Can I Deduct the Cost of a Noncompete Agreement?

Here's What You Need to Know About Taxation of Noncompete Agreements

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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.

This article reviews the basics of noncompete agreements and explains 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 someone else, 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 covenant not to compete) is an agreement between two parties in which one party compensates the other party for agreeing not to compete. The agreement includes details on the type of competition, along with the time period and the area over which the person cannot compete.

 In turn, the person who signs the noncompete must receive fair compensation in exchange for their agreement. This amount can be monetary or non-monetary.

Note

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

Here’s an example: JR is an executive at a software company. The company required him to sign a noncompete agreement when he was hired, keeping him from setting up a rival company within a certain area within a certain time period. In return, the company pays JR a signing bonus. 

 In another example, Cara is selling her business. The new owners want to make sure she doesn’t set up a new business down the street from them, taking all her clients with her. In return for signing the noncompete the new business pays her with shares of stock in the new company.  

Kinds of Noncompete Agreements

 There are two kinds of noncompete situations: employment agreements and business sale agreements. These two types of agreements have a lot of similarities but some key differences. In both cases, the noncompete can be a clause in a contract or a stand-alone agreement.

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

Non-compete 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 Costs for Noncompete Agreements

 In either type of noncompete agreement, the consideration is considered a legitimate business expense. If you buy a company and pay the former owner $300,000 for their agreement not to compete, you can take this $300,000 as a business expense. The same is true if you compensate an employee for signing an agreement not to compete.

The question, though, is whether you can take the expense 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. 

 In a 2010 Tax Court case, a company paid $400,000 to a former employee for a one-year covenant not to compete. The Tax Court ruled that even though the agreement was for one year, the noncompete agreement was intangible, and it should 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.

Note

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 1040?

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

Is a noncompete an asset?

In the sale of a business, the seller signs a noncompete agreement at the request of the buyer. 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 (similar to depreciation). The amount that can be amortized is set on the adjusted basis of the asset, meaning all of the initial costs of the asset.

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Sources
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
  1. Cornell Legal Information Institute. "Covenant Not To Compete."

  2. Workplace Fairness. "Non-Compete Agreements."

  3. Cornell Legal Information Institute. "Valuable Consideration."

  4. State of California Department of Justice. "Attorney General Bonta Reminds Employers and Workers That Noncompete Agreements Are Not Enforceable Under California Law."

  5. IRS. "Frontier Chevrolet Co., v. Commissioner of Internal Revenue."

  6. Leagal. "Recovery Group, Inc. v. Commissioner of Internal Revenue."

  7. The Tax Adviser. "Handling Tax Issues Related to Noncompete Agreements."

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