Covenants Not to Compete

 

Decorative Scales of JusticeWhen a business is sold, it is common practice for the buyer to require that the seller refrain from competing in the same field.  This requires a non competition clause in the contract for sale.  These covenants are enforceable if they are reasonable.  Courts are hesitant to take away a person’s ability to make a living.  For example, in California a covenant not to compete must have reasonable time and geographic restrictions.  You cannot enforce an agreement that prohibits the seller from ever engaging in the same business anywhere.  The exact limits on completion depend on the type of business.

Federal tax law requires that a portion of the purchase price be allocated to a covenant not to compete.  This brings up potential traps for the unwary.  Generally when a business is sold most of the gain for the seller is long-term capital gain taxed at favorable rates.  However, any amount allocated to the covenant not to compete is ordinary income, taxed at the highest individual tax rate applicable to the seller.  For this reason most sellers want to allocate a small amount to this item.  The buyer is indifferent for tax purposes because the cost is amortized the same as the cost of goodwill.  However, there is a non-tax reason for the buyer to want a large amount allocated to the covenant.
If the seller does breach the covenant and start a new business in the same field, the buyer can bring a lawsuit.  If the buyer is successful and the seller is found to be in breach the buyer then has to prove damages.  The seller’s lawyer is going to tell the court that the buyer and seller have already determined the amount of damages and included it in the original contract.  The lawyer will then show the court the amount that both parties agreed to allocate to the covenant and ask the court to award damages in this amount.
In my own practice as a CPA and a tax and business law attorney in San Francisco I have seen service businesses that sold for several million dollars with an amount allocated to the covenant not to compete of only ten thousand dollars.  If the seller decided to go back into business and solicit his old customers in direct violation of the covenant, this would possibly be his only cost.

Buyers and sellers have competing goals in the area of covenants not to compete.  Anyone buying or selling a business should obtain a competent advisor who is knowledgeable in this area before signing a contract.