Analyst’s Noncompete Agreement Considerations in Corporate Acquisitions

Part II of II

This is the second of a two-part article (Read Part I here) 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.

The Substance of the Noncompete Agreement

The Internal Revenue Service’s (the Service) position is that, in acquisitive transactions, noncompete agreements only have value when the seller has an actual capacity to compete with the target company. In assessing the fair market value of any selling shareholder/employee noncompete agreement, the Service will consider the seller’s capacity to compete based on such factors as age, health, financial ability, technical expertise, industry contracts, regulatory or other restrictions, and geographic proximity.

In addition, in assessing the fair market value of any seller noncompete agreement, the Service typically looks for one of the following conditions:

1. The target company is a service-based business (or a knowledge-based business)—and not a capital-intensive business.
2. The selling shareholder/employee has identifiable technical expertise (such as proprietary knowledge of process designs, product recipes or formulas, or other trade secrets).
3. The selling shareholder/employee has personal relationships with suppliers, vendors, subcontractors, bankers, or other providers of goods and services to the target company.
4. The selling shareholder/employee has personal relationships with key employees of and/or consultants to the target company.
5. The selling shareholder/employee has personal relationships with customers, clients, patients, distributors, dealers, franchisees, and so forth.
6. The selling shareholder/employee is well known in the industry or profession for having unique experience, expertise, prominence, or eminence.

In assessing the fair market value of any seller noncomplete agreement, the Service also considers the legal enforceability of the contract. Such legal enforceability is often an issue of state-specific contract law and employment law statutes and judicial precedent. These state-specific contract law issues may include the following factors:

1. The term of the agreement; depending on the state and the industry or profession, courts generally consider two- to three-year terms to be reasonable.
2. The scope of the agreement; this factor generally considers the extent of the restrictions on the seller’s ability to earn a living.
3. The geographic area covered by the agreement; this factor generally considers whether the seller’s noncompetition territory is local, regional, or national.

The Double Taxation in the Sale of C Corporation Shareholders

If the target company is a C corporation and the transaction is structured as an asset sale (or as a stock sale followed by a Section 338 election), then the selling shareholders may be subject to double taxation on the gain related to the sale. That is, first, the target company itself will recognize a taxable gain on the sale of its assets to the acquirer (to the extent that the sale price exceeds the target company’s asset tax basis). Second, the selling shareholders also are subject to taxation when the target company distributes the remaining (after-tax) sale proceeds to the shareholders. That is, the selling shareholders are subject to tax on the gain related to the target company’s distribution of the transaction sale proceeds.

For this reason, the selling shareholders in such a transaction have an economic incentive to overstate the allocation of the total transaction consideration to any noncompete agreements. The payments for the noncompete agreements are only taxed once to the selling shareholders. In addition, the selling shareholders have an economic incentive to overstate the allocation of the total transaction consideration to any intangible assets that are personally owned by those selling shareholders. For example, in a private company sale transaction, the selling shareholders may personally own trade secrets, customer/client relationships, or personal goodwill. The acquirer’s payments for these personally owned intangible assets is only taxed once to the selling shareholders. And, whether these intangible assets are target-company-owned or selling-shareholder-owned, they are Section 197 intangible assets to the acquirer. That means that, regardless of who the seller is, the acquirer will amortize the value of the acquired intangible assets over the Section 197 15-year period.

For example, in the decision in Norwalk, T.C. Memo. 198-275, the Tax Court concluded that the goodwill purchased in the business acquisition was the seller’s personal goodwill—and not the target company’s institutional goodwill. In that case, the acquirer did not obtain noncompete agreements with the selling shareholder/employee. Based on the specific facts of that case, the Tax Court opined that there was acquired goodwill—in the form of valuable client relationships. However, the valuable goodwill was an intangible asset that was owned personally by the selling shareholder. The goodwill was not an intangible asset that was owned by the target company. Therefore, that part of the transaction consideration was only subject to one level of taxation—to the selling shareholders (and not to the target company).

The point is that the double taxation related to certain private company sale transactions can be avoided. That avoidance would occur if the sellers can demonstrate that they personally own—and control—valuable intangible assets. In the typical private company sale transaction, that valuable intangible asset is the sellers’ personal goodwill.

Typically, the selling shareholder/employees will have a zero-tax basis in the self-created personal goodwill. Therefore, the entire amount of the transaction consideration will be taxable gain to the sellers. However, the personal goodwill should be a Section 1231 capital asset. Therefore, the amount of the transaction purchase price allocated to personal goodwill will only be taxed once—at a long-term capital gain tax rate. Depending on the sellers’ level of taxable income, that capital gain tax rate may be 15 percent or 20 percent.

Purchase Price Allocation to Personal Intangible Assets

The Service may likely examine an acquisitive transaction when a large portion of the transaction consideration is allocated to the sellers’ personal goodwill. In most private company purchase price allocations, the Service expects to see a large portion of the transaction consideration allocated to the target company’s institutional goodwill.

When a material amount of seller personal goodwill is transferred in a target company purchase transaction, the transaction participants should obtain both legal advice and valuation analyst advice. Legal counsel will analyze the ownership of the transferred intangible assets. And legal counsel will ensure that all of the transaction documents are properly prepared to document which parties are transferring which intangible assets.

The valuation analyst will identify which intangible assets exist with respect to the business acquisition transfer, and the analyst will identify all of the economic attributes related to each transferred intangible asset. Based on the identification and assessment of these economic attributes, the valuation analyst will estimate the fair market value of each transferred intangible asset. This intangible asset valuation analysis may be used for both the sellers’ transaction sale price allocation and the acquirer’s transaction purchase price allocation.

As a legal consideration, counsel will document that the seller-owned intangible assets were not previously sold, contributed, or otherwise transferred to the target company. If the sellers are shareholder/employees, then the counsel will review any employment agreements, shareholder agreements, or existing noncompete agreements. The counsel will consider whether such agreements previously transferred ownership of any existing or created intangible assets from the employees to the employer target company.

In particular, the counsel will often draft two separate asset and/or stock purchase agreements: (1) one agreement related to the transfer of personally owned intangible assets and (2) one agreement related to the transfer of corporate-owned intangible assets. If there is only one set of asset purchase or stock purchase transaction documents, counsel will ensure that there are separate contractual provisions related to (1) the transfer of any personally owned intangible assets and (2) the transfer of any corporate-owned intangible assets.

In the decision in Martin Ice Cream Co., 110 T.C. 189 (1998), the Tax Court concluded that the customer relationships intangible asset transferred in the business acquisition had been personally owned by the shareholder/employee. The customer relationships intangible asset was not an asset owned or controlled by the target company. In reaching this conclusion in the Martin case, the Tax Court emphasized two issues:

1. The selling shareholder/employee did not have either an employee agreement or an existing noncompete agreement with the target company.
2. The customer relationship intangible asset had never been transferred to the target company.

In the Martin decision, the Tax Court concluded that the target company did own other intangible assets that were also transferred in the business acquisition. Specifically, the Tax Court recognized that the target company owned the following intangible assets: (1) distribution rights and (2) corporate books and records. However, the court did not assign a significant amount of value to these corporate-owned intangible assets.

In the Martin case, the sale of the customer relationships intangible asset personally from the selling stockholder to the corporate acquirer avoided the double taxation on that portion of the total transaction proceeds. In addition, the sale of the personally owned intangible asset to the corporate acquirer was taxed to the selling shareholder at a lower capital gain tax rate.

Consulting Agreements versus Noncompete Agreements

As an alternative consideration to asking the sellers to enter into noncompete agreements, the acquirer may consider asking the sellers to enter into consulting agreements. This alternative consideration is particularly relevant if the selling shareholders will not remain as employees of the target company post transaction. Obviously, the selling shareholders cannot be employees of—and consultants to—the acquired target company at the same time.

The payments made by the acquirer to the seller consultants are deductible to the buyer over the term of the consulting agreement. In other words, the consulting agreement payments are deductible to the buyer when the payments are made to the seller consultants—and not over a 15-year amortization period (as would be the case with noncompete agreement payments). Accordingly, the acquirer gets a much faster tax recovery on the fair market value of consulting agreements than on any fair market value assigned in the transaction to noncompete agreements.

To the selling shareholders, the payments received from a noncompete agreement and the payments received from a consulting agreement are both considered to be ordinary income. The only difference (and the only downside to the sellers) is that the consulting agreement payments are subject to employment taxes. That is, the consulting payments are subject to FICA and other employment taxes.

In many cases, the sellers may already earn wages or self-employment income that would put them above the FICA and other employment tax withholding limitations. In such instances, these sellers would not be subject to such additional employment-related taxes.

However, the consulting payments will likely be subject to the 2.99 percent Medicare Health Insurance portion of self-employment taxes. And the consulting payments may be subject to the additional 0.9 percent Medicare tax on earned income. However, the acquirer and the sellers may be able to negotiate a compromise with respect to such employment-related taxes. That is, there is a material present value benefit to the acquirer to deduct consulting payments immediately—compared to deducting noncompete payments over 15 years. This present value benefit may be large enough to encourage the acquirer to “make whole” the sellers regarding the additional payroll taxes related to the consulting agreement (versus noncompete agreement) payments.

Of course, in such consulting agreement arrangements, the sellers should be expected to consult with the acquirer with respect to the target company. The Service may scrutinize such a consulting agreement arrangement. If the selling shareholders do not actually “consult,” then the Service may recharacterize the consulting agreement payments as (15-year amortization) noncompete agreement payments.

Summary and Conclusion

Corporate acquirers typically expect that the sellers will enter noncompete agreements with respect to the target company. This acquirer expectation is typical whether the seller is a parent corporation or an individual selling shareholder. This acquirer expectation is particularly relevant when the target company is a private company, and the sellers are shareholder/employees.

There are income tax considerations to both the acquirer and to the sellers about how the target company sale transaction is structured. There are income tax considerations to both the acquirer and to the sellers regarding what portion of the total transaction consideration is allocated to any noncompete agreements.

Although much of this discussion applies to all target company acquisitions, this discussion focused on the type of M&A transaction where the target company is a private C corporation and the sellers are shareholder/employees.

In order to maximize the income tax benefits to all parties to the acquisitive transaction, all parties to the business transfer should consult with both legal counsel and valuation analysts.

The legal counsel will review the structure of any noncompete agreements and any other transaction agreements. And the counsel will review the structure of any noncompete agreements and other transaction agreements. In addition, the counsel will review the ownership of any seller personally owned intangible assets that are transferred in the target company acquisition.

The valuation analyst will document the economic attributes of the noncompete agreements and any other intangible assets transferred in the target company acquisition. In addition, the analyst will develop a supportable and credible fair market value valuation of the noncompete agreements and any other intangible assets.

The sellers may rely upon such an intangible asset valuation for transaction sale price allocation purposes. And the acquirer may rely upon such an intangible asset valuation for transaction purchase price allocation purposes.

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.

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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.