Planning for and Documenting Covenant Not To Compete Allocation

Published Categorized as Federal Income Tax
Planning For And Documenting Covenant Not To Compete Allocation
Planning For And Documenting Covenant Not To Compete Allocation

The recent Becker v. Commissioner, 92 T.C.M. 481 (2006), case shows why it is important for taxpayers to plan and document transactions at or near the time that the transactions take place. This is particularly true for larger dollar transactions. The transaction in the Becker case involved the sale of a family-owned business and a non-compete agreement that was entered into as part of the sale.

The Facts in the Becker Case

Becker was an employee of and partial owner of a family business that is controlled by his father. Family discord resulted in Becker no longer being employed by the family business and agreeing to sell his business interest back to the business. The business was to pay Becker $24 million in exchange for his interest in the business and, as part of this agreement, Becker executed an agreement not to complete with the family business for a period of three years.

Becker’s accountant later informed Becker that he missed a tax planning opportunity by not allocating part of the $24 million dollar proceeds to the covenant not to compete. Negotiations ensued. Becker and the family business were not able to agree on an amount of the cost to allocate to the covenant not to compete. The parties reported different allocations on their tax returns.

The IRS noticed the different allocations and issued protective notices of deficiency to each party. These notices led to the dispute and the court’s decision in the Becker case.

The Tax Savings Opportunity

Had Becker allocated a portion of the monies received to the covenant not to complete, that amount would have been taxed at the ordinary tax rates (rather than the lesser capital gains tax rate), but the family business would have been able to take an amortization deduction for the portion allocated to the covenant not to compete. The family business would not have been able to deduct the cost otherwise.

These competing interests can be solved with proper tax planning, as adjustments can be made to the purchase and sale values to account for the tax liabilities.

Many taxpayers fail to plan for this issue and do not include the tax liability in their valuations.
This is evidenced by the number of tax disputes involving this very issue. The U.S. tax court’s opinion in Becker describes a number of these prior court cases. The court cases focus on the intent of the parties and the underlying documentation.

Based on this prior case law, the court in Becker held that no portion of the funds received by Becker was allocable to the covenant not to compete. Becker lost. His loss was primarily due to the lack of contemporaneous documentation supporting his position.

The Take Away: Timely Tax Planning and Documentation is Key

Transactions like this one should be documented at the time the deal is done. Identifying the issue after the fact will almost certainly result in a tax dispute with the IRS and, ultimately, result in the U.S. Treasury collecting more tax than it otherwise would.

It should be noted that this same type of situation often comes up in the context of divorcing spouses and divorce settlements, employees and employee benefits, and even companies and personal injury settlements.

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