Commentary: Non-compete agreements can be employed as effective tools to protect the buyer of a business from direct or indirect competition from the seller. Certainly, buyers and sellers will often include a non-compete agreement as a term of the sale transaction itself. However, in utilizing these agreements, it is crucial for both parties to the sale to remain aware of two key points. First, restrictions on competition are generally only enforceable to the extent that they are reasonable. And second, in the sale of a business, a covenant not to compete could have significant tax implications for the buyer and seller alike.
A non-compete agreement will typically state that in exchange for a specified payment (which could be part of the sale price), the seller will promise not to go into a similar type of business, within a certain geographic area for a specified period of time. In some cases, the agreement will also prohibit the seller from using certain confidential trade secrets or business processes that are being transferred to the buyer. Again, however, it is critical to keep in mind that a court will only enforce a non-compete provision if it is reasonable in scope and duration. Thus, a non-compete clause should generally only restrict the seller from working or being affiliated with a business that is similar or at least in the same industry as the one he is selling.
The question becomes how narrowly to define the industry. Moreover, the restriction should arguably be limited to the same geographic area from which the seller’s business derived its customers, and it should only apply for a reasonable period of time. What is reasonable will depend on the specifics of the industry, the business and even the region. Notably, different states have different standards for evaluating the “reasonableness” of a non-compete agreement.
Although we are not offering tax advice, it is essential to keep in mind that non-compete agreements could have significant implications for the parties to the transaction. In negotiating a sale price for the business, the buyer and seller must decide upon what portion of the purchase price is to be allocated to the covenant not to compete. The basic issue is that with an asset sale of a business, each asset sold is treated separately for tax purposes. Under current law, those assets treated as capital gains are taxed at a significantly lower rate than those treated as ordinary income. However, gains on certain intangible assets, such as covenants not to compete, are not generally eligible for capital gains treatment. Thus, in allocating the purchase price to the various assets of the business, the parties should keep in mind that allocating even a small portion of the purchase price to the covenant not to compete could significantly lower the after- tax amount that the seller will make from the sale.
In light of these potentially significant business and tax implications, both the buyer and the seller should use careful consideration in determining the structure of a non-compete agreement and the value associated with the covenant not to compete that is being transferred to the buyer. The best practice for both parties is to consult a tax professional to assist in defining the terms of the purchase.
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