Possible Tax Consequences of Covenants Not to Compete

October 20, 2010

This blog has made several posts regarding covenants not to compete. Covenants not to compete are generally viewed as positive steps for businesses to protect their interests and prevent key employees from leaving and taking clients with them. A recent federal district court opinion, Howard v. United States, suggests that consideration of future tax ramifications for professional services providers that incorporate and subsequently sell their practices are now necessary.

On July 30, 2010, a federal district court in Washington held that a dentist’s covenant not to compete he signed with his own practice, a C-Corporation, converted his goodwill, which is ordinarily personal, into a corporate asset. The effect of converting his otherwise personal goodwill to a corporate asset was that upon sale of his practice, his goodwill was taxed at the corporate level, then taxed again when it was distributed as a dividend to him. If his goodwill had been considered personal it would have been taxed once as a long-term capital gain, which is currently taxed at a lower level than a dividend which is taxed as ordinary income.

The district court stated that in order to determine the nature of his goodwill the court must examine the appropriate state law. The court went on, however, to cite a federal appellate court and two tax opinions in determining that the goodwill was a corporate asset. Thus the characterization is likely not a state issue. The Washington District Court explained its reasoning for converting the goodwill from a personal to corporate asset by stating that generally there is no corporate goodwill when the success of the business depends on key employees, but where an employee enters into a covenant not to compete, his or her personal relationships with clients become property of the corporation. The characterization only applies, however, during the period of employment that the employee had a covenant not to compete agreement in place.

There are three important things to keep in my from this recent case:

  1. This problem only arises when the corporation is taxed as a C corporation. S Corporation and other entities that choose to be taxed as partnerships are not affected because the income upon sale passes through to the individual on his tax return. Allow the goodwill would still be a corporate asset, the problem of double taxation is moot.
  2. The problem of taxing goodwill only occurs when the employee that signed the agreement is the one selling his interest. In the case the dentist was the sole shareholder of his practice. The goodwill was treated as a sale to the corporation and then a dividend to the taxpayer.
  3. The characterization of the money as a dividend or long-term capital gain only matters when the rates are different, which they currently are. No one is sure yet if capital gains rates will continue to be lower than ordinary income as the federal government still contemplates the future of the Bush-era tax cuts.
  4. A problem of taxation also arises on the corporate level for C corporations that buy out key employees who have signed these agreements. The goodwill is taxed at corporate level prior to making a distribution to the employee.

The bottom line is that professional services providers should seek consultation when executing these agreements and when selling their practices.