A non-compete clause, or a covenant not to compete (CNC), is commonly used in a sale of a businesses in order to protect the Buyer from having the Seller directly or indirectly compete with the business just recently sold, within an agreed upon geographic area and for a limited time frame, typically three to five years.

One of the tax implications of allocating a portion of the purchase price to the CNC is that any amount out of the total purchase price that the parties allocate to the CNC is taxed as ordinary income.

Even in a relatively small transaction, applying ordinary income tax rates to a portion of the purchase price will significantly lower the after tax amount the Seller will keep from the sale price.

Here is one option the parties should consider to reduce the tax liability when the deal includes a CNC agreement. The Seller should sign a CNC with no allocation of any portion of the sale price to the CNC, side by side with a liquidated damages clause that will impose an agreed upon amount of liquidated damages in the event the Seller breaches the CNC.

Ordinary tax rates apply only to the portion of the purchase price that was allocated to the CNC – but if the parties do not allocate any amount to the CNC, and instead utilize a liquidated penalty clause – no consideration was paid to the Seller for the Agreement Not to Compete (CNC) – and therefore the ordinary income tax rates would not apply.

Let us look at the following example:

A $3 million transaction in which the Buyer requires the Seller to sign a noncompete for an amount of $500,000.

Assuming a combined federal and state ordinary income tax rate of 45% - if the parties allocate the amount of $500,000 to the CNC we are looking at a tax bill on the CNC portion of the deal of about $225,000.

On the other hand if the same portion of the purchase price - $500,000 was not allocated to the CNC, and the parties would agree to include a liquidated damages clause instead - the $500,000 might be considered part of the goodwill of the business - and taxed at a lower combined federal and state rate of approximately 25% - $125,000 – a tax savings of $100,000.

Disclaimer: The above information is based on interpretation of the signed below and cannot act as a substitute for consulting with an accountant and / or an attorney.