Ways to reduce taxes when selling a business: covenant not to compete.

A non-compete clause, or a covenant not to compete (CNC), is commonly used in sales of businesses in order to protect the Buyer from having the Seller directly or indirectly compete with the business just recently sold within an agreed upon geographic area and for a limited time frame, typically for three to five years.

One of the tax implications of allocating a portion of the purchase price to the CNC is that any amount the parties allocate to the CNC is taxed as ordinary income.

Even in a relatively small transaction applying ordinary income tax rates to a portion of the purchase price will significantly lower the after tax amount the Seller will keep from the sale price.

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One way to reduce the tax liability when the parties include a CNC agreement is have the Seller sign a non compete agreement that does not allocate any portion of the sale price to the CNC, side by side with a general liquidated damages clause that will impose an agreed upon amount of liquidated damages in the event of breach of contract.

According to the IRS instructions, the ordinary tax rates apply only to the portion of the sale that was allocated to the CNC, but if the parties agree to substitute the allocation with a penalty clause, there is no allocation, and there was no consideration paid to the owner not to compete, in that case the ordinary income tax rates would not apply.

Let’s look at the following example, a $3 million transaction in which the Buyer requires the Seller to sign a noncompete for an amount of $500,000.

Assuming a combined federal and state ordinary income tax rates of 45%, if the parties allocate the amount of $500,000 to the CNC we are looking at a tax bill on the CNC portion of the deal of between $225,000.

On the other hand if the same portion of the purchase price, $500,000 was not allocated to the CNC, and the parties would agree to include a penalty clause instead, the $500,000 could be considered part of the goodwill of the business the tax liability would be significantly lower and be taxed at a combined federal and state rate of approx 25%-$125,000, a tax savings of $100,000.