Non-Compete Agreement Was Not Properly Taxable to Partnership, Since It Bound Corporation and Two Employees Only

While the case of DJB Holding Corporation v. Commissioner, 116 AFTR 2d ¶ 2015-5313, CA9, principally involved the issue of the lack of existence of a purported partnership (which is discussed elsewhere), there was another issue of interest.

The taxpayers in question had sold the assets of a C corporation owned by a partnership that was itself owned by two S corporations that the individuals controlled via ESOPs.  The agreement had provided that $3.4 million of the sales price represented an agreement not to compete.

The taxpayers had reported that amount in its entirety on the return of the partnership that owned the C corporation, causing it to flow out to the S corporations and, since they were each owned 100% by an ESOP, no current tax would be due nor was any paid.

At the trial court level the Tax Court had held that, in fact, the agreement not to compete was entirely income of the C corporation.  The Court noted that the agreement bound the C corporation and each of the two employees, blocking their ability to compete with the new owner.  The Court went on to find that since the employees, as officers, were bound to provide their services to the corporation that the entire balance of the agreement represented income to the C corporation.

The Ninth Circuit sustained the result, but did not agree with the reasoning—and also strongly suggested that no one had actually suggested what should have been the actual treatment.

The Ninth Circuit noted that under California law all employment is at will.  As well, the individuals were currently working for the S corporations as employees and not for C corporation (the S corporation provided services to the C corporation).  And even at the S level, they had the right to quit.  Thus, the panel found, they had to be personally bound not to compete and, in fact, had been so bound.

But while agreeing that the entire agreement was not necessarily income of the C corporation, the panel noted that nothing suggested the partnership had a right to this income.  Thus the Court found that the Tax Court had not erred in finding that it was not reasonable to allocate any of the non-compete agreement to the partnership.

In a footnote, though, the panel did make a suggestion that may be helpful in planning for such arrangements, at least in a state with laws like California.  While some of the non-compete was the corporation’s, it also clearly was related to each of the two owners.The panel noted in footnote 9:

Were the question before us, we may be inclined to hold that the Tax Court clearly erred in failing to assign any share of the noncompetition agreement's proceeds to Barone and Watkins individually. Neither party has asked that we do so.

Since the taxpayers were “swinging for the fences” with their position (looking to get a full deferral of the non-compete agreement) it appears they had not raised the fallback position that a majority of the $3.4 million should have been taxed directly to them rather than going through the C corporation.  And, given that the redemption of the C shares would flow through the S corporations and into the ESOPs, the situation may have been one where, in fact, this result was “better” for the taxpayers, at least in the short-term.