Have You Thought About a Non-Compete Agreement With Yourself?

Yes, you read that right.  A non-compete agreement with yourself.  It might sound counter intuitive, but in fact, having such an agreement can afford you a significant tax reduction if you own a business taxed as an S corporation and decide to sell it.  Here’s how it works:

In a typical business sale structured as an asset purchase, which is how the majority of sales of private entities are structured, the purchase price is composed of at least two parts. The first is the purchase price for the assets, and the other a consulting agreement under which the selling owner agrees to stay on for some length of time to guide the buyer in the business. As part and parcel of the sale of a business, the buyer will always insist on the selling shareholders to enter into a non-competition agreement so the seller cannot turn around and start a new business selling to the same customers.  Most of the time the non-competition agreement is signed at the closing of the sale of the business and goes hand-in-hand with the consulting agreement.

The purchase price is allocated first to hard assets with the excess allocated to the non-competition agreement as goodwill.  Aside from certain specific assets taxed as higher capital gains rates, the sale of most the assets is taxed at capital gain rates of fifteen or twenty percent, depending on your tax bracket.  Income received from the consulting agreement is taxed at ordinary income rates, which may be as high as thirty-seven percent (37%).  Frequently the IRS treats payments under a non-competition agreement signed at closing as disguised consulting payments, which are taxed as ordinary income.

But consider this: If a selling shareholder has already signed a non-competition agreement with the company the shareholder owns, the non-competition agreement is an asset owned by the company, which is then transferred (assigned) to the buyer at closing.  Because the non-competition agreement is now a company asset, it is taxed as the sale of a capital asset, so any monies received for it are taxed at capital gain rates.  To be effective and avoid what is known as the step-transaction doctrine (which the IRS uses to unwind and re-characterize certain transactions so it can collect more tax), the non-competition cannot be executed once a buyer is on the horizon, so proper advance planning is crucial.

Sellers who file married filing jointly with incomes between $78,751 and $488,850 are taxed at the 15% capital gains rate and will be taxed on ordinary income at 24% (on incomes from $165,001 to $315,000), 32% (on incomes from $315,001 to $400,000), or 35% (on incomes from $400,001 to $600,000).  Using this strategy, a seller who has an annual income of $450,000 will pay twenty percent less tax on the amounts allocated to the non-competition agreement.

From the buyer’s standpoint, it does not matter.  Either way, the buyer will treat the non-competition agreement as a Section 197 intangible whether the non-competition agreement is owned by the selling company and is assigned at closing, or whether the selling shareholders enter into a new non-competition agreement at closing.

Let’s look at an example.  Sellers A and B, each S-corporations, have each been in business for fifteen years.  They are both selling their businesses for a total of $2.5 million and each has $500,000 in basis in their respective businesses.  Both enter into three-year consulting agreements. Seller A has an existing non-competition agreement with her business that prohibits her from competing with the business for a period of three years if she leaves the business or if substantially all the assets are sold in a consensual sale (i.e., asset sale).

For Seller A the purchase price is paid as follows: $ 1.5 million to equipment, inventory, and work in progress, $850,000 to Section 197 intangibles (goodwill, including the non-competition agreement), and $150,000 paid to the shareholder of Seller A under a consulting agreement at the rate of $50,000 a year for three years.

Seller B does not have an existing non-competition agreement it can transfer as part of the sale, so the buyer requires selling shareholder to enter into a three-year non-competition agreement as a condition of the sale.  If Seller B attempts to spread the total purchase price in the same manner as Seller A, the IRS will re-characterize a portion of the sums received for goodwill as disguised consulting payments.  Because the non-competition agreement was entered into at the time of the sale directly between the selling shareholder and the buyer, Seller B receives $ 1.5 million for equipment, inventory, and work in progress, $250,000 for Section 197 intangibles (goodwill), and Seller B’s shareholder receives the remaining $750,000 in three equal, annual payments under the consulting agreement.

Seller A’s shareholder’s total tax bill is calculated like this: The first $500,00 is the recovery of basis and is not taxed.  The next $434,550 is capital gains is taxed at 15% (shareholder is single) for $65,182.50 in tax.  The remaining capital gain of $1,415,450 ($2,350,000 – $500,000 (basis recovery) – $434,550) is taxed at 20% for $283,090 in tax.  Payments under the consulting agreement are taxed at ordinary income rates (assume no other income and no deductions) for a total of $33,000 ($11,000 per year for 3 years) for a total tax bill of $381,272.50.

Seller B’s shareholder’s (also single) total tax bill is calculated like this: $65,182.50 for the first $434,500 after basis recovery (just like Seller A) and $163,090 for the next $1,315,450 ($1,750,000 – $434,500).  Tax on payments under the consulting agreement are $262,500 ($87,500 a year based on current tax brackets), giving the shareholder of Seller B a total tax bill of $490,772.50.

Clearly, Seller A’s strategy is superior since it resulted in a tax savings of $109,500. Which approach would you have chosen if you were selling your S-corporation?

Hagan Barrett PLLC guides business owners in the most tax efficient ways to sell their businesses.  We would be happy to assist you or your counsel in structuring your business to lower your tax bill.