Analyst’s Noncompete Agreement Considerations in Corporate Acquisitions
(Part I of II)
This is a two-part article that focuses on the situation where the target company is a private corporation, and the sellers are employee/shareholders. This discussion summarizes the taxation and valuation considerations related to a transaction where employee/shareholders are selling the private C corporation stock to a C corporation acquirer. Some of the taxation and valuation considerations also apply to the corporate acquirer’s purchase of the corporate subsidiary stock of a parent corporation seller. However, the principal focus of this discussion will be on valuation and taxation guidance related to the employee/shareholders’ sale of a closely held corporation. Valuation analysts are not expected to be M&A transaction tax advisors or deal structuring experts. However, valuation analysts who practice in the M&A transaction arena are expected to work with the transaction principal’s legal counsel, tax accountants, and other professional advisors. Valuation analysts who practice in the M&A discipline are expected to understand the basics of how intangible asset identification and valuation influence the taxation aspects of the transaction.
Introduction
Corporate acquirers typically expect that seller noncompete agreements will be included in the merger and acquisition (M&A) transaction structure. That acquirer expectation is present in most business acquisitions. And, that acquirer expectation is certainly present in the acquisition of a professional services business.
If the seller of the target company is a parent corporation, then the buyer will expect a noncompetition agreement with the corporate seller. In other words, the buyer does not want the seller corporation to compete with its prior subsidiary company during the term of the noncompete agreement. The buyer wants to protect its investment in the target company. Therefore, the buyer wants to prohibit competition either from the seller’s start-up new business venture or from the seller’s acquisition in the target company’s industry.
If the target company sellers are individuals (and, particularly, if the sellers are employee/shareholders), then the buyer will expect a noncompetition agreement directly with the selling shareholders. In other words, the buyer does not want the employee/shareholders to take the transaction sale proceeds and start, acquire, or work for another company in the target company’s industry.
This discussion focuses on the situation where the target company is a private corporation, and the sellers are employee/shareholders. This discussion summarizes the taxation and valuation considerations related to a transaction where employee/shareholders are selling the private C corporation stock to a C corporation acquirer. Some of the taxation and valuation considerations also apply to the corporate acquirer’s purchase of the corporate subsidiary stock of a parent corporation seller. However, the principal focus of this discussion will be on valuation and taxation guidance related to the employee/shareholders’ sale of a closely held corporation.
Valuation analysts are not expected to be M&A transaction tax advisors or deal structuring experts. However, valuation analysts who practice in the M&A transaction arena are expected to work with the transaction principal’s legal counsel, tax accountants, and other professional advisors. Valuation analysts who practice in the M&A discipline are expected to understand the basics of how intangible asset identification and valuation influence the taxation aspects of the transaction.
Noncompete Agreements
If there is a noncompetition provision in the transaction stock purchase agreement or the transaction asset purchase agreement, then that provision is typically referred to as a noncompete or noncompetition covenant. If there is a separate contract between the transaction counterparties (outside of the stock purchase agreement or the asset purchase agreement), then that contract is typically referred to as a noncompete or noncompetition agreement.
However, the transaction contract provisions are structured, the objectives of the transaction counterparties are the same. The sellers want to sell the target company and receive the sale proceeds. The acquirer wants to protect its investment in the target company. Accordingly, the sellers agree not to compete in the industry or profession of the target company for a specified period. Noncompete agreements are individually negotiated, and they vary as to the following terms and provisions:
- The definition of the target industry, industry segment, or profession
- The definition of competition or noncompetition (versus, for example, non-solicitation)
- The term or length of the noncompetition period
- The geographic area covered by the noncompetition agreement
- The penalties for intentional or unintentional violations of the noncompetition provisions
Noncompete agreements are contracts under state law. Each state may have its own interpretation of what noncompete agreement provisions are considered reasonable and enforceable under that state’s laws. Accordingly, the legal counsel for each of the transaction counterparties should carefully draft and review the noncompete agreement terms and provisions. This discussion is not intended to provide legal advice. Rather, this discussion solely considers the taxation and valuation considerations of the noncompete agreement during the transaction negotiations.
Typically, the consideration paid by the buyer to the seller for a noncompete agreement is not part of the transaction purchase price paid for the stock of the C corporation target company. The noncompete agreement with the seller is generally considered to be an amortizable intangible asset that is acquired by the buyer. The value of that intangible asset is separate from the value of the target company stock that is acquired by the buyer.
The noncompete agreement intangible asset is generally amortizable by the buyer over a 15-year amortization period under Internal Revenue Code Section 197(d). The payments received by the employee/shareholders as consideration for any noncompete agreement are typically considered ordinary income (and not capital gain) to the sellers. Therefore, the allocation of the total transaction consideration between the target company stock and the noncompete agreement is typically an important consideration to both the buyer and the sellers. And this total transaction consideration allocation is often an area of disagreement between the Internal Revenue Service (the Service) and both sets of transaction counterparties.
Amortization of the Noncompete Agreement
Under Section 197(d), a noncompete agreement either with a parent corporation seller or with the selling shareholders/employees should be amortizable by the acquirer over a 15-year cost recovery period. However, Section 197(d)(1)(E) indicates that a noncompete agreement is not a Section 197 intangible asset if the agreement is not entered “in connection with an acquisition (directly or indirectly) of an interest in a trade or business or substantial portions thereof.”
Therefore, a noncompete agreement entered with target company non-shareholder employees should not be considered a Section 197 intangible asset. Accordingly, such noncompete agreements with non-shareholder employees should not be amortized over 15 years. Rather, acquirers would expect to be able to amortize such a noncompete agreement over the contract term of the agreement. Usually, such noncompete agreement contract terms are fairly short-term—such as two or three years. Nonetheless, the Service may take the position that all of the transaction-related noncompete agreements should be amortized over 15 years. Even though the counterparties to the noncompete agreements are not the sellers, the Service may claim that the agreements were entered into as part of the business acquisition. This Service position will not change the value of the non-seller noncompete agreements. But it will spread out the acquirer’s income tax amortization deductions over a longer period.
The courts have concluded that seller noncompete agreements should be amortized over the Section 197 15-year period. The First Circuit affirmed such a Tax Court decision in Recovery Group, Inc., 652 F.3d 122 (1st Cir. 2011). In Recovery Group, the Tax Court ruled that a noncompete agreement related to the redemption of a 23 percent block of S corporation stock was a Section 197 intangible asset. Even though the noncompete agreement had a one-year contractual term, the Tax Court ruled that the cost of the agreement had to be amortized over 15 years. In Recovery Group, the Tax Court (and the Court of Appeals) concluded that any noncompete agreement payment related to the purchase or redemption of stock must be amortized over the Section 197 15-year period—regardless of the contractual term of the individual agreement.
Tax Incentives to Understate the Value of the Noncompete Agreement
Some acquirers would have an economic incentive to understate the target company purchase price allocation to the seller’s noncompete agreement. The noncompete agreement value will be amortized over 15 years. Many other categories of target company assets may be depreciated over much shorter periods. Acquirers will typically receive cost recovery on the target company’s receivables and inventory in the year after the acquisition. Acquirers will typically be able to depreciate the target company’s machinery and equipment over periods of less than 15 years.
Such acquirers may have an economic incentive to allocate a very small portion of the target company purchase price to any seller noncompete agreement. The acquirer will amortize any value allocated to the noncompete agreement intangible asset over a relatively long 15-year period. For this reason, the Service may challenge the amount of the total transaction consideration that the acquirer allocates to any seller noncompete agreement. The Service may claim that the allocation was understated—and that the agreements actual fair market value is greater than the amount reported by the acquirer.
The seller shareholders may also have an economic incentive to understate the target company purchase price allocation to the noncompete agreements. Noncompete agreement payments received by a seller are treated as ordinary income. In contrast, payments received by a seller for the target company stock (a capital asset) or for the target company real estate, equipment, or goodwill (Section 1231 assets) are treated as capital gains.
So, if both the acquirer and the selling shareholders have an economic incentive to understate the purchase price allocation to the noncompete agreements, the Service will likely scrutinize the value assigned to that intangible asset. In particular, the Service may challenge any transaction where little or none of the target company purchase price is allocated to any seller noncompete agreement. Depending on how the transaction is structured, the Service realizes that the acquirer may be indifferent as to a purchase price allocation to goodwill or to the noncompete agreement. To the acquirer, these are Section 197 intangible assets subject to a 15-year amortization. To the selling shareholders, the noncompete allocation results in ordinary income—while the goodwill (a capital asset) allocation results in a capital gain.
Tax Incentives to Overstate the Value of the Noncompete Agreement
Because of the relatively lengthy 15-year amortization period, acquirers have the above-described incentive to understate the value of any noncompete agreement in (1) Section 1060 asset purchase transactions or (2) stock purchase transactions that qualify for the Section 338 election (i.e., that are treated as asset purchase transactions). In contrast, in stock purchase transactions that do not qualify for the Section 338 election, the acquirer has an economic incentive to overstate the value of any seller noncompete agreements.
In the typical stock purchase transaction, the acquirer receives a carryover tax basis in the target company assets. That is, the acquirer does not get to depreciate or amortize any purchase price premium paid in excess of the target assets’ tax basis. In such a transaction structure, the acquirer has an incentive to overstate the total consideration allocation to any noncompete agreements. Instead of a zero-cost recovery on the purchase price premium, the acquirer may amortize the purchase price allocated to the Section 197 noncompete agreements over 15 years.
In such a transaction structure, the Service may scrutinize the amount of the purchase price allocated to any seller noncompete agreement. The Service may claim that the purchase price allocation is greater than the actual fair market value of the seller noncompete agreement.
In the second part of this article, the author discusses the substance of a noncompete agreement, tax issues, purchase price allocation and differences between non-competes and consulting agreements.
The opinions and materials contained herein do not necessarily reflect the opinions and beliefs of the author’s employer. In making this presentation, neither the presenter nor Willamette Management Associates is undertaking to provide any legal, accounting, or tax advice in connection with this presentation. Any party receiving this presentation must rely on its own legal counsel, accountants, and other similar expert advisors for legal, accounting, tax, and other similar advice relating to the subject matter of this presentation.
Robert Reilly, CPA, ASA, ABV, CVA, CFF, CMA, is a Managing Director in the Chicago office of Willamette Management Associates, a Citizens company. His practice includes valuation analysis, damages analysis, and transfer price analysis.
Mr. Reilly has performed the following types of valuation and economic analyses: economic event analyses, merger and acquisition valuations, divestiture and spin-off valuations, solvency and insolvency analyses, fairness and adequacy opinions, reasonably equivalent value analyses, ESOP formation and adequate consideration analyses, private inurement/excess benefit/intermediate sanctions opinions, acquisition purchase accounting allocations, reasonableness of compensation analyses, restructuring and reorganization analyses, tangible property/intangible property intercompany transfer price analyses, and lost profits/reasonable royalty/cost to cure economic damages analyses.
Mr. Reilly has prepared these valuation and economic analyses for the following purposes: transaction pricing and structuring (merger, acquisition, liquidation, and divestiture); taxation planning and compliance (federal income, gift, estate, and generation-skipping tax; state and local property tax; transfer tax); financing securitization and collateralization; employee corporate ownership (ESOP employer stock transaction and compliance valuations); forensic analysis and dispute resolution; strategic planning and management information; bankruptcy and reorganization (recapitalization, reorganization, restructuring); financial accounting and public reporting; and regulatory compliance and corporate governance.
Mr. Reilly can be contacted at (773) 399-4318 or by e-mail to RFReilly@Willamette.com.
