Stock Redemptions with Non Compete Agreements Do Have Tax Implications

Summer 2007

The U.S. Tax Court recently decided a case that reiterates the need for the careful planning of transactions that involve the redemption of stock when an agreement not to compete is included as part of the transaction.

The case, which involved a successful family business, resulted from disputes over the management and control of the company, the termination of a family member’s employment, and the redemption of that individual’s stock in the company. The redemption agreement stated that the shareholder would sell the entire common stock interest in the company for a set price, with interest at the rate of 10 percent per annum on the unpaid balance. The agreement also included a provision that the seller agreed to a three-year covenant not to compete. There was significant specificity concerning what the seller could and could not do in connection with the non-compete agreement.

Several months after the redemption, the former shareholder’s accountant informed the shareholder that a tax benefit had been missed by the company by not allocating a portion of the sale consideration to the covenant not to compete. The accountant suggested that there might be additional consideration paid to the former shareholder if an agreement could be reached with the company to allocate a portion of the purchase price to the covenant not to compete. The former shareholder and the accountant met with the company to discuss redrafting the agreement, but no agreement was reached.

On the former shareholder’s personal tax return, the transaction was reported as a capital gain transaction. On the corporate income tax return prepared for the family business, the corporation claimed an amortization deduction based on an allocation of part of the consideration to the covenant not to compete. The IRS reviewed this transaction and challenged the inconsistent positions reflected in the individual and corporate tax returns.

The case eventually made its way to the Tax Court. After a thorough review of the facts and many arguments, the Tax Court sided with the former shareholder, concluding that an allocation of the purchase price to the covenant not to compete was not appropriate in this instance. The Tax Court, therefore, disallowed the corporation’s amortization deduction. Thus, the individual’s treatment of reporting all of the income from the transaction as capital gain is appropriate.

The Tax Court made the following points with its decision:

• The transaction involved two basic components—a stock sale and a covenant not to compete.
• There were no discussions about allocation of the price to the covenant prior to, or at the time, the agreement was signed.
• The agreement did not allocate any portion of the price to the covenant.
• After the agreement was signed, one party made a unilateral allocation of the purchase price to the covenant.

The Tax Court held that there was no mutual intent to allocate a portion of the consideration to the covenant not to compete.

This case clearly identifies the significant planning opportunity available in stock transactions that involve non-compete agreements. If treated as a pure stock transaction, the seller will recognize capital gain and the buyer will get no amortization deduction. If, however, there is an allocation to the covenant not to compete, the seller will recognize ordinary income while the buying corporation will get an amortization deduction in connection with the allocated amount.

With a significant difference in capital gains and ordinary tax rates, considering the tax implications of a stock sale with a covenant is wholly appropriate. The seller might be well to receive ordinary income treatment by agreeing to the recognition of the allocation to a covenant not to compete if the seller receives a higher overall consideration from the buyer.

In the end, the selling price is the most important factor in this kind of transaction. However, do not overlook the planning opportunities that may exist in the appropriate allocation of a purchase price to the stock being redeemed and a covenant if an agreement not to compete is being considered. As this case points out, failure to consider this allocation could be a significant tax detriment to the buyer in a redemption transaction.

For more detail on this case, see Becker, TC Memo 2006-264 and IRC Section 197.

Larry S. Blair, CPA, JD, is a partner with the law firm of Metz Lewis LLC in Pittsburgh, and is a member of the Pennsylvania CPA Journal Editorial Board. He can be reached at lblair@metzlewis.com.

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