Non-compete covenant won’t engender tax
Self-employment levy doesn’t apply as purpose of the commitment is to guarantee no earnings
Q: I am selling a business operated as a sole proprietorship. The buyer is paying for assets and a covenant not to compete. I know that the money allocated to the assets is not subject to self-employment tax but, since the covenant is to stop me from actually doing something, I am not sure if it is subject to self-employment tax. The buyer’s tax adviser is handling the allocation of the purchase price, but he says that I need to ask my own adviser about the selfemployment tax. Do you know?
A. The SE tax applies to income from a trade or business, as you are well aware since you must have paid this tax on your proprietorship (schedule C) income in past years. A payment for a covenant not to compete (CNTC) is not subject to self-employment (SE) tax.
The Tax Court has said that an agreement not to compete with another business is not made in the pursuit of a trade or business.
Any payments that are
received in exchange for a commitment not to compete are not received in pursuit of a trade or business and are therefore exempt from SE tax.
However, it is not always clear what a particular payment relates to and it can be difficult to separate payments for goodwill from a CNTC or from a consulting arrangement. If the purchase price allocation successfully separates the CNTC payments from other consideration, you should have ordinary income not subject to SE tax.
Q: I own stock in a family business operated as an S corporation. We are in negotiations to buy the stock of another S corporation. We want to continue to operate the new business as an S corporation and the plan is to have family members (three brothers and a sister) buy the stock in the same percentages as we own the current corporation. Our dad is willing to loan us funds we need to buy the stock, but he wants a secured interest in the assets of our current corporation. Is it OK to use assets of one
corporation as security for a loan to buy another corporation, provided the ownership is the same in both corporations?
Yes it is, and it is not even necessary that the ownership be identical. If the loan is in default and the security is transferred to your dad, it would be treated as if the corporation sold the property.
If the security is transferred to your dad, identical ownership would be helpful because the tax effect of the transfer (deemed sale by the corporation) would be shared in proportion to the use of the loan.
The proportional loan benefit would make the income tax allocation seem fair and would also avoid the need to consider the need for some ancillary characterization of use of corporate assets owned by one group to discharge a debt owned by another group.
You might also think about an alternative structure for the purchase, where the corporation you currently control buys 100 percent of the stock of the new corporation and makes a tax election to treat the new corporation as a division of the existing corporation.
An S corporation cannot have a corporate owner, so the purchase by the existing S corporation would generally cause the new corporation to lose its S corporation status.
But the tax law allows you to pretend the acquired corporation was liquidated into the parent, so that it is treated as a division rather than as a subsidiary.
This election should give you the same ownership as you propose (all family members having the same proportional ownership in both corporations), but with the need to file only one corporate tax return (Form 1120S).
If you are interested in having the corporation be the purchaser of the new corporation’s stock, the election just to treat the new corporation as a division of the current one is made by filing IRS Form 8869.
When you make the election, you pretend (for tax purposes) that the new corporation was liquidated into the current one.
The corporation will still exist for state law (and state annual filing) purposes, but will report as a division for income tax purposes.