Is a payment for signing a non-compete agreement earned income?

[Effen]

I have a prospective client who received a $500K payment in 2024 for signing a  “non-compete agreement”.  This will be reported on a 1099.  Can income for signing a non-complete be used as “earned income” for pension purposes? 

This person has other self-employment income that can be used, but wondering if they could also use the $500k in 2024?

[Belgarath]

Interesting. Although I'd defer to the CPA, I'm inclined to think it would qualify - the "value" of the non-compete agreement to the purchaser, and payment to the sole prop, is probably due to the material income producing efforts of the sole prop in 401(c)(2). Just IMHO. Seems a little "gray" to me.

[C. B. Zeller]

What does your prospective client do and who paid them the $500k?

I'm guessing your prospective client is a consultant or something along those lines, and this payment was from one of their clients who wants to preclude them from providing their services to any of their competitors? So not really a non-compete, but more of an exclusivity agreement? Or maybe something that prevents your prospect from going into business for themselves in competition with their client?

If that's the case, then I think it probably is usable for pension purposes, as it directly relates to the services they provide as part of their business. Essentially they received a bonus for doing such good work that their client wants to keep your client to themselves.

On the other hand, if your prospective client isn't providing ongoing services to the person that paid them the $500k, then I would feel differently about it. For example if the payer felt that whatever your client is doing might be a threat to their business, so they are paying them $500k to get lost. In that case, the payment is for work they are NOT doing and would probably not be usable income for a pension.

Interesting question! I'll qualify my entire reply here and say that this is a bit outside my area of expertise - I would recommend getting an attorney to review the facts.

[Paul I]

The client should have a discussion with their personal tax attorney, CPA or tax return preparer about how the $500,000 non-compete payment will be recognized on the client's personal tax return.  The topic is beyond the expertise of most retirement plan consultants.  I suggest taking a look at the following sources to see the types of issues that are involved:

• https://willamette.com/837/Noncompetes_2022.pdf
• https://www.thetaxadviser.com/issues/2021/may/tax-issues-noncompete-agreements.html

From the perspective of a retirement plan, ultimately you will want the client to provide documentation of how much if any of the payment will be reported as net earnings from self-employment for a year on the individual's personal tax return.

[david rigby]

Interesting topic @Effen.  I hope to hear how this question is resolved.

[fmsinc]

https://www.thetaxadviser.com/issues/2021/may/tax-issues-noncompete-agreements.html

[Dare Johnson]

The IRS instructions for Form 1099 indicate that non-compete payments are reported on Form 1099-Misc Box 3, other income, and therefore not subject to self-employment taxes.  

The additional Medicare tax (2.9% + .9%) on $500k would offset any benefit of an increased retirement plan deduction so it doesn't make sense to report as self-employment income.

 

[Effen]

Thank you.  The article was very helpful.  Covenants not to compete are intangible assets amortized over 15 years (Sec. 197(d)). This makes it clear that they would not be "earned income".  However, the article mentions a potential restructuring of the Covenants into a consulting agreement, "to the extent that a portion of the consideration can be legitimately attributed to the consulting agreement" but it seems like this is generally done to favor the buyer.

Thank you all.  

[Belgarath]

Interesting information!