The business owner had been working with a business intermediary (business broker) to sell her business. The attorneys were brought in very late in the transaction. Until that time, for whatever reason, little attention was paid to the allocation of purchase price for the transaction, including goodwill and a noncompete covenant.
As most astute business owners understand, there are three parties to every business sale: the buyer, the seller and the IRS. When a business is sold, it is not uncommon for a portion of its sale price to be attributable to a noncompete agreement between the seller and the buyer and, in most small businesses, a significant portion will be allocated to the departing owner(s) personal goodwill. The portion of the sale price attributable to goodwill is generally treated as a capital asset (qualifying, in most cases, for more favorable long term capital gains tax rates to the seller), and the payment received for the noncompete agreement is taxable as ordinary income to the seller. For tax purposes, a covenant not to compete is recognized when it is severable from goodwill, the agreement is separately bargained for, and the covenant can be shown to have “economic substance.”
When negotiating a business sale it vital to address the tax issues associated with the “allocation of purchase price” at the negotiation stage of the transaction. In addition to allocating the purchase price between personal goodwill and noncompete agreements a properly structured allocation will also include reasonable percentages allocated between other components of the business such as inventory, equipment and other tangible personal property owned by the business.
The buyer and seller should agree to the allocation of purchase price from the outset of the transaction (at the term sheet stage, for example) so there are no disconnects and each party is on the same page when filing subsequent tax returns and other tax information. In the end, the sale was closed but the closing was delayed while the parties worked out a fair allocation for the buyer and the seller.
At Welts, White & Fontaine, P.C. our lawyers have experience representing buyers or sellers of closely held businesses. We can help you develop strategies for a successful navigation of New Hampshire’s business transaction landscape. Please contact Attorney John Polgrean if you have questions or concerns about your business planning endeavors. (603) 883-0797. firstname.lastname@example.org
Author: John Polgrean
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