Amortization of Covenants Not to Compete

In today’s ever changing corporate climate, there may be instances where it is appropriate for a company to enter into a covenant not to compete with employees / partners / founders / etc. who wish to leave the company. One of the biggest components of covenants not to compete is the duration of the covenant. Regardless of whether a covenant not to compete is entered into in connection with the acquisition of a corporation or partnership through direct purchase of the assets or indirectly through the purchase of stock or partnership interests, the covenant is considered an Internal Revenue Section 197 intangible and must be amortized over 15 years.

Internal Revenue Code Section 197 allows taxpayers to amortize certain intangible assets over a 15 year period on a straight line basis beginning with the month the intangible asset was acquired. Use of the 15 year period is mandatory for Section 197 intangibles. A period based on the actual useful life of the asset cannot be substituted for the 15 year period. The tax amortization treatment of covenants not to compete are defined within the Internal Revenue Code, which states that any covenant not to compete entered into in connection with an acquisition (directly or indirectly) of an interest in a trade or business, or substantial portion thereof, is a Section 197 asset. If taxpayers were allowed to deduct covenants not to compete over their typically short lives, Congress believed this would provide too much incentive for taxpayers to understate the value of the stock and overstate the value of the covenant which would result in a greater tax benefit. Therefore, Congress decided to reduce this incentive for the added tax benefit by requiring the covenants to be treated as a Section 197 asset

The Internal Revenue Code states that a substantial portion of the assets must be purchased in connection with a covenant not to compete in order for the covenant to be considered a Section 197 asset. (However, in the case of Recovery Group, Inc vs. Commissioner, the Tax Court ruled that the purchase of stock in conjunction with a covenant not to compete does not have to be substantial for the covenant to be considered a Section 197 intangible.)

It is very important for the covenant not to compete agreement to be properly documented. In the case of John H. Miner vs. Commissioner, John Miner was a shareholder in an S Corporation, which paid $175,000 to a departing shareholder. An oral agreement was reached and never documented. The tax return reflected $175,000 as a covenant not to compete and amortized that amount. The United States Tax Court ruled that no part of the payment was made in connection with a covenant not to compete. The court came to this conclusion due to the fact there was no written agreement between the corporation and the departing shareholder. Since there wasn’t proper documentation of a covenant not to compete agreement, the paying corporation lost the tax benefit of being able to amortize a portion of the selling price.