The federal First Circuit Court of Appeals recently rejected a taxpayer’s claim for a refund based on recharacterization of a payment for a non-competition agreement. Muskat v. United States, 2009 WL 211067 (1st Cir. 2009).

In connection with the sale of a business structured as an asset sale, the Buyer and the CEO (who was also the largest shareholder of the Seller) agreed in definitive documents that $1.0 million of the retained CEO’s new compensation package would be allocated to his non-compete covenants. Although the CEO initially recorded that payout as ordinary income for his 1998 taxes, in 2002 he filed an amended return for 1998, recharacterizing the $1 million payment as consideration of his personal goodwill, which he argued entitled him to capital gain treatment (which would have entitled him to a refund of over $200,000). The IRS denied Muskat’s request so he brought an enforcement action against the IRS. The district court, too, denied his request, finding that Muskat lacked “strong proof” that the non-competition payment was intended as payment for personal “goodwill” rather than as a covenant not to compete.

The First Circuit noted two basic principles at play in reviewing the appeal: first, generally speaking, payments in return for covenants not to compete are taxable as ordinary income and payments for goodwill are taxable as capital gains; and, second, ordinary income is usually taxed at a higher rate than capital gains. It also explained the “strong proof” rule of which Muskat’s claim was subject. This rule of heightened burden for one appealing a decision of the IRS applies “when the parties to a transaction have executed a written instrument allocating sums of money for particular items, and one party thereafter seeks to alter the written allocation for tax purposes on the basis that the sums were, in realty, intended as compensation for some other item.” Muskat argued, among other things, that his non competition agreement was in reality a payment for his personal goodwill as president of the company. The First Circuit rejected that argument, noting that his non competition agreement was a “garden-variety agreement not to compete” and it affirmed the district court’s decision. It reiterated that compensation for non-competition agreements remain ordinary income. It is only if an agreement is actually a purchase of goodwill that the compensation may be classified as a capital gains.

This case, however, raises a point of consideration for drafters and parties to non competition agreements and asset purchase agreements where one of the primary assets is goodwill. Although Muskat had to overcome a significant burden (of strong proof) to reverse the IRS qualification, the First Circuit did note that the compensation under the agreement expressly was for Muskat’s promise not to compete against the Buyer and “to protect [the target’s] goodwill.” Query whether Muskat would have prevailed if the documents allocated a portion of the consideration paid to his personal goodwill. Companies and individuals dealing in non-competition agreements in connection with the sale of a business or goodwill should consult a tax professional for advice about these issues.