What Is a Noncompete Agreement?
A noncompete agreement (sometimes called an agreement or a covenant not to compete) is an agreement between two parties in which one party compensates the other party for agreeing not to compete with them for business purposes. The agreement includes details on the type of competition that’s barred, along with the time period and the area over which the person cannot compete. The individual who signs the noncompete agreement must receive fair compensation in exchange. Payment can be monetary or non-monetary.
Examples of a Noncompete Agreement
JR is an executive at a software company. The company required JR to sign a noncompete agreement when JR was hired, barring JR from setting up a rival company within a certain area within a certain time period. The company pays JR a signing bonus in return. In another example, AB is selling their business. The new owners want to make sure AB doesn’t set up a new business down the street from them, taking all their clients with them. The new business pays AB with shares of stock in the new company in return for signing the noncompete.
Types of Noncompete Agreements
There are two kinds of noncompete situations: employment agreements and business sale agreements. They have a lot of similarities but some key differences. The noncompete can be a clause in a contract or a stand-alone agreement in both cases.
Employment agreement: This kind of noncompete agreement is signed by employees who must agree that if they leave the company, they will not compete with their former employer. Business sale agreement: The other kind of noncompete agreement is signed by business owners who sell their companies, agreeing not to compete with the new owner.
Deducting the Costs of Noncompete Agreements
The consideration is considered to be a legitimate business expense in either type of noncompete agreement. You can claim the $300,000 as a business expense if you buy a company and pay the former owner $300,000 for their agreement not to compete. The same is the case if you compensate an employee for signing an agreement not to compete. The question is whether you can claim the expense all in one year or whether you must spread it out over several years. The federal tax code classifies a noncompete agreement as an “amortizable section 197 intangible.” This means that the cost of the agreement has value as an intangible asset of the company, similar to a copyright or trademark. Amortization is a process that spreads out the cost over 15 years. A company paid $400,000 to a former employee for a one-year covenant not to compete in a 2010 Tax Court case. The Tax Court ruled that even though the agreement was for one year, the noncompete agreement was intangible, and it should therefore be amortized over 15 years. The Tax Court’s ruling cost the company a good deal of money in taxes owed and in fines and penalties because they couldn’t take the expense in one year. This situation points out the benefit of hiring a licensed tax professional to guide you through the process of creating a noncompete agreement.
