Key Takeaways

  • Allocation of purchase price determines how a business sale price is distributed across tangible and intangible assets.
  • Noncompete covenants are often included in business sales to protect the buyer’s investment but create complex tax consequences.
  • Buyers typically prefer allocating value to assets that allow for amortization or depreciation; sellers usually seek capital gain treatment.
  • The IRS scrutinizes allocations to noncompete agreements, as they can shift tax burdens significantly.
  • Clear negotiation, proper valuation, and documentation are critical to minimize disputes and unexpected tax liabilities.

Allocation of purchase price to noncompete refers to the specific parts of a business that are included in a sale. There are many things to consider in addition to the cost of the business. Additionally, if a noncompete is required during the sale, there are added values to consider.

Purchase Price Allocation

Purchase price allocation specifically allocates and specifies the purchased parts of the business. When a business is purchased, the sale usually only includes the assets of the business. There are many factors that can affect the purchase price of a business:

  • Nontransferable items present: This includes liquor licenses or government contracts.
  • Tax implications: Competing interests in regards to tax implications can affect the price.
  • Cash and investments: In most asset sales, cash and investments stay with the seller.
  • Accounts receivable: This is income that has already been earned by the seller, but has not yet been collected.

In most business sales, the seller is looking for as many tax deductions as possible. On the other hand, the buyer is looking for a sale that includes a lot of assets with capital gains. Evaluating the purchase price allocation is an extremely complex situation and requires careful review of accounting methods and assets included in the purchase sale.

It is also important to evaluate any assets included that are eligible for depreciation. This can further affect the sale price. There are two types of elements of gain possible when dealing with depreciation:

  • Recapture of depreciation
  • Capital gain

The allocation of purchase price is one of the most important parts of the business sale transaction. Most tax professionals will utilize the following method to determine the purchase price allocation:

  • Value all assets acquired
  • Determine what amount needs to be allocated
  • Assign values to each of the seven asset categories

This calculation is extremely important because it will determine how the funds are taxed. Some businesses do not calculate the purchase price allocation until the end of the sale. This can be a costly mistake. Instead, the seller should begin drafting an allocation of purchase price right after receiving an intent to purchase offer.

IRS Asset Allocation Rules

When structuring a business sale, both buyers and sellers must follow the IRS’s purchase price allocation rules under Internal Revenue Code Section 1060. The purchase price must be divided among seven classes of assets, ranging from cash and tangible property to goodwill and other intangibles. Noncompete agreements fall into Class VII (intangible assets) along with goodwill.

Misclassification can lead to disputes with the IRS. For example, overstating goodwill versus the noncompete value may trigger audits. That’s why having a well-supported allocation agreement—often filed with IRS Form 8594—is critical.

Noncompete Covenants in Mergers and Acquisitions: Compensation or Capital Gain?

Some business sales include noncompete agreements. The noncompete agreement may also be accompanied by a nondisclosure document. Noncompetes in a business sale can be difficult to legally enforce and are a disadvantage in terms of taxes for both the buyer and the seller. If a noncompete is needed, the value and length of contract should be kept low for both parties.

A noncompete is common when the seller played an important role in the day-to-day activities of the business. There are tax implications when using a noncompete agreement. A noncompete agreement can be taxed because the seller is losing out on potential income. Additionally, the business is sometimes gaining the expertise of the seller during the transitionary period and a value needs to be assigned to this.

Some buyers will attempt to correct this problem by assigning a specific value to the noncompete document. However, this usually only helps with assigning a value during litigation and is not the accepted tax value. Since there are a lot of factors to consider when calculating the taxable amount of a noncompete agreement, it is important to work with a tax attorney that can help you organize the information.

Tax Treatment of Noncompete Agreements

From a tax perspective, payments allocated to a noncompete are usually treated as ordinary income to the seller. This can mean higher tax rates compared to capital gains. On the buyer’s side, amounts allocated to the covenant not to compete can be amortized over 15 years under IRC Section 197, creating long-term deductions.

This dynamic often leads to negotiation tension:

  • Buyers want to assign more value to the noncompete for amortization benefits.
  • Sellers want to minimize allocation to avoid ordinary income tax treatment.

Courts have ruled that the allocation must reflect economic reality. If the noncompete is essential to protecting the acquired business, assigning a significant value may be justified. If the seller has little influence over the market, a high valuation may not withstand IRS scrutiny.

Valuation Factors for Noncompete Covenants

Valuing a noncompete agreement involves analyzing several factors, including:

  • Seller’s role in the business: Greater influence increases the covenant’s value.
  • Geographic scope and duration: Broader restrictions typically justify higher valuation.
  • Industry competition: The risk of the seller re-entering the market directly impacts value.
  • Customer and employee relationships: If the seller holds strong relationships, the covenant becomes more critical.

Valuation experts may use discounted cash flow methods or market comparisons to assign a defensible value. Both parties should document these considerations carefully in case of IRS review.

Calculating Additional Tax Deductions

When a buyer purchases a business, they are responsible for paying sales tax. In most cases, the buyer simply adds the amount to the buying price. The exact amount of sales tax due will depend on the purchase price and the specific state tax laws. Sales tax on the purchase can be considered a tax deduction.

In many business sales, the seller sticks around for a period of time to help with transitioning the clients. When this occurs, the value of the seller's employment needs to be calculated. This is another tax deduction. Some businesses may choose to use the consulting setup as a form of seller financing. It is important to have a specified end date for the seller's consulting period. Some attorneys recommend a limit of one year.

Negotiation Strategies for Buyers and Sellers

Because the allocation of purchase price to noncompete agreements has opposing tax effects, negotiations can become contentious. Common strategies include:

  • Trade-offs: Buyers may agree to allocate less to the noncompete if sellers accept adjustments in goodwill or consulting fees.
  • Blended approaches: Spreading value across consulting agreements, goodwill, and noncompetes to balance tax impact.
  • Advance planning: Addressing allocation early in negotiations to avoid last-minute disputes.

Ultimately, both parties benefit from a mutually acceptable allocation that reduces IRS challenge risk while meeting each side’s financial objectives. Consulting both tax and legal advisors is essential to structure the deal properly.

Frequently Asked Questions

1. Why is the allocation of purchase price to noncompete important?

It determines how much of the sale price is taxed as capital gains versus ordinary income, affecting both buyer and seller tax obligations.

2. How does the IRS treat noncompete payments?

The seller reports them as ordinary income, while the buyer may amortize the payment over 15 years under IRC Section 197.

3. Can the buyer and seller agree on any allocation they want?

Yes, but the allocation must reflect economic reality. The IRS may challenge allocations that appear unreasonable or solely tax-motivated.

4. What factors affect the valuation of a noncompete?

Key factors include the seller’s market influence, the covenant’s duration and geographic scope, and the competitive landscape.

5. How can disputes over allocation be minimized?

By negotiating early, documenting valuation factors, and filing consistent IRS Form 8594, both parties reduce the risk of conflict and IRS scrutiny.

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