Assume you buy a business and as part of the acquisition $100,000 is allocated to a noncompete to prevent the seller from competing against you.
The starting point for tax purposes is a business expense, which this is, is immediately deductible per section 162.
However, a noncompete is intangible property. It is not tangible, like a pencil you can hold in your hand. Intangible property cannot be deducted, but must be amortized as an expense over time. (26 USc 263).
IRS regulations for noncompete agreements can be found here.
If the amount paid for the noncompete is de minimis, meaning $5000 or less, the entire amount paid can be immediately deducted.
If the amount paid for a noncompete is more than $5000, then the entire amount paid (not just the amount over $5000) must be amortized over 15 years (26 USC 197). See IRS instructions here.
Assume you are in a 25 percent tax bracket and pay $100,000 for a noncompete. If this were deductible your tax savings would be $25,000.
But because you have to amortize the $100,000 over 15 years, the per year expense is $6667 and the per year tax savings (for 15 years) is $1667.
The amortization rules are one way the IRS screws businesses out of tax savings despite you having an immediate out of pocket cost.
Watch Out For This
Because of the tax rule some attorneys and CPAs advise that a noncompete in a contract be valued at $5000.
The problem is if the seller violates the noncompete and the buyer sues for damages. The seller may claim damages are limited to $5000 as stated for the value of the noncompete.
And This Surprising Twist
If you pay an attorney (or anyone else) to draft a noncompete and the noncompete payment must be amortized over time, the payment to the attorney must also be amortized.
To address this potential problem, if a noncompete is valued at $5000 or less for tax purposes, include this or similar language in the contract:
"The amount paid for the covenant not to compete is $5000 for tax purposes only per 26 CFR 1.263(a)-4. This amount does not reflect, and does not limit, the amount of damage or liability seller may claim if the noncompete is breached."
If the noncompete is for less than 12 months then the amount paid does not need to be amortized but can be deducted all at once.
Another possible solution is not to separately value the noncompete in the sales agreement. Due to the infinite varieties of sales agreements you should consult with a CPA as to any tax impact. An attorney, unless a specialized tax attorney, is unlikely to be of assistance for this issue.