According to Section 197 of the Internal Revenue Code, the cost of acquiring an intangible business asset must be amortized over a 15-year period. This tax rule generally applies to a covenant not to compete.
One case: An individual owned 23 percent of a Massachusetts business that provided consulting and management services to insolvent companies. He informed the president that he wished to leave the company and have his shares bought out. He agreed to a $400,000 payment for a covenant not to compete as part of an $805,000 buy-out of his share. This agreement covered a period of twelve months spanning two calendar years. The company’s accountant calculated and allocated the $400,000 payment for the covenant over the two-year period.
According to the Tax Court, the non-competition payment prohibited him from engaging in competitive activities for a one-year period and was comparable to his annual earnings.
Although the company argued the 23 percent interest was not substantial and was outside the reach of Section 197, the Court held that it was. Judges ruled that the covenant arose out of the acquisition of a business interest. Therefore, the 15-year write-off period under Section 197 applies, even though payments were made over just two years (Recovery Group, Inc., TC Memo 2010-76).
Also Used in Business Sales
Non-compete clauses are also likely to be used in contracts when a business is sold. Basically, they prohibit the seller from starting a competing business, since it would take customers or clients away from the one being sold.
The terms vary but typically describe the time period, the types of businesses that are involved, and the geographic area. As with covenants signed by employees, these agreements should not be overly restrictive. For example, you should not restrict a seller from starting any type of business for the next 25 years since courts would look at the agreement as harming the individual’s ability to earn a living.