When a business sale allocates part of the purchase price to a covenant not to compete, the seller pays ordinary income tax on that amount while the buyer writes it off over 15 years. That mismatch is the core of how non-compete agreements are taxed in a business sale: the same dollar produces opposite tax outcomes for the two sides, which is why the allocation is negotiated hard and scrutinized closely by the IRS.
What the Seller Pays
Money allocated to a non-compete is ordinary income to the seller. That matters because the other big piece of most business sales, goodwill, qualifies for long-term capital gains rates that top out at 20 percent, plus the 3.8 percent net investment income tax for high earners. Non-compete payments are taxed at your marginal rate, which reaches 37 percent for single filers with income above $640,600 or joint filers above $768,700 in 2026.1Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026 The spread between the two rates is the reason sellers want the non-compete allocation kept small.
Timing matters too. A lump-sum payment at closing is taxed entirely in the year the sale closes. Spreading payments across multiple years spreads the income across those years and can keep you out of the top bracket in any single one. For a large payout, the difference between lump sum and installments can be tens of thousands in tax purely from bracket compression.
Self-Employment Tax
Non-compete payments can also trigger self-employment tax at a combined 15.3 percent rate, covering both halves of Social Security and Medicare.2Internal Revenue Service. Self-Employment Tax – Social Security and Medicare Taxes The Social Security piece (12.4 percent) applies only up to $184,500 in earnings for 2026; the Medicare piece (2.9 percent) has no ceiling.3Social Security Administration. Contribution and Benefit Base
Whether it actually applies depends on how the covenant connects to your prior activity. If the non-compete relates to services you performed as an owner or independent contractor, the IRS is more likely to treat the payment as self-employment income. Revenue Ruling 2004-49 addresses this question, and the analysis turns on whether the payment compensates you for stopping a business activity rather than transferring a capital asset.4Internal Revenue Service. Revenue Ruling 2004-49 It is fact-specific, and getting it wrong adds penalties on top of the tax.
What the Buyer Gets to Deduct
For the buyer, the non-compete allocation is a Section 197 intangible amortized over 15 years, or 180 months, in equal monthly increments starting the month the covenant is acquired.5Office of the Law Revision Counsel. 26 USC 197 – Amortization of Goodwill and Certain Other Intangibles A two-year, $300,000 non-compete produces about $1,667 in monthly deductions running long after the restriction itself has expired.
The 15-year period is mandatory. Congress set it to stop buyers from front-loading deductions on short-lived intangibles, and the IRS will disallow anything claimed on a faster schedule.5Office of the Law Revision Counsel. 26 USC 197 – Amortization of Goodwill and Certain Other Intangibles Tracking the monthly deduction accurately over a decade and a half is essential, because errors that surface in a later audit accrue interest back to the original filing.
If the Covenant Ends Early
Here the rules turn counterintuitive. If the non-compete is abandoned, becomes unenforceable, or the covenanted party dies, the buyer cannot write off the remaining balance. Section 197 provides that a covenant not to compete is not treated as disposed of until the buyer disposes of the entire business interest acquired with it.5Office of the Law Revision Counsel. 26 USC 197 – Amortization of Goodwill and Certain Other Intangibles So if the covenant becomes worthless two years in, you keep amortizing it over the remaining 13 as if nothing changed. The only path to recognizing the loss is selling or winding down the whole acquired business.
Why Non-Compete and Goodwill Amortize Over the Same 15 Years
Goodwill acquired in the same deal is also a Section 197 intangible with a 15-year life. From the buyer’s amortization standpoint, it makes no difference whether a dollar lands in the non-compete bucket or the goodwill bucket. Stock deals are a different matter. In a stock purchase without a Section 338 election, the stock price itself is not amortizable at all, so a separately negotiated non-compete gives the buyer at least some deductible amount over 15 years instead of nothing.
Why the Allocation Is a Fight
The same dollar assigned to the non-compete costs the seller ordinary income tax and gives the buyer a slow deduction, so the two sides pull in opposite directions. The seller wants the allocation small so more of the price flows to goodwill and its lower capital gains rate. The buyer’s preference depends on structure: in an asset deal, allocating to short-lived tangible assets like equipment usually beats the 15-year non-compete recovery; in a stock deal without a Section 338 election, any non-compete allocation beats no deduction at all.
Under IRC Section 1060, once the buyer and seller agree in writing on the allocation, that agreement binds both parties for tax purposes unless the IRS finds it inappropriate.6Office of the Law Revision Counsel. 26 USC 1060 – Special Allocation Rules for Certain Asset Acquisitions Neither side can quietly report a different figure later to improve their own result. The numbers on each party’s Form 8594 have to match, and mismatches are one of the easiest audit triggers in a business sale.
How the IRS Tests the Allocation
Even a signed allocation has to reflect economic reality. Courts have applied a four-part framework rooted in Forward Communications Corp. v. United States when reviewing non-compete allocations:
- Severability. The non-compete has to be economically distinct from goodwill. The seller needs realistic means and motivation to compete, such as industry knowledge, client relationships, or access to capital. An 85-year-old retiree with no remaining industry ties is a hard case to make.
- Repudiation. Neither party can walk away from the allocation after signing. Once a specific number is negotiated, both sides are held to it.
- Intent. There has to be evidence both parties genuinely meant to assign value to the covenant at the time of the deal. Documented, separate negotiations over the non-compete carry more weight than a boilerplate clause added at closing.
- Economic reality. The dollar amount has to be supported by a credible appraisal, ideally done before signing. A formal valuation quantifying the projected impact of potential competition is the strongest defense.
Fail any of these and the IRS has grounds to recharacterize the allocation, shifting the tax bill on both sides. This is where most disputes start, and it is why a professional valuation done before closing usually pays for itself.
How Non-Competes Get Valued
The standard method is the “with and without” income approach. A valuation expert builds two projections over the term of the covenant. One assumes the seller honors the restriction; the other assumes they compete. The present value of the difference in cash flows is the fair market value of the non-compete.7Internal Revenue Service. Instructions for Form 8594 – Asset Acquisition Statement Under Section 1060
The discount rate is not a generic cost of capital. It has to account for the probability the seller would actually compete and the likelihood they would succeed. A seller with deep customer relationships, specialized expertise, and capital to launch a competitor supports a higher non-compete value than a passive investor who was never the face of the business. Age, health, geographic ties, and post-sale plans all feed into that probability.
The appraiser needs multi-year financial projections, the specific terms of the covenant (geographic scope, duration, restricted activities), and information about the individual, including their reputation, client relationships, and realistic capacity to start or join a competing business. The finished valuation feeds directly into the purchase price allocation the two parties sign.
Reporting on Form 8594
After closing, both buyer and seller file IRS Form 8594, the Asset Acquisition Statement required under Section 1060, with their federal return for the year of sale.7Internal Revenue Service. Instructions for Form 8594 – Asset Acquisition Statement Under Section 1060 The form sorts the purchase price into seven asset classes. Non-competes go in Class VI, the bucket for Section 197 intangibles other than goodwill; goodwill and going-concern value are Class VII.8Internal Revenue Service. Instructions for Form 8594
The IRS cross-checks the two filings. If the written allocation says $200,000 to the non-compete, both forms need to show $200,000. Inconsistent numbers are among the most reliable audit triggers in business sale filings.
Penalties for Errors
Form 8594 is an information return, so filing errors run through the IRC Section 6721 penalty structure. Penalties per return range from $60 if corrected within 30 days to $340 if not corrected by August 1, with intentional disregard drawing $680 per return (or 10 percent of the amount that should have been reported, whichever is greater) and no annual cap.9Internal Revenue Service. 20.1.7 Information Return Penalties Beyond the filing penalty, a bad allocation can lead to income recharacterization, additional tax, and interest from the original due date.
The FTC Rule Does Not Change This
The Federal Trade Commission tried to ban most non-competes in 2024. A federal district court blocked enforcement that August, the FTC dismissed its own appeal in September 2025, and a Federal Register notice dated February 2026 formally removed the rule.10Federal Trade Commission. Noncompete Rule Non-compete agreements tied to business acquisitions remain valid under federal law, and the tax treatment described here is unaffected. State enforceability rules still vary.