When a business is sold, it is not uncommon for a portion of its sale price to be attributable to a noncompete agreement between the seller and the buyer. For tax purposes, a covenant not to compete is recognized when it is severable from goodwill, the agreement is separately bargained for, and the covenant can be shown to have economic substance. When this is the case, the portion of the sale price attributable to goodwill is generally treated as a capital asset, and the payment received for the noncompete agreement is taxable as ordinary income under Revenue Ruling 69-643, 1969-2 CB 10.
In 1998, Irwin Muskat, a controlling shareholder, sold his family business, Jac Pac Foods Ltd. (Jac Pac), to Manchester Acquisition Corp. (MAC). The purchase agreement included $15 million allocated to Jac Pac’s goodwill and required Muskat to execute a mutually satisfactory noncompete agreement. The noncompete agreement was for 13 years and provided that MAC’s obligation to make the payments would survive Muskat’s death or disability. Muskat initially reported the $1 million he received for the noncompete agreement as ordinary income. But after reconsidering, he claimed that the payment was for his “personal” goodwill. He subsequently filed a $203,434 refund claim, which the IRS contested.
The U.S. District Court for New Hampshire rejected Muskat’s argument that the $1 million was a sale of his personal goodwill. The court opined that negotiations with MAC didn’t include any discussion of Muskat’s personal goodwill and the consideration paid under the noncompete agreement was bargained for as a covenant not to compete. The court reasoned that Muskat failed to show by “strong proof” that, despite the express terms of the agreement, he and MAC had intended the $1 million payment to be made for his personal goodwill and not for the promises he made in his sale agreement.
The First Circuit upheld the district court’s decision, rejecting all of Muskat’s arguments. It concluded that the use by the district court of the “strong proof” rule, which had not been superseded by case law or statute, was appropriate and required Muskat to show by strong proof that the contracting parties intended the payments to compensate for something different than what was indicated at the time the agreement was written. Because the parties to the transaction had executed a written instrument expressly allocating money for a noncompete agreement, the strong-proof rule applied to this situation.
The court also rejected Muskat’s assertion that the contracting parties intended the payments described in the noncompete agreement to serve as de facto compensation for Muskat’s personal goodwill. It was extremely unlikely, the court declared, that the survivability provision and overly lucrative terms for a man of his advanced age indicated that the payments were for something other than refraining from competition. The court further expressed that proving a written allocation lacks a semblance of economic reality doesn’t in and of itself constitute strong proof that the contracting parties intended some other allocation to be implied.
It should also be noted that for noncompete agreements entered into after Dec. 31, 2004, IRC § 409A rules apply to amounts paid unless they are subject to certain grandfather and transition rules. As clarified in the preamble to Treas. Reg. § 1.409A-1(d), payments for these types of agreements are to be treated as deferred compensation because they are a legally binding right obtained in one year for a payment in a later year. In the case at hand, Muskat’s noncompete agreement was entered into in 1998 and lasted for 13 years. Thus, it would not be subject to section 409A unless the agreement was materially modified in 2004 or later years.
Irwin Muskat v. U.S. , No. 08-1513 (1st Cir. 1/29/09)
By Steven C. Thompson, CPA, Ph.D., Texas State University, San Marcos, Texas.