Non-compete Agreement Payment Wasn't Sale of Personal Goodwill

The First Circuit upheld a district court’s holding that money allocated to a non-compete agreement was not for “personal goodwill” when a business’ sale agreement didn’t specifically identify it as such.

May 2009
by Steven Thompson / Journal of Accountancy

When a business is sold, it is common for a portion of its sale price to be attributable to a non-compete agreement between the seller and the buyer. For tax purposes, a covenant not to compete is recognized when it is severable from goodwill, the agreement is separately bargained for, and the covenant can be shown to have economic substance. When this is the case, the portion of the sale price attributable to goodwill is generally treated as a capital asset, and the payment received for the non-compete agreement is taxable as ordinary income under Revenue Ruling 69-643, 1969-2 CB 10.

In 1998, Irwin Muskat, a controlling shareholder, sold his family business, Jac Pac Foods Ltd. (Jac Pac), to Manchester Acquisition Corp. (MAC). The purchase agreement included $15 million allocated to Jac Pac’s goodwill and required Muskat to execute a mutually satisfactory non-compete agreement. The non-compete agreement was for 13 years and provided that MAC’s obligation to make the payments would survive Muskat’s death or disability. Muskat initially reported the $1 million he received for the non-compete agreement as ordinary income. But after reconsidering, he claimed that the payment was for his “personal” goodwill. He subsequently filed a $203,434 refund claim, which the IRS contested.

The U.S. District Court for New Hampshire rejected Muskat’s argument that the $1 million was a sale of his personal goodwill. The court opined that negotiations with MAC didn’t include any discussion of Muskat’s personal goodwill and the consideration paid under the non-compete agreement was bargained for as a covenant not to compete. The court reasoned that Muskat failed to show by “strong proof” that, despite the express terms of the agreement, he and MAC had intended the $1 million payment to be made for his personal goodwill and not for the promises he made in his sale agreement.

This article has been excerpted from the Journal of Accountancy. Read the full article here.