Every business broker will probably agree that a covenant not-to-complete makes good business sense. No buyer would ever want the seller, after closing, to go into competition the next day, next door to the sold business.
Unfortunately, since 1993 (or covenants executed on or August 10, 1993), a covenant-not-to compete cannot be amortized over its term. Rather, the covenant is treated as part of the goodwill and can only be amortized over fifteen years. This is substantially disadvantageous for small businesses and therefore, buyers may consider using a consulting agreement with the seller in order to deduct (consulting) payments as they are paid, or if prepaid, ratably over the term of the consulting agreement. However, for many reasons, including those below, consulting agreements should be drafted carefully, and tax counsel should assist in advising on the use of a consulting agreement.
The Consulting Agreement
To begin with, a consulting agreement is very much unlike a covenant not-to-compete, and does not replace the use of a covenant. While the agreement language may be included within the body of the sales agreement, just like a covenant, and may say that it forbids competition/consultation with others during the consulting period, the similarities probably end there.
The first major difference is obvious; a consulting agreement is based on having the seller (or the seller’s owner) provide services. It must require that the seller be available, that there be value to having the seller’s services and if asked, that the seller actually provide services. An arrangement which guarantees the seller will be paid, even if the seller refuses to perform work, probably will not be treated as a consulting agreement.
The second difference is that payments for services are treated very differently to the seller for tax purposes. It is not only that they are taxed at ordinary income tax rates, but that the payments made may be subject to self-employment tax. The additional taxes to the seller may be very significant and a deal breaker, unless the seller already has other wage income that exceeds the OASDI limit.
In addition, the timing of income recognition of payments on the consulting agreement to the seller may be affected by Section 409A of the Code. If not properly drafted, in certain circumstances, it may trigger constructive receipt of consulting fees. This means that provisions in the agreement must be well drafted. Furthermore, all of these tax differences may discourage the seller from accepting a sizable consulting agreement, if the seller would rather have payments characterized as capital gains (or ordinary income, not subject to self-employment tax.)
A third difference is that the IRS may look at the terms of the consulting agreement, and the facts and circumstances as to services to determine that the allocation of payments to the consulting agreement is reasonable. Here, the Service is looking at the buyer as to whether a portion of the consulting agreement payments, or all of it, should be reallocated to goodwill, a covenant, or the assets sold. For example, a severance payment, without adjustment, at death may be a significant factor indicating that consultations were not required.
Indeed, being too “piggy” here can cause an IRS challenge. In Heritage Auto Center, Inc. v. Commissioner T.C. Memo 1996-21 a 50/50 division between the covenant not-to-compete and the consulting agreement, wherein the draft agreement (term sheet) identified that all of the consulting fee was originally part of the allocation to the covenant initially, was considered too high of an allocation. The court noted that the seller was not needed for providing services and was not called upon to consult. This court conclusion might have been very different, if the seller had been given a significant role, such as serving on the board of directors of buyer, and negotiating major contracts for buyer.
While the use of covenants not-to-compete are a standard practice, the use of reasonable consulting agreements, well drafted, with the advice of legal counsel may assist buyers in maximizing deductions on the purchase of a business. Consulting agreements, like covenants, may also make good business sense.