Covenant not to compete SE tax

Technical topics regarding tax preparation.
#1
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Seems strange that someone collecting on a covenant not to compete has to pay SE tax on the payment.

You are receiving money not to work. I am missing something? Pro Series is showing the covenant as subject to SE tax. I put the income on page 1 of the 1065. Should I be putting the income in a different spot?

Thanks
 

#2
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The payment for a covenant not to compete can represent compensation for surrendering future income. It can also be indistinguishable from goodwill and taxed differently.

There is an excellent article in the April 2011 edition of The Tax Adviser that discusses this issue:

https://www.thetaxadviser.com/issues/2011/apr/clinic-story-01.html
 

#3
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Seems strange that someone collecting on a covenant not to compete has to pay SE tax on the payment


That would be very strange indeed, given that it’s not subject to SE tax.

Pro Series is showing the covenant as subject to SE tax. I put the income on page 1 of the 1065. Should I be putting the income in a different spot?


Hopefully your software has an SE worksheet somewhere. You should use it. Otherwise ProSeries isn’t gonna know…
 

#4
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Thanks Jeff forgot about that sheet. I knew it didn't look right
 

#5
dave829  
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Jeff-Ohio wrote:
Seems strange that someone collecting on a covenant not to compete has to pay SE tax on the payment

That would be very strange indeed, given that it’s not subject to SE tax.

I disagree. Case law says that whether amounts received for a covenant not to compete are net earnings from self-employment depends upon whether the taxpayer is holding himself or herself out to others. Take a look at the following cases:

Barrett, 58 T.C. 284 (1972) (not SE income, taxpayer did not offer services to anyone else)
Barnett, 69 T.C. 609 (1978) (SE income, contract did not prohibit working for anyone else)
Steffens, 707 F.2d 478 (11th Cir. 1983) (reversing TC, not SE income, taxpayer did not offer services to anyone else)
Hornaday, 81 T.C. 830 (1983) (SE income, contract did not prohibit working for anyone else)
 

#6
Pitch78  
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Those appear to be consulting agreements and not non-competition agreements. A different animal.

If you cannot compete, how can you offer services to another?
 

#7
dave829  
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Every non-competition clause that I've seen is in a consulting agreement or is a separate agreement that is signed at the same time as a consulting agreement. Have you seen otherwise?
 

#8
Pitch78  
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Yes, i have seen otherwise. If the consulting agreement allows you to offer services to others, then it is not a non-compete.
 

#9
JR1  
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Must be a locale thing. I've never seen non-competes included as consulting agreement.
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#10
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This issue is far more complicated than I first thought. The courts have not reached a conclusion yet that payments received under a covenant not to compete are not per se subject to self-employment tax. I think that it depends on the circumstances. See the following cases:

Milligan, 38 F.3d 1094 (9th Cir. 1994) (termination payments received by a retired State Farm insurance agent were not subject to self-employment tax despite the fact that they partially derived from a noncompetition agreement).

Jackson, 108 T.C. 130 (1997) (if termination payments received by a retired insurance agent are for a covenant not to compete, they are not self-employment income, but such payments are not per se excluded from self-employment tax in every case).

Muskat, 554 F.3d 183 (1st Cir. 2009) (court refused to consider the question of whether annual payments for a covenant not to compete over a period of 13 years were subject to self-employment tax because the taxpayers did not raise the self-employment tax issue in their administrative refund claim).

Peterson, 827 F.3d 968 (11th Cir. 2016) (one judge dissented from the majority’s opinion that the portion of payments made to a retired Mary Kay consultant that were allocable to a covenant not to compete were not subject to self-employment tax. Judge Rosenbaum said that since the payments were not deferred compensation, they were subject to self-employment tax).
 

#11
Pitch78  
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What Jeff said was that payments for non-competes are not subject to SE. That is true.

I only scanned the Peterson case, and the majority found that the payments to the petitioner were not for the non-compete. So the non-compete was irrelevant.

If your question is whether the payments in your scenario are for a non-compete we would need alot more facts and probably could not give you a definitive answer.

Jackson pretty much sums it up. If they are for a non-compete, then not subject to SE. Just because a non-compete is present and a sum is allocated to the non-compete does not mean that the IRS is bound by that allocation.
 

#12
dave829  
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Pitch78 wrote:Jackson pretty much sums it up. If they are for a non-compete, then not subject to SE. Just because a non-compete is present and a sum is allocated to the non-compete does not mean that the IRS is bound by that allocation.

I don't think it's all that simple. The court first said no SE tax, but then walked back a bit from that conclusion. Here are the relevant excerpts from that case:

If the termination payments are for a covenant not to compete, they are not self-employment income. Payments attributable to a covenant not to compete are not “earned” income, Furman v. United States, 602 F.Supp. 444, 451 (D.S.C. 1984), affd. without published opinion 767 F.2d 911 (4th Cir. 1985), and they are not subject to self-employment tax. Barrett v. Commissioner, 58 T.C. 284 (1972); see also Ohio Farm Bureau Federation, Inc. v. Commissioner, 106 T.C. 222, 236 n.8 (1996). The purpose of the termination payments under the Agreement was to compel petitioner to refrain from entering into an insurance business as a competitor of State Farm. Clearly, State Farm wanted to protect the customer base for its products that had been developed by petitioner during the course of his active affiliation with the company.

* * * * *

In Barrett v. Commissioner, 58 T.C. 284, 289 (1972) (rejected sub silentio with respect to its focus on the “goods-and-services test” in Groetzinger v. Commissioner, 82 T.C. 793 (1984), affd. 771 F.2d 269 (7th Cir. 1985), affd. 480 U.S. 23 (1987)), we accepted the parties’ agreement “that noncompetition does not constitute the carrying on of a trade or business.” In addition, in Ohio Farm Bureau Fedn., Inc. v. Commissioner, 106 T.C. 222, 236 (1996), we suggested that the rationale in Newberry v. Commissioner, 76 T.C. 441 (1981), supported the holding that income from a nonsponsorship and noncompetition agreement does not constitute “unrelated business income” under the definition of that term in section 512(a). Those cases, however, do not mandate the conclusion that income received from a covenant not to compete is per se excluded from the reach of SECA.
 

#13
JR1  
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I'd say they pretty well confirmed no SE tax, other than in some odd situations where there are other considerations.
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#14
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This issue is far more complicated than I first thought.


No it’s not.

Just because a non-compete is present and a sum is allocated to the non-compete does not mean that the IRS is bound by that allocation.


That wasn’t the question. We all know the IRS could change around an allocation.

If you are telling DavidLat that he needs to do so some kind of analysis to ascertain if the allocation was proper in the first place, he will probably tell you to go fly a kite.
 

#15
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A few more details if they help:

Covenant was in connection with the sale of a restaurant. The prior owners can not open up another restaurant for 5 years within 5 miles of the restaurant they sold.
 


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