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

Irwin Muskat was the CEO and largest shareholder of his company, Jac Pac Foods. He entered into an agreement with Corporate Brand Foods America to sell the company with him to remain as CEO. Muskat’s overall compensation package (a part of the asset purchase agreement between Jac Pac and Corporate Brand) included a covenant not to compete, in return for which he was provided separate compensation from his salary at the now-sold company, including an initial $1 million payout under the non-competition agreement.

Although Muskat 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 a capital gain (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 “good will” rather than as a covenant not to compete.

The First Circuit noted two principles in reviewing Muskat’s appeal of this decision; first, that 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, that ordinary income is usually taxed at a higher rate than capital gains. It also explained the “strong proof” rule to 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 reality, intended as compensation for some other item.”

Here, Muskat argued, among other things, that his non competition agreement was in reality a payment for his personal goodwill as president of the company, which was what Corporate Brand purchased in connection with the non competition agreement. 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 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 purchaser (Corporate Brand) and “to protect Jac Pac’s goodwill.” Thus, the questions then raised are whether Muskat could or should have executed separate agreements to take the tax benefits of the goodwill presumably purchased as a part of the sale of the business and whether, ab initio, it was the heightened legal burden placed on Muskat that kept him from successfully qualifying his compensation as a capital gain. The company or individual dealing in non-competition agreements in the sale of a business or goodwill should consult a tax professional for advice about these issues.