The tax treatment of a covenant not to compete cuts in opposite directions for the two sides of a business sale. The buyer must amortize the payment ratably over 15 years as a Section 197 intangible. The seller reports every dollar as ordinary income at regular rates, up to 37% for 2026.1Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026 Because the two sides want opposite outcomes on the same line item, the allocation between the covenant and the rest of the purchase price gets more IRS attention than almost any other number in the deal.
Buyer: Amortize Over 15 Years Under Section 197
A buyer cannot deduct a covenant payment in the year of purchase. Section 197 treats the covenant as an intangible asset that must be amortized ratably over 180 months, beginning the month the covenant is acquired.2Office of the Law Revision Counsel. 26 USC 197 – Amortization of Goodwill and Certain Other Intangibles The length of the restriction itself doesn’t matter. A two-year covenant and a ten-year covenant both amortize over the same 15 years.
The deduction is claimed on Form 4562.3Internal Revenue Service. Instructions for Form 4562 Fifteen years is slow, but it is still better than the alternative for many parts of a purchase price. Money paid for stock in a corporate acquisition, for example, produces no amortization deduction at all. That gap is why buyers push to allocate as much as they reasonably can to the covenant.
No Early Write-Off if the Covenant Becomes Worthless
The 15-year clock keeps running even if the covenant loses all economic value early. If the covenantor dies, retires permanently, or the restriction simply lapses after a few years, the buyer still cannot write off the remaining basis. The statute prohibits treating a covenant as disposed of or becoming worthless before the disposition of the entire interest in connection with which it was entered into.2Office of the Law Revision Counsel. 26 USC 197 – Amortization of Goodwill and Certain Other Intangibles
If the buyer disposes of one Section 197 intangible from a transaction but keeps others acquired in the same deal, any loss that would otherwise be recognized is added to the basis of the retained intangibles instead. Small amortization deductions continue over the remaining years; no lump-sum loss is available.
Seller: Ordinary Income at Regular Rates
Every payment the seller receives under the covenant is taxed as ordinary income. This is the worst available character for the seller. Payments allocated to goodwill or to stock held more than a year qualify for long-term capital gains rates, which top out at 20% for most high earners. The spread between 37% and 20% on a large payment is the whole reason sellers push back on covenant allocations.
The reasoning behind ordinary treatment is that the covenant compensates the seller for giving up future earnings, not for parting with a capital asset. That characterization stands even when the covenant is negotiated at the same time as the goodwill sale and appears in the same document.
Not Passive Income
Sellers hoping to soak up suspended passive activity losses with a covenant payment are out of luck. The IRS specifically excludes covenant income from passive activity income.4Internal Revenue Service. Publication 925 – Passive Activity and At-Risk Rules It sits in the nonpassive bucket, so it cannot absorb rental losses or other passive deductions.
No Installment Reporting
Structuring the covenant as a multi-year payout does not defer the tax. The installment method under Section 453 applies to dispositions of property, and a covenant not to compete is not a sale of property; it is an agreement to refrain from an activity. Each payment is reported as ordinary income in the year received. A five-year covenant payout means five years of ordinary income, one installment at a time.
Why the Allocation Is the Central Fight
Buyer and seller want opposite dollar amounts on the covenant line, and the IRS knows it. When both sides are well advised, the tension tends to produce allocations that reflect real economics. When one side dominates the negotiation, or when the parties quietly line up to favor the buyer, the IRS looks harder.
The core question is whether the covenant has independent economic significance apart from the goodwill transfer. Courts ask a practical version of that question: did the seller actually pose a competitive threat to the buyer after closing? The factors that matter include the seller’s age, health, financial resources, industry expertise, customer relationships, and the geographic scope of the business. A 75-year-old seller in poor health with no interest in returning to the industry is a weak candidate for a large covenant allocation.
If the covenant is just window dressing on a goodwill sale, the IRS can collapse the covenant allocation into goodwill. Both remain 15-year Section 197 intangibles, so the buyer’s amortization schedule doesn’t change, but the character on the seller’s side flips from ordinary income to capital gain. That is the outcome sellers want and buyers accept only when they have to.
Watch for Recharacterization as Compensation
When a selling owner stays on as an employee or consultant, a different challenge appears: the IRS may recharacterize the covenant payment as disguised wages or consulting fees, which pulls in employment tax withholding the parties never planned for. Courts look at whether the continuing employee is already being reasonably compensated for their services. A $200,000 salary paired with a $500,000 “covenant” payment invites a question about whether the covenant reflects genuine competitive risk or is extra compensation packaged to skip payroll taxes.
Reporting the Allocation on Form 8594
When the deal is an applicable asset acquisition — a transfer of assets constituting a trade or business, where the buyer’s basis depends on the price paid — both parties must file Form 8594 with their returns for the year of sale.5Office of the Law Revision Counsel. 26 USC 1060 – Special Allocation Rules for Certain Asset Acquisitions Section 1060 requires the total consideration to be allocated among seven asset classes using the residual method.
Covenants not to compete fall into Class VI, which covers Section 197 intangibles other than goodwill and going concern value. Goodwill and going concern value sit alone in Class VII and receive whatever purchase price is left after the earlier classes are filled.6Internal Revenue Service. Instructions for Form 8594 The form also requires a supplemental statement identifying any covenant and disclosing the maximum consideration payable under it, giving the IRS a direct view of how the parties split the price.
Buyer and seller Form 8594 allocations must match. A mismatch is one of the fastest ways to draw an examination. If the purchase agreement fixes the allocation, both parties are generally bound by it on their filings.
Penalties for Missing or Incorrect Filings
Form 8594 is an information return, and failures fall under Section 6721. For returns due in 2026, the penalties run:7Internal Revenue Service. Information Return Penalties
- Corrected within 30 days: $60 per return
- Corrected after 30 days but by August 1: $130 per return
- After August 1 or never filed: $340 per return
- Intentional disregard: $680 per return, no annual cap
The dollar penalties are usually a secondary concern. A mismatched or missing Form 8594 gives the IRS a reason to reopen the entire allocation, and that kind of review can rewrite both parties’ tax positions for years.
Documentation That Holds Up
The purchase agreement should treat the covenant as a separately negotiated element with its own stated value, not a boilerplate paragraph. The allocation needs an economic rationale behind it: what competitive threat did the seller pose, what would a competing business cost the buyer in lost revenue, and how does the covenant’s value relate to that risk. Language that just states a number without any analysis is what the IRS targets.
Contemporaneous documentation carries far more weight than reconstruction after an audit letter arrives. A short valuation memo prepared before closing — one that walks through the seller’s ability to compete, the market, and the revenue at risk — is significantly more persuasive than testimony offered years later. A formal appraisal isn’t required in every case, but the file needs to contain something more than a figure that happens to produce a favorable tax result.