Selling a Business
Substance and form really do count.
by Donald Williamson/The Tax Adviser
Three concepts regularly come into play when contemplating the sale of a business: non-compete covenants, consulting agreements, and goodwill. On the surface, the tax treatment of each seems fairly straightforward.
However, the wording of the purchase agreement, or the lack thereof, can raise problems and issues. Following is a brief overview of the three concepts and then a discussion of specific areas to consider when crafting agreements, with the hope of providing sellers and buyers with guidance to avoid pitfalls.
The exhibit below shows the tax implications of these three concepts for the seller and the buyer.
Exhibit: Tax Implication to the Seller and Buyer
Competing Interests of Buyer and Seller
Under the current federal tax rates, the seller, other than a C corporation, would prefer to sell goodwill and thus benefit from capital gain tax treatment (if the seller has held the stock for more than one year). The buyer, however, is likely to want to protect his or her investment by ensuring that the seller does not immediately compete with the business and/or to retain the seller’s services for a period of time. The buyer has a preference to allocate more of the purchase price to the consulting agreement, which would result in a current deduction, as opposed to the non-compete agreement, which must be amortized over 15 years.
From the seller’s perspective, a non-compete agreement is generally preferable to a consulting agreement from a tax standpoint because payments under a consulting agreement will be subject to self-employment tax. Self-employment income, however, does afford the individual taxpayer the ability to establish a variety of tax-saving vehicles, including retirement plans and medical reimbursement plans. These tax-saving vehicles generally need to be established within certain time limits and cannot be established after the fact.
Importance of Substance and Form
If a non-compete covenant and a consulting agreement are contemplated, it is important that substance and form actually exist to support the respective agreements.
The parties need to have competing interests to support a non-compete agreement. Furthermore, the non-compete agreement needs to be realistic. It is difficult to argue that a seller will compete if he or she does not have the financial ability, is in poor health, or spends much of his or her time after the sale vacationing.
A clear example of non-competing interests is provided in Mackey’s, Inc., T.C. Memo. 1975-280, in which the seller retained a majority interest in the company. The seller also moved overseas within less than a month of signing the documents. The Tax Court found that this non-compete covenant was invalid because it merely restricted the taxpayer from competing against himself, and the consulting agreement was invalid because the taxpayer did not perform any services. The Tax Court held that both the non-compete payments and the consulting fees were disguised dividends.
Existing agreements should be reviewed to ensure a conflict does not exist. For example, if a fast-food restaurant franchise is being sold, the existing franchise agreement may prevent another store opening within a specified distance. It would be difficult to argue the validity of the non-compete if the distance specified was greater than the distance in an already existing franchise agreement. The non-compete covenant should also have provisions for breach of contract if the seller fails to comply with the terms of the covenant. The IRS may argue that the lack of breach of contract provisions is disguised goodwill.
A consulting agreement by its nature presupposes that the seller will perform some sort of consulting services for the buyer to ensure a smooth transition. In order to have substance, the seller — as the consultant — will need to perform actual and meaningful consulting services.
If both a non-compete and a consulting agreement will be structured, it is important that they be distinguishable. That is, they should provide for specific allocations and avoid ambiguity so the Service does not re-characterize the non-compete agreement as a consulting agreement and thus subject the payments to self-employment tax. Obtaining a valuation report from an independent appraiser that provides an allocation of the various pieces can be a valuable tool to support the allocations.
Congress anticipated the attempt to shift the purchase price away from non-compete covenants, and in the legislative history of Sec. 197 it directed that any arrangement that “requires the former owner of an interest in a trade or business to continue to perform services (or to provide property or the use of property)” is considered to have substantially the same effect as a non-compete covenant where the amount paid to the former owner of the business pursuant to the arrangement exceeds the amount that represents “reasonable compensation for the services actually rendered (or the property or use of property actually provided)” (H.R. Conf. Rep’t No. 103-213, 103d Cong., 1st Sess. (1993)).
Both substance and form are important when crafting documents to sell a business. The Service and the courts will look beyond the written word to confirm that the actions support the agreements and, where they do not, will re-characterize the payments. The re-characterization can range from currently deductible to amortizable, from not subject to self-employment tax to subject to self-employment tax, and even to disguised dividends — none of which are favorable outcomes.
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Dawn M. Beatty, CPA, EEPB Certified Public Accountants & Consultants, Houston, TX, is a contributing writer for The Tax Adviser. Her views as expressed in this article do not necessarily reflect the views of the AICPA, The Tax Adviser or the AICPA CPA Insider™.
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