Individuals often provide services to closely owned businesses in which they own an interest. When an individual ends a regular employment relationship with such a business, payments may be made for the redemption or other transfer of the individual’s ownership interest, for ongoing consulting or transitional services, and for covenants that may preserve the business’ earnings and value, such as a covenant by the individual not to compete with the business for a specified period of time after the buy-out. The tax consequences of these categories of payments vary greatly, and the individual, the business, and its remaining owners will thus typically have a keen interest in the precise classification of any payments for tax purposes.
Any payments received for services or for a covenant not to compete will result in ordinary income, but payments received as consideration for surrender of an ownership interest in the business will generally result in capital gain, and then only if the consideration received exceeds the individual’s basis in the interest. From the perspective of the business, if conducted in corporate form, and its continuing owners, a payment for the redemption of stock (or its purchase by other owners) will generally not result in any immediate tax benefit, while a payment for services will be deductible over the period to which the services relate. If the business obtains a covenant not to compete from the individual, the deductibility of payments made for the covenant will depend on special rules explored by a recent case.
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