Covenant to not compete income

[BTS]

Taxpayers sold a 1065 business in 2022 and part of the monies was a "covenant not to compete". Total business purchase price (including non compete money) is on an installment sale for 5 years. The taxpayers "current preparer" says all of the "non compete" monies has to be claimed in 2022.  Even though the non compete monies is being paid over 5 years ?  I've searched and found nothing that says it all has to be all claimed the year of the sale. Thats taxing monies they have not received yet.  I say spread it over 5 years as Cap. Gains.  Am I wrong ?

[ILLMAS]

I don't know if you researched your question first, but here is good write up:  https://www.thetaxadviser.com/issues/2021/may/tax-issues-noncompete-agreements.html

[BTS]

1 hour ago, ILLMAS said:

I don't know if you researched your question first, but here is good write up:  https://www.thetaxadviser.com/issues/2021/may/tax-issues-noncompete-agreements.html

Read through that and other articles earlier.  None answer what I am asking.  Does the seller claim all the "non compete" the year it sells , or spread it out over the 5 years the buyers are paying it to the seller ?  The current preparer is listing all the "non compete" monies on form 4797 Pt II Ordinary Gains and Losses ? The taxpayers only received a fifth (5 year installment sale) of it. 

[Lee B]

Depending on how the covenant not to compete is worded and structured it could go either way.

There isn't enough information to tell.

[BTS]

Unfortunately all I was given is a copy of the 2022 1065 & 1040 to look at.  And a copy of the "Promissory Note" signed by the buyers.  Pretty simple note.  Lists equipment value (150k), inventory value (50k), goodwill value (150k), and non compete value (150k).  That total was $500,000.  And the 5 year payment structure of $100k plus 3% interest per year.  Taxpayers questioned the preparer as to why all the $100k in "Non Compete" had to be claimed in year one ?  The preparer is showing a $200k payment for 2022 when all that was received is $100k.  Preparer told them it was the law ?  These are friends (that are not clients) and I said I would ask around tax forums. We do not do many 1065's and those we do are pretty cut and dry.  Never came across this scenario before with "Non Compete" monies.  Seems strange the preparer is claiming it all the "non compete" when they only got a 1/5th.  

[Lee B]

Frankly, this isn't encouraging. If I had been advising a seller in a similar situation I would have insisted on a separate written covenant non compete agreement

with a separate 5 year payment structure clearly spelling that each year's payment was specifically related to the same year's non compete.

[DANRVAN]

18 hours ago, BTS said:

Total business purchase price (including non compete money) is on an installment sale for 5 years.

 

That looks clear to me, as you stated in your 2nd post $100,000 was allocated in the contract.

 

18 hours ago, BTS said:

I've searched and found nothing that says it all has to be all claimed the year of the sale.

 

Look at sec 453(b)(2) which does not indicate the covenant is excluded from installment sale treatment.

 

18 hours ago, BTS said:

I say spread it over 5 years as Cap. Gains. 

 It is ordinary, see  RR 69-643

 

 

[DANRVAN]

1 hour ago, BTS said:

  Preparer told them it was the law ?

 

Have him ask for the code section or authoritative source, or ask how section 453(b)(2) applies in his situation.

 

Looks to me like $20,000 (1/5) would be reported in 2022.

[BTS]

45 minutes ago, DANRVAN said:

 

Have him ask for the code section or authoritative source, or ask how section 453(b)(2) applies in his situation.

 

Looks to me like $20,000 (1/5) would be reported in 2022.

I agree.  I will have them ask. And see if they can get me a copy of any legal documents related to the sale.   Thanks for the input

[Lee B]

From my point of view, without the legal documents, everything is still to be decided?

[DANRVAN]

47 minutes ago, BTS said:

copy of any legal documents related to the sale. 

 

Why would you need any more documentation  if the note clearly states that $100,000  of the $500,000 principal  is allocated to the covenant?   Then clearly one-fifth of the payments are also allocated to the covenant.

 

19 hours ago, BTS said:

good write up:  https://www.thetaxadviser.com/issues/2021/may/tax-issues-noncompete-agreements.html

 

 That  article is not relevant to this situation.   The allocation has already been made and there is no reason to question it.

[Lee B]

3 hours ago, BTS said:

 . . . .  Pretty simple note.  Lists equipment value (150k), inventory value (50k), goodwill value (150k), and non compete value (150k).  That total was $500,000.   . . . Taxpayers questioned the preparer as to why all the $100k in "Non Compete" had to be claimed in year one ?  

 

[BTS]

Contacted the taxpayers and they are going to ask what code the preparer relied on for the decision to claim it all.  But I agree from my reading the non compete should be spread over the life of the promissory note.

[DANRVAN]

4 hours ago, BTS said:

why all the $100k in "Non Compete" had to be claimed in year one ?  The preparer is showing a $200k payment for 2022 when all that was received is $100k

 

6 minutes ago, cbslee said:

and non compete value (150k). 

 

Looks like preparer has several things to explain......

 

[Lion EA]

My question is why isn't the actual payment (was it $100,000?) divided proportionately into the various categories for the year of that payment? In other words, no extra "income" tacked onto a return when that "income" is over and above what was actually received in that year.

I haven't done a sale in ages and do remember something about gain due to depreciation in the first year, but your research re non-compete payments and the comments here don't lead to any special timing on the non-compete total.

[DANRVAN]

4 hours ago, BTS said:

Lists equipment value (150k), inventory value (50k),

 Inventory does not qualify for sect 453 and depreciation on equipment is subject to recapture in the year of sale.

 

  If equipment was fully depreciated then 150,000 for equipment and 50,000 for inventory would be recognized in the year of sale.

[BTS]

Everything else on the 1065 and 1040 returns are correct.  Depreciation recapture, etc..   Its just the issue of claiming the 150k in non compete all the first year.  When clearly they didn't receive it all in year one.    But their CPA says its all taxable in year one.  Emailed them questions to ask, will see how CPA responds.  

[Lee B]

5 hours ago, BTS said:

. . . . .  These are friends (that are not clients) and I said I would ask around tax forums. . .

 

16 minutes ago, BTS said:

. . . .     But their CPA says its all taxable in year one.  Emailed them questions to ask, will see how CPA responds.  . . . 

I get the fact they are your friends, but doesn't it create a weird dynamic

[BTS]

1 hour ago, cbslee said:

 

I get the fact they are your friends, but doesn't it create a weird dynamic

Kind of.  I surely do not want them to jump from current preparer to us, friends or not.  We are trying to downsize and get away from these type of returns.  And they know that we wouldn't take them on.   Been a mentally and physically tiresome year and we are not getting younger.  Need my Dr. to prescribe some Valium !!