Tax Treatment of Intangible Assets
The transfer of intangible assets -- generally goodwill and a covenant on the part of the seller not to compete -- are commonly part of the sale of a business. However, the income-tax treatment of these intangibles can differ significantly. There needs to be a clear definition of what is being bargained for when parties engage in the sale of a business.
Covenant Not To Compete
When a business is sold, a payment made by the buyer to the seller under a covenant not to compete is generally taxable to the seller as ordinary income (Rev. Rul. 69-643, 1969-2 CB 10). The buyer may be able to amortize the amount paid for a covenant not to compete over 15 years where the rules for Internal Revenue Code Section 197 intangibles apply. Otherwise, they are amortizable over the period the covenant runs.
Goodwill, on the other hand, is a capital asset. It is the expectation that customers will continue to patronize a specific place of business based on a preexisting business relationship. Therefore, goodwill cannot exist as a separate entity. It must be sold with a going concern or business having a locality or name and cannot be sold independently. Goodwill generally attaches to the business as an entity, the physical location of the business, its trade name, the number and quality of its customers, or specialized knowledge of its staff. For federal income-tax purposes, goodwill is considered to be a capital asset (International Multifoods Corp., 108 TC No. 25, 1997).
IRC Section 197 governs situations where the purchaser of a business makes payments both for goodwill and pursuant to a noncompete agreement. In such cases, both types of intangible assets must be ratably amortized by the buyer over a 15-year period.
In Muskat v. U.S. (CA-1, 1/29/2009), the First Circuit considered whether payments made under a noncompete agreement could properly be characterized as having been made for personal goodwill and, as a result, be taxable as capital gain, not ordinary income. The taxpayer initially characterized the noncompete payments as ordinary income but thereafter sought to recharacterize the payments as having been made for personal goodwill.
A district court rejected the taxpayer’s argument that certain features of the noncompete agreement actually rendered payments made under it as payments for the sale of his personal goodwill. Instead, the court found that under the express terms of the agreement, the consideration provided by the buyer was specifically for the covenant not to compete. Also, no proof was submitted to demonstrate that personal goodwill was a consideration during the negotiations in drafting the noncompete agreement. Absent “strong proof” that the payments made under the agreement were actually intended to compensate the seller for his personal goodwill, the court held they were properly taxable as ordinary income.
On appeal, the First Circuit upheld the district court’s ruling and rationale. The appeals court reiterated the precedent that a taxpayer in this situation requires strong proof where written contracts exist that specifically allocate sums for various aspects of the transaction, including those relating to the noncompete agreement, yet are silent as to personal goodwill. An express reference to a payment made for the business’ goodwill in the governing documents, in conjunction with a complete lack of evidence that personal goodwill was contemplated by the parties during relevant negotiations, led to the appeals court’s agreement with the lower court’s ruling.
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Somerset CPAs, P.C.
3925 River Crossing Pkwy.
Indianapolis, IN 46240