My client is 50% owner in a C Corp. He is negotiating the sale of his 50% interest to the other 50% shareholder.
They have come to tentative agreement on the structure of the sale and I just want to ensure I understand how to treat everything. They have agreed on the following:
50% of cash in bank account on 4/1 paid out as compensation
$20,000 for purchase of stock on 4/1.
$350,000 for non compete paid out monthly over 12 months.
The non compete payments would be taxable as ordinary income to my client, not subject to Social Security & Medicare, correct?
However, I have been researching this, and it seems as though this non compete agreement might not really be treated as an expense to the buyer and ordinary income to the seller because it is so closely tied to the sale of the stock. See below re: Schultz. However I do believe that competition from the seller would pose substantial threat to the buyer. My client sold all of the deals. He could very easily start up his own business and move them over to him since he has the relationship with the client.
In Schultz, both the Commissioner and Tax Court found that the covenant not to compete, although stated separately as to value, was essential to the sale of good will of the business and had no real economic value of its own. The court was unable to find that the covenant had an independent basis in fact to the extent “that reasonable men, genuinely concerned with their economic future, might bargain for such an agreement.” 294 F.2d at 55. In other words, in order for the covenant to be treated as a surrender of future income, it must appear that the potential competition of the seller would pose a substantial economic threat to the buyer such that the covenant was not appended as a mere tax gimmick.