Amortization of a covenant not to compete acquired with a business runs straight-line over 15 years under Internal Revenue Code Section 197, no matter how long the covenant itself lasts. The deduction begins in the month of acquisition and runs for exactly 180 months. Divide the amount allocated to the covenant by 180, and that’s your monthly write-off; multiply by 12 for the annual figure you’ll claim on Form 4562.
A $150,000 covenant produces $833.33 per month, or $10,000 per year, every year for fifteen years. A three-year covenant produces the same schedule. A five-year covenant produces the same schedule. The contractual term of the promise doesn’t drive the tax recovery period.
Why the 15-Year Period Is Fixed
Section 197 sweeps a long list of intangibles acquired in connection with a business into one mandatory amortization framework, and covenants not to compete are explicitly named.1Office of the Law Revision Counsel. 26 US Code 197 – Amortization of Goodwill and Certain Other Intangibles Goodwill, customer lists, workforce in place, and covenants all share the same 180-month recovery period. Congress chose a uniform period to eliminate disputes over useful life and to prevent buyers and sellers from tailoring shorter contractual terms to accelerate deductions.
The deduction flows through your return on Form 4562, which handles depreciation and amortization for all qualifying assets.2Internal Revenue Service. Form 4562 – Depreciation and Amortization
Early Termination Does Not Accelerate the Write-Off
This is the trap. If your three-year covenant expires in year three, or the seller breaches it in year two, you might expect to deduct the remaining unamortized balance. You can’t. Section 197 contains a special rule aimed directly at covenants: the covenant is never treated as disposed of or worthless until you dispose of the entire business interest connected to it.1Office of the Law Revision Counsel. 26 US Code 197 – Amortization of Goodwill and Certain Other Intangibles You keep amortizing the original cost over the remaining months of the 15-year period as if nothing changed.
The Treasury regulations give a concrete example: a covenant entered into in connection with a stock purchase continues to be amortized ratably over the full 15-year recovery period even after the covenant expires, unless all of the acquired business interests are also disposed of or become worthless.3eCFR. 26 CFR 1.197-2 – Amortization of Goodwill and Certain Other Intangibles
The broader anti-abandonment rule under Section 197(f)(1) reinforces this. If you dispose of any Section 197 intangible while retaining others acquired in the same transaction, no loss is allowed. The remaining basis from the abandoned intangible gets folded into the basis of the retained intangibles.1Office of the Law Revision Counsel. 26 US Code 197 – Amortization of Goodwill and Certain Other Intangibles The only way to recognize a loss is to sell or dispose of the entire bundle of Section 197 intangibles from that acquisition.
The Allocation Number Drives Everything
The 15-year rule tells you the schedule. It says nothing about the dollar figure you’re spreading. That number comes from the purchase price allocation under Section 1060, which requires both buyer and seller to use the residual method for dividing the total price among acquired assets.4Office of the Law Revision Counsel. 26 USC 1060 – Special Allocation Rules for Certain Asset Acquisitions
The residual method fills seven asset classes in priority order. Tangible assets like cash, inventory, and equipment go first. What remains flows to intangibles. The covenant not to compete falls into Class VI, which covers Section 197 intangibles other than goodwill and going concern value. Any leftover consideration after Class VI lands in Class VII: goodwill.5Internal Revenue Service. Instructions for Form 8594
A written allocation agreement between buyer and seller binds both parties for tax purposes unless the IRS determines it’s inappropriate.4Office of the Law Revision Counsel. 26 USC 1060 – Special Allocation Rules for Certain Asset Acquisitions Both sides then report the agreed allocation on Form 8594, filed with each party’s tax return for the year of the acquisition.6Internal Revenue Service. About Form 8594, Asset Acquisition Statement Under Section 1060 The mutual reporting requirement is what gives the number its teeth. If the buyer’s Form 8594 and the seller’s Form 8594 don’t match, both returns get flagged.
Valuation and Audit Risk
Buyers naturally want a large amount allocated to the covenant, because the full figure amortizes. Sellers generally push the other way, because covenant proceeds are ordinary income for them rather than capital gain. The compromise number has to reflect economic reality, and the IRS watches both sides.
A defensible valuation looks at the seller’s actual ability to compete: industry expertise, customer relationships, financial resources to launch a rival operation. A seller with all three supports a meaningful covenant value. A passive owner who hasn’t touched daily operations in years does not. Assigning a large payment to a covenant against someone who couldn’t realistically compete is exactly the kind of allocation the IRS challenges.
Valuation professionals typically model the economic harm the buyer would suffer without the covenant, comparing projected cash flows with and without the competitive threat. An independent appraisal done at the time of the deal is the strongest defense in an audit. If the IRS decides the covenant has no independent economic substance, it can reclassify the payment as goodwill. Because both categories amortize over 15 years, the buyer’s deduction timing doesn’t change, but the reclassification hits the seller and can bring penalties.
The accuracy-related penalty for a substantial valuation misstatement is 20 percent of the resulting tax underpayment. For a gross valuation misstatement, it climbs to 40 percent.7eCFR. 26 CFR 1.6662-2 – Accuracy-Related Penalty Those penalties reach both parties.
How the Covenant Differs From Goodwill
Under Section 197 the tax treatment is identical, but the two assets are conceptually distinct, and the distinction affects how much you can reasonably allocate to each. Goodwill reflects the acquired business’s overall reputation and earning power. A covenant is a personal restriction on a specific seller not to act. It’s tied to that person’s promise, not the business’s general standing. That matters when a valuation expert has to justify the split, and it matters if a court later voids the covenant for overreach on time or geography. A voided covenant can leave the buyer without the competitive protection it paid for, and without a clean basis for the allocation the IRS is now free to revisit.
Filing the Deduction
Report the annual amortization on Form 4562 each year for 15 years.2Internal Revenue Service. Form 4562 – Depreciation and Amortization File Form 8594 with your return for the year of the acquisition to document the allocation, and file an amended Form 8594 if the allocation later changes.6Internal Revenue Service. About Form 8594, Asset Acquisition Statement Under Section 1060 Failing to file a correct Form 8594 by the due date can trigger information return penalties under Sections 6721 through 6724.5Internal Revenue Service. Instructions for Form 8594
State Conformity Is Not Automatic
Most states follow the federal Section 197 framework, but not all. Some states conform to the Internal Revenue Code as of a fixed date, so recent federal changes may not flow through automatically. Others decouple from specific federal provisions or impose their own adjustments. If you operate across multiple states, verify each state’s treatment before assuming the 15-year federal schedule carries over to the state return.