Understanding the Non-Compete Buyout in an Asset Purchase
A non-compete buyout is a payment from the buyer to the seller, or to key owners or employees of the seller, in exchange for an agreement not to compete with the acquired business for a specified time and geography. In an asset purchase, this covenant is commonly documented as a stand-alone agreement and separately allocated a portion of the purchase price. The reasoning is straightforward but legally and fiscally complex: the buyer is purchasing not only tangible and intangible assets, but also the assurance that the seller will not immediately erode the purchased goodwill and customer relationships. That assurance is economically valuable, and the tax law treats it as a distinct intangible with its own rules and consequences.
Despite appearing simple, non-compete agreements in asset deals sit at the intersection of federal income tax, information reporting, employment tax, state and local apportionment, and valuation principles. A poorly conceived allocation or an imprecise covenant can shift material value from capital gain-eligible intangibles, such as goodwill, to ordinary income items, such as a non-compete, with cascading effects on both sides of the transaction. As an attorney and CPA, I routinely observe scenarios where parties agree on “how much” but not “what for,” and that disconnect is often where tax risk—and opportunity—reside.
Why Allocation Matters: Purchase Price vs. Covenant Not to Compete
Purchase price allocation is not merely an accounting exercise; it is the backbone of how each party reports income, amortization, and basis. The buyer generally prefers larger allocations to amortizable intangibles, including a covenant not to compete, to secure deductions over time. The seller, particularly an individual or pass-through owner, may prefer allocations to goodwill and other capital assets potentially eligible for preferential capital gain rates. Allocating too much to a non-compete can convert what the seller expected to be capital gain into ordinary income, altering after-tax proceeds substantially.
Compounding this dynamic are the compliance requirements that force consistency. The Internal Revenue Code obligates buyers and sellers to use a consistent allocation under the residual method, and to disclose that allocation on a jointly reported form. If a side agreement or informal understanding attempts to shift value after the fact—say, to maximize the buyer’s amortization—both parties can face exposure in the event of an audit. This is where careful drafting and pre-closing modeling are indispensable.
Seller-Side Tax Treatment of a Non-Compete Payment
For the seller, consideration specifically allocated to a covenant not to compete is generally treated as ordinary income. This is a critical distinction from the sale of goodwill, which typically produces capital gain. Ordinary income treatment can significantly increase the seller’s effective tax rate, particularly where the seller’s marginal rate exceeds the capital gains rate by a wide margin. Moreover, in closely held businesses where owners are personally signing the non-compete, payments may be made directly to those individuals rather than to the entity, magnifying the need to address withholding and information reporting early.
Whether such income is subject to self-employment tax is a frequent point of confusion. The analysis is highly fact-specific. In many cases, payments for refraining from competition are not treated as earnings from a trade or business carried on by the recipient at the time of the payment, arguably taking them outside self-employment tax. However, facts suggesting that the payment is a substitute for services, or is integrated with ongoing consulting or employment, may push the characterization toward self-employment income or even wages. Sellers should not assume a one-size-fits-all result; contemporaneous documentation of roles, services (if any), and the independent economic value of the covenant is vital.
Buyer-Side Tax Treatment and Amortization Rules
On the buyer’s side, a covenant not to compete entered into in connection with the acquisition of a business is typically a Section 197 intangible. As such, it is amortizable on a straight-line basis over 15 years. This treatment applies even if the covenant’s contractual term is shorter than 15 years. Buyers often seek to allocate meaningful value to the non-compete to capture amortization deductions, but they must balance this against the seller’s tax cost and the risk of recharacterization if the allocation does not reflect economic reality.
Because Section 197 mandates a uniform amortization period for covered intangibles, buyers should model the tax benefit of non-compete amortization relative to other classes of assets. For example, increases in allocations to inventory or short-lived tangible personal property may deliver more immediate deductions, while allocations to goodwill and non-competes spread benefits over 15 years. A meticulous cash tax analysis can reveal optimal allocation ranges that satisfy both the business purpose and defensible valuation principles.
Section 1060, Form 8594, and Residual Method Allocation
Asset acquisitions of a trade or business are governed by the residual method under Section 1060. Under this framework, the purchase price is allocated in a prescribed order across classes of assets, with intangible assets such as covenants not to compete and goodwill captured in the final classes. Both parties must file Form 8594, Asset Acquisition Statement, to report the total consideration and its allocation among asset classes. Consistency between buyer and seller filings is crucial; mismatches invite IRS scrutiny and can materially complicate examinations.
Because the residual method allocates the “residual” to certain intangibles after assigning value to identifiable assets, parties must be deliberate in valuing and documenting the covenant. Over-allocating to the non-compete at the expense of goodwill may raise economic substance concerns, while under-allocating may understate the buyer’s amortizable basis. Professional valuation input can be decisive in striking a defensible balance, particularly where the market dynamics make the covenant central to the deal thesis.
Employment Taxes, Ordinary Income, and Self-Employment Considerations
When the seller (or a principal of the seller) is also entering into employment or consulting arrangements with the buyer, the boundary between a non-compete payment and compensation for services can blur. Payments that are contingent on continued employment, performance metrics, or services rendered can be recharacterized as wages, triggering employment tax withholding and payroll reporting. Conversely, a standalone unconditional non-compete paid at closing is more likely to be treated as non-wage ordinary income, potentially reported on an information return such as Form 1099, if applicable.
Another subtlety involves self-employment tax for individuals. Authorities diverge, and outcomes turn on whether the payment is tied to a trade or business carried on by the payee and whether the non-compete is effectively replacing service income. Sellers often assume that a covenant payment is automatically exempt from self-employment tax. That is a misconception. The actual structure, how the agreement is integrated with other contracts, and the seller’s continuing activities can tilt the analysis. A pre-closing review of the seller’s roles, paired with precise drafting, can mitigate unpleasant surprises.
State and Local Tax Nuances and Apportionment
State taxation adds a layer of complexity that is frequently underestimated. Many states treat non-compete income as sourced to the state where the underlying business operates or where the covenant restricts activity, even if the payee has moved or resides elsewhere. This can result in multi-state filings, apportionment complexities, and potential double taxation if credit mechanisms are imperfect. Buyers must also consider whether state conformity to federal amortization rules applies in full, in part, or not at all.
Local jurisdictions can create additional friction with business license taxes or gross receipts-based levies that capture non-compete income. The tax characterization of the covenant—ordinary income to the seller and amortizable intangible to the buyer—may be recognized differently in state regimes. Transaction planners should run state models before finalizing allocations, especially in deals spanning multiple states or involving remote or mobile businesses.
Valuation, Economic Substance, and IRS Scrutiny
The IRS focuses on whether the non-compete allocation reflects genuine economic value. If the seller poses little realistic competitive threat—due to retirement, non-portable personal goodwill, or contractual limitations—a large non-compete allocation may be vulnerable. By contrast, where the seller has strong personal relationships, niche expertise, or a portable brand, a substantial non-compete can be well supported. Documentation such as market analyses, customer dependency metrics, and churn sensitivity modeling can corroborate the covenant’s stand-alone value.
Valuation professionals often apply income-based methods, estimating the buyer’s loss exposure without a covenant and discounting the avoided loss over the non-compete term. While this method is accepted in principle, the inputs are debatable and heavily fact dependent. A defensible allocation requires consistency between the business case used to secure investment or financing and the valuation narrative supporting the covenant. Misalignment between the “deal deck” and the tax valuation is a common audit trigger.
Interaction with Goodwill, Workforce in Place, and Personal vs. Entity Goodwill
Non-competes interplay with goodwill in subtle ways. If material value resides in personal goodwill of an individual owner—built on that person’s reputation and relationships—then compensating the individual for a non-compete and a related assignment of personal goodwill may be essential for the buyer to capture the full economic value. Conversely, if goodwill is institutional and embedded in the entity’s processes, brand, and workforce in place, heavy allocation to a personal non-compete may be inconsistent. The allocation should track where the goodwill truly sits and how it can be preserved post-closing.
Courts have scrutinized allocations that appear to shift value from goodwill to non-compete solely to engineer tax outcomes. Where personal goodwill is credibly present, separate agreements and explicit assignments can be appropriate and tax-efficient, but they must match the operational reality. Buyers should assess whether the value really follows the people or the platform, and sellers should understand that overstating a non-compete to chase amortization can backfire if the IRS recharacterizes amounts as goodwill or compensation.
Special Cases: Partnerships, S Corporations, and C Corporations
In pass-through structures, such as partnerships and S corporations, the allocation of non-compete payments can have partner- or shareholder-level effects. If payments are made to the entity, they flow through and are generally ordinary income to owners. If paid directly to individual owners who sign personal covenants, the tax burden lands at the individual level, potentially with different sourcing and reporting. In partnerships, agreements must address whether the payment is to the partnership or to the partners, how it is shared, and how it affects capital accounts and Section 704 allocations.
In C corporation contexts, non-compete payments to the corporation are ordinary income at the corporate level, and any subsequent distributions can trigger a second level of tax. To mitigate double taxation, parties sometimes contemplate paying individuals directly for personal covenants where appropriate and defensible. However, misallocating payments from the corporation to individuals to sidestep tax can lead to recharacterization, payroll tax exposure, and penalties. Careful entity-level and owner-level modeling is essential before finalizing any approach.
Cross-Border and Nonresident Seller Considerations
Where a nonresident alien or foreign corporation is a payee, sourcing and withholding issues arise. Payments for agreeing not to compete in the United States are often treated as U.S.-source income, potentially subject to withholding in the absence of treaty protection. Depending on the facts, the income may be effectively connected with a U.S. trade or business or treated as fixed or determinable annual or periodical income. Classifying the payment correctly determines withholding obligations, return filing, and eligibility for treaty benefits.
Buyers must not assume that FIRPTA, which concerns U.S. real property interests, governs these payments; most non-compete amounts are not within that regime. Instead, standard nonresident withholding rules can apply, and contractual gross-up provisions may be needed if the seller demands a net amount. Coordination with immigration counsel can also be prudent if the covenant intersects with post-closing service arrangements that affect visa status or work authorizations.
Drafting Tips: Contract Language that Drives Tax Outcomes
Precision in drafting is critical. The purchase agreement should expressly allocate consideration among asset classes, including a clearly stated amount for the covenant not to compete that aligns with valuation support. The covenant agreement should have a commercially reasonable term and scope, include a separate recitation of consideration, and avoid contingent features that make the payment look like wages or services compensation. If the seller will also consult or be employed, those agreements should clearly segregate compensation arrangements from the non-compete consideration and describe separate business purposes.
Additionally, the agreements should designate who is receiving the non-compete consideration—entity, individual owners, or both—reflecting the underlying economics and any personal goodwill assignments. Representations and covenants around tax reporting, information returns, and Form 8594 filings should be included. Where state tax exposure is expected, add provisions on cooperation, apportionment data, and access to books to support filing positions.
Common Pitfalls and Misconceptions to Avoid
A frequent misconception is that a non-compete allocation is a simple lever the buyer can pull to “create deductions.” In practice, shifting value to a covenant can increase the seller’s tax cost, poison negotiations, and draw scrutiny if the seller lacks the capacity or intent to compete. Another error is assuming that a boilerplate non-compete at a nominal amount will suffice. If the seller is a credible competitor, undervaluing the covenant undermines the buyer’s protection and leaves amortization deductions on the table, while also weakening the legal enforceability of the restraint in some jurisdictions.
Equally problematic is the failure to align tax reporting with the contractual allocation. If the seller reports more as capital gain on goodwill while the buyer reports a larger non-compete, the mismatch is discoverable through Form 8594 and can lead to adjustments and penalties. Finally, ignoring state and employment tax characterization can trigger unexpected withholding, assessments, and amended returns. A disciplined, documented approach is the antidote to each of these pitfalls.
Practical Examples Illustrating Different Outcomes
Consider a professional services firm where the founder holds deep client relationships and plans to remain active in the market. A substantial allocation to a non-compete, supported by an income-based valuation showing significant anticipated client attrition absent a covenant, is defensible. The buyer amortizes the amount over 15 years. The seller recognizes ordinary income on the covenant amount and capital gain on goodwill. If the seller also signs a consulting agreement with performance-based earnouts, a portion of the payments could be recharacterized as compensation if the documents are not carefully segregated.
Contrast that with a manufacturing business where the seller is retiring and the customer base relies on long-term contracts with the company, not the owner. Here, goodwill is primarily institutional. A large non-compete allocation would be hard to defend, and over-allocation risks recharacterization into goodwill. The buyer still benefits from Section 197 amortization of goodwill, while the seller benefits from capital gain treatment. Attempting to shoehorn value into a non-compete purely for buyer tax benefits would be shortsighted and risky.
Due Diligence Checklist and Documentation Essentials
Effective diligence on non-compete allocations starts with a clear mapping of competitive threats: who could the seller solicit, what relationships are portable, and how quickly could market share be eroded? Buyers should assemble contemporaneous evidence—sales pipeline analyses, customer concentration metrics, non-solicit exposure, and attrition modeling—to support the covenant’s value. A formal valuation memorandum that quantifies expected losses without a covenant and credits the covenant with a risk-adjusted benefit creates a robust audit trail.
On the compliance front, prepare draft Form 8594s before closing so that both parties agree on the reporting. Confirm information reporting obligations, including whether amounts are reportable to individual signatories and what, if any, withholding applies. Memorialize in the purchase agreement that both parties will file consistent forms and cooperate in defending allocations. These steps may seem administrative, but they are often the difference between a smooth post-closing and a costly controversy.
When to Seek Professional Help and How to Prepare
A seasoned advisor who is both an attorney and a CPA can integrate the legal enforceability of the covenant with the tax optimization and reporting that follow. Engage counsel and tax advisors early, ideally before a letter of intent hardens expectations around purchase price and structure. Pre-negotiation tax modeling can quantify after-tax proceeds for the seller and cash tax impacts for the buyer under multiple allocation scenarios, enabling an informed, fact-driven negotiation rather than a last-minute scramble.
Preparation pays dividends. Assemble organizational charts, historical financials, customer retention data, and any prior non-compete or non-solicit agreements. Be candid about the seller’s post-closing plans. If the seller is truly exiting the market, that fact informs valuation and allocation. If the seller will remain a potential competitor, that reality supports a meaningful covenant value. In all events, recognize that even “simple” deals harbor complex tax dynamics, and that careful drafting and documentation are not optional—they are essential risk controls.
