Can I Deduct the Cost of a Noncompete Agreement?

Noncompete agreements are common in business situations to protect a business from competition from employees or former owners. Businesses typically compensate the signer, creating a business expense. It can help to review the basics of noncompete agreements so you understand how to deduct the cost of compensation in a noncompete on your business tax return.

Key Takeaways

• A noncompete agreement is a contract that keeps someone from competing with either an employer or the buyer of a business.
• The signer should receive fair compensation to make this a legal contract.
• The cost of this compensation is considered a business expense.
• This cost must be amortized as a Section 197 intangible asset over 15 years.

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.

Note

Both parties are giving something of value, such as money, services, or a promise, in exchange for something they want. Without consideration on both sides, the agreement would not be a valid contract without consideration on both sides.

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.

Note

Noncompete agreements must adhere to state laws. Some states have ruled them to be unenforceable, and some states require fair compensation. Always check with your attorney before creating or signing a noncompete agreement.

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.

Frequently Asked Questions (FAQs)

Where do I report a noncompete on Form 1040?

You may have received compensation (a bonus, maybe) in return if you signed a noncompete agreement when you were hired as an employee or at another time during your employment. This compensation is taxable to you as ordinary income. It goes on your Form 1040 tax return along with your other income, and it’s used to determine your tax rate and taxable income.

Is a noncompete an asset?

The seller signs a noncompete agreement at the request of the buyer in the sale of a business. The amount the buyer pays to the seller for this agreement creates an intangible asset that must be spread out over 15 years, using a process called amortization, which is similar to depreciation. The amount that can be amortized is set on the adjusted basis of the asset, or all its initial costs.