the consideration received will be taxed on the owner at normal income rates, regardless of whether the transaction is structured as a sale of shares or assets. However, if the agreement is entered into solely to carry out the transfer of customers, the agreement does not necessarily result in normal income for the beneficiary, but can rather be considered part of the purchase of the company. In such a situation, the value attributable to the restrictive covenant may give rise to a capital gains treatment. The rules on the tax treatment of non-compete obligations are simple as long as the parties understand the tax treatment of these agreements and goodwill. Goodwill is considered a capital asset and the seller has the right to process the amount allocated to goodwill at favorable capital gains rates. Unfortunately, the buyer is denied any tax deduction, as goodwill is assumed to have an indefinite useful life. For most acquisitions where the target employee owner has played a significant role in the operation of the acquired business, the acquirer and owner will enter into a non-compete agreement as part of the transaction. This is usually the case whether or not the owner has an ongoing relationship with the business.
The treatment of the non-compete obligation, either as a netting agreement or as an integral part of the acquisition of goodwill, will significantly alter the tax treatment for both the owner and the acquirer. In determining whether the conclusion of a non-compete agreement or similar agreement constitutes the acquisition or transfer of fixed assets indistinguishable from goodwill or, on the contrary, a separate and distinct remuneration agreement, the courts take into account the context in which the agreement was signed. In making this decision, courts often apply a theory of economic reality to non-compete agreements (see Allison, no. 9633 (E.D. Cal., 1970); Schultz, 294 F.2d 52 (9. Cir. 1961)). If the economic content of the transaction leads to the conclusion that the performance of a contract or similar agreement constitutes a passing-on of future income, this provision will be respected whether or not the agreement is separable from the sale of goodwill. In Norwalk, T.C. Note. In 1998-279, the court found that goodwill was not an asset held by the company because there were no non-compete agreements with shareholders and employees. Therefore, goodwill (in the form of customer relationships) was tied individually to employees and it was not an asset owned by the company.
This represents a potential planning opportunity for sellers who can document the presence of goodwill (e.g.B valuable personal relationships with customers) that belongs to the seller personally and not to the company. In such cases, double taxation can be avoided if part of the total proceeds of sales paid to the seller can be allocated to the seller`s personal goodwill. Assuming the seller has no basis in the self-created goodwill, the proceeds allocated to their goodwill are taxed once at the maximum long-term capital gains rate of 15% or 20% (depending on the seller`s taxable income). When a business is sold, it is common for the buyer to require that the seller not compete in the same area. This implies an obligation of non-competition in the purchase contract. These commitments are enforceable if they are reasonable. The courts are reluctant to deprive a person of the ability to earn a living. For example, in California, a non-compete agreement must have reasonable time and geography restrictions.
You cannot enforce an agreement that prohibits the seller from operating the same business anywhere. The exact completion limits depend on the type of business. The above examples do not provide enough information to give a definitive answer. J will continue to act as a key member of management following the transaction. This factor goes both ways, since limiting J to the creation of a competing company is a factor that could lead to the provision that the confederation is paid for the transfer of future income. However, J will continue to work as an adequately remunerated employee with an employment contract, which could be a favourable factor in concluding that the non-compete agreement had no economic significance and was necessary to carry out the purchase of goodwill. In addition, goodwill is the principal asset acquired in connection with the transaction, which is a factor that supports the treatment of the non-compete obligation as indistinguishable from acquired goodwill. Understanding the intent and content of the non-compete obligation is a key aspect that must be understood before the end of processing.
When negotiating a business sale, it is important to consider tax issues related to the “purchase price allocation” in the negotiation phase of the transaction. In addition to allocating the purchase price between personal goodwill and non-compete obligations, a well-structured allocation also includes reasonable percentages that are allocated among other components of the business such as inventory, equipment and other tangible personal assets of the company. The purchase price is initially allocated to material assets, with the surplus allocated to the non-compete obligation as goodwill. Aside from some specific assets that are taxed as higher capital gains rates, the sale of most assets is taxed at capital gains rates of fifteen or twenty percent, depending on your tax bracket. Income from the consulting contract is taxed at normal income rates, which can be up to thirty-seven percent (37%). Often, the IRS treats payments under a non-compete agreement signed at the time of conclusion as disguised consulting payments that are taxed as ordinary income. The business owner had worked with a business broker to sell her business. Lawyers were involved very late in the transaction.
So far, for whatever reason, little attention has been paid to the distribution of the purchase price of the transaction, including goodwill and a non-compete obligation. This calculation is extremely important because it determines how the funds are taxed. Some companies do not calculate the purchase price allocation until the end of the sale. This can be a costly mistake. Instead, the seller should start developing a purchase price allocation immediately after receiving an offer of intent to purchase. Buyers and sellers have competing goals in the field of alliances, not to compete. Anyone buying or selling a business should talk to a competent consultant who is familiar with this area before signing the contract. It should be noted that non-compete obligations may also conflict with ineligible deferred compensation plans.
This problem is terribly complex, but the penalties for doing it wrong are heavy. If a non-compete obligation related to a deferred indemnification agreement is found to violate Section 409A of the IRC, the penalty is a 20% surcharge plus a significant interest penalty. The IRS`s position is that severance pay that depends on a non-compete obligation may violate Section 409A if there is a theoretical possibility that the employee could influence the year in which the payment is made. .