Non-compete agreements are typically included as part of the terms of a business sale transaction to protect the buyer from direct or indirect competition from the seller. A buyer would not want to purchase a business if the seller could relocate down the street. For this reason, buyers usually require that this threat be eliminated.

There are two main issues about which buyers and sellers should be aware. First, a non-compete agreement has limitations on time, industry, and geographic range of competition if it is to be enforceable, and, second, there are tax implications for both the buyer and the seller.

Limitations of Non-Compete Agreements

The terms of the non-compete should not be too broad or overly burdensome on the seller. Restrictions such as scope, time, and range of competition are generally only enforceable to the extent that they are reasonable.

Among the issues usually outlined in a non-compete agreement between buyer and seller are:
  • specific payment being made for a seller’s agreement not to compete
  • specific time period of non-compete (3 to 5 years)
  • specific geographic area
  • specific industry sector 
A non-compete agreement will typically state that 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. The agreement may also prohibit the seller from using confidential trade secrets or business processes that are being transferred to the buyer.

Again, keep in mind that a non-compete agreement will typically only be enforceable if it is reasonable in scope and duration. Therefore, a non-compete should only restrict the seller from working or being affiliated with a business that is similar or in the same industry as the one being sold. The restriction is usually limited to the same geographic area from which the customers of the business are sourced and apply for a reasonable period of time. What is reasonable will depend on the specifics of the industry, the business, and region. Standards for evaluating the reasonableness of a non-compete agreement may differ by State.

Tax Implications

Also at issue with non-compete agreements is taxation. A non-compete could have significant implications for both the seller and the buyer in a business sale transaction. Non-compete agreements are generally taxed as ordinary income to the seller, which from the seller's perspective is less than desirable. But, for a buyer, it is expensed as incurred, which is desirable for the buyer but not the seller. But in some instances, the seller may be able to achieve the preferred capital-gain taxation rate by incorporating the non-compete payments into the general goodwill of the business or a portion of the payment as personal goodwill. In these instances, the buyer would be prohibited from expensing these payments as incurred, as would be preferred, but instead amortizing them as goodwill payments.

Because of these issues, how the non-compete is structured becomes a negotiating point between buyer and seller. The buyer and seller must decide what portion of the purchase price is to be allocated to the covenant not to compete on IRS Section 1060 Form 8594, Asset Acquisition Statement.

In an asset sale transaction, 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 a non-compete agreement, are not generally eligible for capital gains treatment. Therefore, when allocating the purchase price to the various assets of the business, the parties should keep in mind that the allocation of the purchase price attributed to the covenant not to compete could significantly lower the after-tax amount that the seller will make from the sale.

It is prudent and recommended that both parties consult a tax professional and/or an attorney to assist in defining the terms of the purchase. However, it is important that those professionals be familiar with business transfer transactions.