Covenant Not to Compete: Section 197 Amortization and Form 8594

When a business changes hands and part of the price is paid for the seller’s promise not to compete, the buyer must amortize that payment straight-line over 15 years as a Section 197 intangible, and the seller reports it as ordinary income. That is the core of covenant not to compete tax treatment, and it holds even when the covenant itself only restricts the seller for two or three years. The mismatch between the covenant’s real life and its 15-year tax recovery window drives most of the planning, and most of the surprises.

Why the 15-Year Rule Applies

Section 197 of the Internal Revenue Code lists a covenant not to compete as an intangible asset whenever the agreement is entered into “in connection with an acquisition (directly or indirectly) of an interest in a trade or business or substantial portion thereof.”¹ The statute also sweeps in any arrangement with “substantially the same effect,” so relabeling the restriction as a consulting limitation or transition services clause changes nothing.

This applies whether the buyer takes the whole company, a division, or a meaningful chunk of operating assets, and whether the covenant is priced separately in the purchase agreement or bundled with goodwill. Once it is tied to a business acquisition, Section 197 controls.

One boundary worth flagging. A non-compete tied to a plain employment arrangement, rather than to the purchase of a business, is not a Section 197 intangible if the payment represents reasonable compensation for services actually performed.² The IRS watches this line closely, because misclassifying an acquisition covenant as employment pay would let the buyer deduct the cost far faster than 15 years.

What the Buyer Actually Deducts

Section 197 requires the buyer to amortize the covenant ratably over 15 years (180 months), starting with the month the intangible is acquired.¹ Ratably means equal monthly amounts, which is the straight-line method. A buyer who pays $150,000 for a three-year covenant deducts $10,000 a year for 15 years, not $50,000 a year for three.

Congress chose that period to put every Section 197 intangible (goodwill, customer lists, covenants, and the rest) on the same schedule and end fights over useful life. The practical effect is that the seller’s competitive restraint expires long before the buyer is done writing off the cost.

No Early Write-Off When the Covenant Expires

If the covenant expires or becomes worthless before the 15 years are up, the buyer generally cannot claim the remaining unamortized balance as a loss. Section 197(f)(1) blocks that deduction so long as the buyer still holds any other Section 197 intangible from the same transaction.¹ Since nearly every business acquisition produces goodwill at a minimum, this rule almost always bites.

Instead of a loss, the leftover basis of the expired covenant is added to the basis of the remaining Section 197 intangibles from the same deal and continues to be recovered through their ongoing amortization. A loss deduction only opens up once the buyer disposes of all the Section 197 intangibles acquired in the transaction.

Covenants carry an extra restriction on top of that. Section 197(f)(1)(B) provides that a covenant cannot be treated as disposed of or worthless until the buyer disposes of the entire business interest connected to it.¹ Even after the three-year non-compete has lapsed and the seller is competing openly again, the buyer keeps amortizing on the same 15-year schedule until the business itself is sold.

Contingent and Installment Payments

Many purchase agreements pay part of the covenant amount in installments or tie it to future performance. When a contingent payment increases the covenant’s basis during the 15-year window, the extra amount is amortized ratably over whatever is left of that original 15-year period, starting in the month of the basis increase.²

If a contingent payment arrives after the original 15-year period has fully expired, the entire amount is deductible immediately in the year it is properly included in basis.² Late-arriving contingent payments are the one situation where a buyer gets faster-than-15-year recovery.

What the Seller Owes

The seller’s side of the covenant looks nothing like the sale of the underlying business. Payments received for agreeing not to compete are ordinary income, not capital gain. They are not proceeds from selling a capital asset; they are compensation for restricting the seller’s own future business activity. Ordinary rates run higher than long-term capital gains rates, and the whole payment is taxed in the year received (or accrued), without the preferential treatment that applies to goodwill and other capital assets.

Section 197(f)(3) treats amounts paid under a covenant as chargeable to a capital account, which governs the buyer’s side but also reflects the statute’s view that these payments sit apart from the sale of the underlying business assets.¹

This creates a natural tug-of-war in negotiations. Sellers want the covenant priced low because ordinary rates hurt. Buyers want it priced high because a separately identifiable intangible can be amortized, while extra dollars pushed into stock basis produce no current tax benefit at all. Whatever the parties agree in writing becomes binding on both of them under Section 1060, so the deal-table numbers have permanent tax consequences.³

Allocation, Valuation, and Form 8594

The dollar amount assigned to the covenant is one of the most audit-prone pieces of any business acquisition. The IRS knows buyers have an incentive to inflate it and that sellers sometimes go along if the overall economics still work. Courts apply an “economic reality” test: the covenant has to reflect a genuine competitive threat, not a label pasted onto a portion of the purchase price.

When examining an allocation, the IRS and courts weigh whether the seller could realistically compete (age, health, and industry standing all matter), the geographic and industry scope of the restriction, its duration and enforceability under state law, whether the allocation was truly arm’s length, and whether the covenant’s share of the total price is plausible against the value of the goodwill and other assets acquired.⁴ A formal pre-closing appraisal from a qualified valuator does not guarantee the number will survive audit, but it strengthens the buyer’s position considerably.

If the IRS wins a valuation adjustment that causes a tax underpayment, accuracy-related penalties under Section 6662 apply. The standard penalty is 20% of the underpayment attributable to a substantial valuation misstatement, defined as claiming a value 150% or more of the correct amount. If the overstatement reaches 200% or more, the penalty doubles to 40%. The penalty only kicks in when the underpayment attributable to the misstatement exceeds $5,000 ($10,000 for C corporations), a threshold easily crossed in a real deal.⁵

Both parties report the allocation on Form 8594, the Asset Acquisition Statement required by Section 1060, attached to their income tax return for the year the sale closes. The form splits the purchase price into seven asset classes. Covenants not to compete land in Class VI, the class for Section 197 intangibles other than goodwill and going concern value (which are Class VII).⁶

The IRS automatically matches the buyer’s and seller’s Form 8594 filings, so any inconsistency is an audit flag. A written allocation agreement locked down before filing is binding on both sides under Section 1060 unless the IRS determines it is not appropriate.³ Missing the filing deadline without reasonable cause can trigger penalties under Sections 6721 through 6724.⁷ Timely filing also fixes the start date for the 15-year amortization clock, which matters if the IRS later questions when the deductions began.

1
Office of the Law Revision Counsel. 26 USC 197 – Amortization of Goodwill and Certain Other Intangibles
2
eCFR. 26 CFR 1.197-2 – Amortization of Goodwill and Certain Other Intangibles
3
Office of the Law Revision Counsel. 26 USC 1060 – Special Allocation Rules for Certain Asset Acquisitions
4
Internal Revenue Service. Reasonable Compensation Job Aid for IRS Valuation Professionals
5
Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments
6
Internal Revenue Service. Instructions for Form 8594 – Asset Acquisition Statement Under Section 1060
7
Internal Revenue Service. Instructions for Form 8594 (11/2021)