The following article is adapted from reprinted from the M&A Tax Report, Vol. 7, No. 7, February 1999, Panel Publishers, New York, NY.

COVENANTS NOT TO COMPETE: BE REALISTIC

By Robert W. Wood, San Francisco

In the context of private company acquisitions, particularly closely held and family businesses, the amount of consideration allocated to a covenant not to compete often sparks debate. Although the buyer may have strong non-tax reasons for insisting upon a covenant not to compete that is both broad, of sufficient duration and yet that is enforceable under state law, the seller also has reasons for receiving noncompete and consulting payments. All too often, the sellers do not adequately distinguish in their own minds between the tax treatment of the covenant payment and the payments for consulting or other services.

C.H. Robinson Case

The recent case of C.H. Robinson, Inc., et al. v. Commissioner, T.C. Memo 1998-430 (1998), underscores the importance of maintaining this distinction. In the C.H. Robinson case, C.H. Robinson, Inc. and Meyer Customs Brokers, Inc. were engaged in the business of rendering customs brokerage services. The president and sole shareholder of the Meyer company (Mr. Meyer) was a well-respected and well-known customs broker. Accordingly, C.H. Robinson, Inc. and its subsidiary, C.H. Robinson International, began negotiations to acquire Meyer's assets, including its goodwill. The closing occurred in 1990, with C.H. Robinson International making a cash payment of $300,000 to Meyer Customs Brokers, plus paying $1.3 million to Meyer individually under a three-year covenant not to compete. For each of the years 1990 through 1992, Mr. Meyer received an additional $292,000 under the covenant.

On top of the covenant not to compete, Mr. Meyer entered into a three-year employment agreement, calling for contingent salary bonuses, depending on whether Robinson International reached its net profit goals for each of the respective years. Mr. Meyer received annual payments of $250,000 as bonuses for 1990 through 1992. International deducted these payments (as well as the amounts paid to Meyer under the covenant) as ordinary business expenses. The IRS disallowed the deductions, asserting that they were nondeductible capital expenditures.

Covenant Too Rich

In Tax Court, the IRS view was upheld, the Tax Court concluding that payments for the covenant represented nondeductible capital expenditures because the payment relating to the covenant did not reflect economic reality. The court concluded that the $1.3 million paid to Mr. Meyer at the closing (in addition to the $300,000) was effectively a payment for the company's assets. After all, the two cash payments, $1.3 million plus $300,000, closely resembled the original terms by which International was to pay $1.5 million for the target's assets. This particular feature of the case, which seems obvious, should be a strong warning to those who argue back and forth about an allocation of purchase price following an original statement that a particular price would be paid for the assets.

The Tax Court in C.H. Robinson, Inc. went on to hold that the additional payments under the covenant not to compete were deductible business expenses, finding that they did reflect economic reality. The court noted that Mr. Meyer had sufficient capital available and the ability to start a new customs brokerage business to compete with International. This real life ability to compete is often a factor in these cases, making the courts willing to allocate significant dollars to a covenant not to compete.

Finally, the Tax Court concluded that the annual salary bonuses were properly deductible, constituting ordinary and necessary business expenses. The court found that these payments constituted reasonable compensation. The court also noted that the company's earnings depended primarily on Mr. Meyer's efforts. Meyer maintained all of the former clients of Meyer Customs Brokers, and managed the expansion of the company post-acquisition. The court also found that the bonuses paid to Mr. Meyer were comparable to his annual salaries prior to the acquisition.

Conclusion

The lesson of C.H. Robinson, Inc. v. Commissioner is clear. One should be realistic in allocating amounts between a covenant not to compete and salary or bonus amounts. More importantly, one should be realistic in allocating payments between a covenant not to compete and the purchase price for assets.

Covenants Not to Compete: Be Realistic, Vol. 7, No. 7, M&A Tax Report (February 1999), p. 3.