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Dr. Fiona Chen
Dr. Fiona Chen, Certified Public Accountant (CPA)
Category: Tax
Satisfied Customers: 355
Experience:  Former IRS Revenue Agent
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Client sold the business and was paid for a Restrictive Covenant

Customer Question

I have a client that sold their business and as part of the agreement was paid for a Restrictive Covenant not to compete. Can an argument be made to pick the income up as ordinary income but not have it subject to self-employment tax since no work will be performed?
Submitted: 2 months ago.
Category: Tax
Expert:  Dr. Fiona Chen replied 2 months ago.

Dear Customer,

If the business is sold, it is sales proceeds. In most of the situations, if the taxpayer has held the business for more than one year, the sales proceeds should be (long-term) capital gain. If the company has many assets, then, each group of them may need to be counted separately.

See the website link for further information on sale of your business by the IRS.

https://www.irs.gov/businesses/small-businesses-self-employed/sale-of-a-business

Please feel free to follow up.

Regards,

Fiona

Fiona Chen, MPA, Ph.D., CPA, ABV, CFF, CITP

Customer: replied 2 months ago.
The contract of sale specifically allocated the sales price between fixed assets and the Restrictive Covenant not to compete. The business entity was not sold, only the fixed assets, patient lists and the Restrictive Covenant so that the Optometrist (the seller) in this case would not compete after the sale.
Expert:  Dr. Fiona Chen replied 2 months ago.

Dear Customer,

The covenant not to compete is part of the sales proceeds. It is long-term capital loss. He was not an employee of the this new buyer. Even the name is ***** ***** it is not an employment contract to reimburse previous, departing employees. There is no implied loss or compensation for labor lost or cost.

They just want him to promise he will leave his clientele to the new buyer. If he opens up another business close by, his old clients may go to him. Therefore, you can consider that is sale of goodwill, the company's client's list and reputation. "The goodwill amounts to the excess of the "purchase consideration" (the money paid to purchase the asset or business) over the total value of the assets and liabilities. It is classified as an intangible asset on the balance sheet, since it can neither be seen nor touched."

Substance over form. No matter how they called it, it is part of the sales proceeds. He is not leaving a former employer and being laid off. He is selling his business including his clientele base. This term is common in sales/purchase terms.

Regards,

Fiona

Expert:  Dr. Fiona Chen replied 2 months ago.

Dear Customer,

The articles and discussion on the subject are enclosed for your consideration. You have the first hand documents and details.

Since the sales is not finalized yet, you may want to strongly suggest your client to specify in the contract that the covenant of non-compete is to compensate for the sales proceeds of "personal goodwill".

Regards,

Fiona

https://www.aicpastore.com/Content/media/PRODUCER_CONTENT/Newsletters/Articles_2008/CPA/Oct/Selling.jsp

http://www.journalofaccountancy.com/issues/2009/may/noncompeteagreement.html

Expert:  Dr. Fiona Chen replied 2 months ago.

p.s. Correction: in the two posting before, long-term capital gain and not long-term capital loss.

Expert:  Dr. Fiona Chen replied 2 months ago.

Dear Customer,

The argument you need to make for your client is personal goodwill and not work non-performed. If it is work non-preformed, it is regular income.

Please feel free to follow up.

Regards,

Fiona

Expert:  Dr. Fiona Chen replied 2 months ago.

Dear Customer,

I wish you continued the discussion. But it probably is permissive for me to continue develop the discussion to cover the possible situation range of your client's situation.

This article below has the most complete discussion from regular income to capital gain to self employment income.

http://www.thetaxadviser.com/issues/2011/apr/clinic-story-01.html

Below is a complete IRS settlement guideline on the subject. It is a settlement guideline because the subject matter is a grey area.

https://www.irs.gov/pub/irs-utl/asg-covenants-not-to-compete.pdf

The below articles give us strong argument for personal goodwill.

http://www.thetaxadviser.com/issues/2014/may/payne-may2014.html

Below is a link of affirming tax court case on economic reality of carrying out the agreement.

https://www.irs.gov/pub/irs-utl/cov_not_to_compete_appeal_john_jorgl_v_comm.pdf

The IRS latest instruction places the Covenants not to compete entered into in connection with the acquisition of a business into Section 197 intangibles for amortization. This could be a non-earned income argument vs. self employed income (1099 misc.).

https://www.irs.gov/publications/p544/ch02.html

Section 197 Intangibles

Section 197 intangibles are certain intangible assets acquired after August 10, 1993 (after July 25, 1991, if chosen), and held in connection with the conduct of a trade or business or an activity entered into for profit whose costs are amortized over 15 years. They include the following assets.

  • Goodwill.

  • Going concern value.

  • Workforce in place.

  • Business books and records, operating systems, and other information bases.

  • Patents, copyrights, formulas, processes, designs, patterns, know how, formats, and similar items.

  • Customer-based intangibles.

  • Supplier-based intangibles.

  • Licenses, permits, and other rights granted by a governmental unit.

  • Covenants not to compete entered into in connection with the acquisition of a business.

  • Franchises, trademarks, and trade names.

See chapter 8 of Pub. 535 for a description of each intangible.

Covenant not to compete. A covenant not to compete (or similar arrangement) that is a section 197 intangible cannot be treated as disposed of or worthless before you have disposed of your entire interest in the trade or business for which the covenant was entered into. Members of the same controlled group of corporations and commonly controlled businesses are treated as a single entity in determining whether a member has disposed of its entire interest in a trade or business.

Please feel free to follow up.

Regards,

Fiona