Deductibility of Covenants Paid Not to Compete

In a recent ruling, Recovery Group, Inc. v. Commissioner, (TC Memo 2010-76), the tax court answered a common question about the sale of a partnership or corporation interest that involved a covenant not to compete. A common scenario for transferring an owner’s interest when the owner leaves a company is that the remaining owners purchase that interest. A purchase price allocation is made between the value of the partnership or stock interest, goodwill, and a covenant not to compete.

The values assigned to each component are more important than you might think. The value assigned to purchase the partnership interest is usually stepped up and the assets within the partnership receive new values. In order to properly accomplish this, tax elections must be filed. This usually leads to tax deductible assets for the remaining partners in the form of inventory or fixed assets. If a stock interest is purchased, then the value is not currently deductible, similar to buying stock shares in Walmart, until the stock interest is later sold. If goodwill is purchased, the goodwill asset is amortized over 15 years.

This leaves the question about value assigned to the non-compete agreement, as well as when and how much is deductible. In the case examined by the tax court, $400,000 of the purchase price was assigned to the covenant not to compete and was deducted over the term of the agreement, the following twelve months. The purchase terms of the departing owner’s interest consisted of a down payment of $200,000 and a note for $600,000 over three years. The tax court disagreed with the twelve month deduction and ruled that the non-compete was akin to goodwill, i.e. an intangible asset, and should be amortized over 15 years -- the amortization life of that asset group.

In reviewing this case, it should be noted that the term of the non compete, one year, and the payment period of the non compete, three years, did not govern the deductibility term. In reviewing the tax side of a proposed purchase transaction, covenants not to compete will be treated like goodwill for deductibility purposes.

If you have questions or comments, please let Pancho or Kelly know call them at 501.753.9700.