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15 02-19 "C" Corporation Asset Sale - Martin Ice Cream and Bross: Personal Goodwill To Reduce the "Double" Tax

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The Problem of Sale of "C" Corporation - it is usually a sale of the assets. What is Personal Goodwill? What are the benefits? What are the characteristics? What happened in Martin Ice Cream to make personal goodwill so attractive? It was affirmed in Norwalk, but the taxpayer lost in Solomon and Howard. The 2014 Bross Trucking case affirmed that there is a pro-taxpayer approach as did the estate tax case of Adell. How do you do the planning for this? First, you must do it years in advance of a sale. You need to value the personal goodwill and document it.

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15 02-19 "C" Corporation Asset Sale - Martin Ice Cream and Bross: Personal Goodwill To Reduce the "Double" Tax

  1. 1. LAW OFFICES GIVNER & KAYE A PROFESSIONAL CORPORATION SUITE 445 12100 WILSHIRE BOULEVARD LOS ANGELES, CALIFORNIA 90025 www.GivnerKaye.com BRUCE GIVNER (bruce@GivnerKaye.com) OWEN D. KAYE (owen@GivnerKaye.com) KATHLEEN GIVNER (kathy@GivnerKaye.com) NEDA BARKHORDAR (neda@GivnerKaye.com) PHONE (310) 207-8008 (818) 785-7579 FAX (310) 207-8708 (818) 785-3027 February 19, 2015 “C” Corporation Asset Sale Martin Ice Cream and Bross: Personal Goodwill To Reduce The “Double” Tax Introduction. 1. Problem Of Sale Of “C” Corporation. Buyers want to buy assets. Assume Joe’s basis in the stock is zero. Assume the corporation’s basis in its assets is zero. Assume the buyer pays $10,000,000 for the assets. The corporate tax is roughly 34% federal and 8.84% deductible state for about 40% leaving $6,000,000. Joe then liquidates the corporation and pays 37.1% ($2,226,000), leaving $3,774,000, for a total tax bite of 62.26%. By contrast, had it been an “S” corporation, assuming no ordinary income assets, the tax would have been 33.1% (no 3.8% tax on net investment income) so Joe would have netted $6,690,000. The difference between the two is $2,916,000, a 29.16% tax differential. 2. Personal Goodwill.1 2.1. What Is it? 1 Reinstein and Weg, “Personal Service, Loan-Outs, and Other `C’ Corporations – Are They Still Viable? The Current State of the Art,” 2006 USC Institute.
  2. 2. LAW OFFICES GIVNER & KAYE A PROFESSIONAL CORPORATION “C” Corporation Asset Sale – Martin Ice Cream and Bross: Personal Goodwill To Reduce The “Double” Tax February 19, 2015 Page 2 of 23 2.2. What Are The Benefits? Selling shareholders’ gain from the sale of personal goodwill is capital gain. Acquired business does not have entity-level gain on the sale of personal goodwill. Buyer of personal goodwill may be entitled to amortization deductions under §197. 2.2. What Are The Characteristics? Personal Goodwill Characteristics No non-compete agreement between the selling shareholder and the company. Business is highly dependent on individual’s personal relationships, reputation, skills, know-how. Individual’s service is important to the sales process. Operations in which shareholders are highly involved. Businesses with few and high-volume customers. Company is highly technical, specialized, or engaged in professional services. Company has contracts that are terminable at will. More common in companies with higher portion of intangible assets. Loss of key individual would negatively impact company’s revenue and/or profitability. Business Goodwill Characteristics Non-compete agreement exists between the selling shareholder and the company.
  3. 3. LAW OFFICES GIVNER & KAYE A PROFESSIONAL CORPORATION “C” Corporation Asset Sale – Martin Ice Cream and Bross: Personal Goodwill To Reduce The “Double” Tax February 19, 2015 Page 3 of 23 Larger business with formal organizational structure, processes, and controls. Sales are generated from company brand name recognition, company sales team. Businesses with diversified customer base. Manufacturing businesses or companies that are asset intensive. Selling shareholder is not intimately involved with the business. Companies that have deep management teams. Companies that have long-term contracts with customers. Loss of key individual would not materially impact the revenue and/or profitability of the company, or the individual could be replaced easily. 3. Employee Compensation.
  4. 4. LAW OFFICES GIVNER & KAYE A PROFESSIONAL CORPORATION “C” Corporation Asset Sale – Martin Ice Cream and Bross: Personal Goodwill To Reduce The “Double” Tax February 19, 2015 Page 4 of 23 Case Law. 1. Martin Ice Cream.2 2 110 T.C. 189 (1998).
  5. 5. LAW OFFICES GIVNER & KAYE A PROFESSIONAL CORPORATION “C” Corporation Asset Sale – Martin Ice Cream and Bross: Personal Goodwill To Reduce The “Double” Tax February 19, 2015 Page 5 of 23 2. Norwalk.3 A two-shareholder accounting corporation elected to liquidate. Although each shareholder had an employment agreement which contained a non-compete and nondisclosure provision, the agreements expired before the liquidation. The two former shareholders promptly joined an existing accounting partnership and transferred assets distributed to them to the new practice. 3 T.C. Memo 1998-279.
  6. 6. LAW OFFICES GIVNER & KAYE A PROFESSIONAL CORPORATION “C” Corporation Asset Sale – Martin Ice Cream and Bross: Personal Goodwill To Reduce The “Double” Tax February 19, 2015 Page 6 of 23 3. Solomon.4 The case involved the sale of a corporate division of Solomon Colors, Inc. that mined, milled, and sold a particular type of iron ore to the foundry, fertilizer, and cement industries. Prince Manufacturing Co. paid $1.5 million, with $1.4 million allocated to a customer list and a covenant not to compete. The remaining $100,000 was allocated to the sale of the ore business and equaled the equipment value. The terms of the CNTC stated that Solomon Colors and the individual signatories (Robert and Richard Solomon and their wives) would not compete with Prince. Of the $1.5 million purchase price, $700,000 was paid directly to the corporation’s majority shareholders, a father and son who were the company’s chief executives. The taxpayers claimed that a portion of the asset labeled “customer list” in the agreement represented relationships with customers, with whom they had built relationships 4 T.C. Memo 2008-102.
  7. 7. LAW OFFICES GIVNER & KAYE A PROFESSIONAL CORPORATION “C” Corporation Asset Sale – Martin Ice Cream and Bross: Personal Goodwill To Reduce The “Double” Tax February 19, 2015 Page 7 of 23 over many decades, and personal goodwill belonging to Robert Solomon and Richard Solomon. The IRS claimed they sold assets that were customer lists distributed from the company. The Tax Court ruled against the taxpayers noting the following. First, nothing in the agreement between the parties made reference to the sale of personal goodwill. The asset purchase agreement contained conflicting provisions as to whether payments to shareholders were for customer lists or non-compete payments. Second, the Tax Court did not find that the value of Solomon Colors in the market was due to the quality of service and customer relationships developed by Robert and Richard Solomon. Rather, since the company was a processing and manufacturing business, as opposed to a personal services business, the business did not depend on the employee/owners for its success. Finally, although the taxpayers entered into non-compete agreements, they did not sign employment or consulting agreements. Since the shareholders were not hired by the buyer, their personal attributes were not available to the buyer after the sale. These facts prompted the Tax Court to conclude that it was unlikely Prince was buying personal goodwill. The Tax Court concluded that the proceeds paid directly to the shareholders were actually attributable to their CNTC rather than for a customer list or personal goodwill. 4. Howard.5 In 1980, Dr. Larry Howard (dentist) incorporated his practice and was its sole shareholder, officer, and director. He entered into an employment agreement and a covenant not to compete with the corporation. The covenant lasted as long as he held any stock of the corporation plus 3 years. In 2002, Dr. Howard and Howard Corporation sold the practice to Dr. Brian Finn and his personal service corporation. In that agreement (the Asset Purchase Agreement), Dr. Howard was allocated $549,900 for his personal goodwill and $16,000 for consideration for a covenant not to compete with Finn Corporation. Howard Corporation received $47,100 for its assets. 5 106 AFTR 2 nd ¶2010-5140 (DC WA 7/30/2010).
  8. 8. LAW OFFICES GIVNER & KAYE A PROFESSIONAL CORPORATION “C” Corporation Asset Sale – Martin Ice Cream and Bross: Personal Goodwill To Reduce The “Double” Tax February 19, 2015 Page 8 of 23 Dr. Howard and his wife filed a joint 2002 return and reported $320,358 as long-term capital gain income from the sale of goodwill to Finn Corporation. On audit, IRS re- characterized the sale of the goodwill as a corporate asset and treated the amount received by the Howards from the sale to Finn Corporation as a $320,358 dividend from Dr. Howard's PSC. IRS determined that there was a $60,129 deficiency and $14,792 interest owed based on the difference in long-term capital gain rates and dividend income rates. The Howards paid the amount, filed a refund claim, and eventually filed a refund suit with the court. The district court found that the goodwill was a corporate asset of Howard Corporation, and that the Howards weren't entitled to a refund. The court noted that courts have distinguished between personal and corporate ownership of goodwill depending on whether the employee had an ongoing employment contract and a covenant not to compete. The Court concluded that Dr. Howard was a Howard Corporation employee with a covenant not to compete with Howard Corporation from '80 through 2003 (plus three years, or 2006). Any goodwill generated during that time period was Howard Corporation goodwill. If an employee works for a corporation under contract and with a CNTC with that corporation, as Dr. Howard did, then the corporation, and not the individual professional, owns the goodwill that is generated from the professional's work. Dr. Finn testified that the price for the dental practice had been presented and accepted, without negotiation, and that he didn't recall any discussion as to the allocation of the proceeds. 5. Kennedy.6 James Kennedy was engaged in an employee benefits consulting business since 1990. In 1995, the sole proprietorship was incorporated as KCG International, a C corporation. In 2000, the business was sold to Mack & Parker (“M&P”). The parties executed a final purchase-and-sale agreement that consisted of a goodwill agreement, consulting agreement, and asset purchase agreement. Under the agreements, Kennedy would work with M&P as a consultant, without salary, and continue to provide services to his former clients for the next five years, after which he planned to retire. Also, under the 6 T.C. Memo 2010-206 (9/22/2010).
  9. 9. LAW OFFICES GIVNER & KAYE A PROFESSIONAL CORPORATION “C” Corporation Asset Sale – Martin Ice Cream and Bross: Personal Goodwill To Reduce The “Double” Tax February 19, 2015 Page 9 of 23 agreements, Kennedy and KCG would not compete with M&P for five years. M&P would make a $10,000 lump-sum payment to KCG and annual payments to KCG and Kennedy for 5 years. The annual payment amounts would depend on revenue received from Kennedy’s former clients and were allocated 75% to Kennedy in exchange for the “personal goodwill” associated with his customer relationships, his know-how, and his promise not to compete or otherwise engage independently in employee benefits consulting. The other 25% was designated as payment for consulting services. The asset purchase agreement required that KCG convey its relationships with 46 clients. The goodwill agreement required Kennedy to convey his personal relationships with the same 46 clients. Almost all of them had been long-time clients of Kennedy even before he incorporated. Kennedy began work with M&P and devoted far more time in his new role than he anticipated. During the first year after the transaction, 46% of M&P’s revenue was traceable to time billed personally by Kennedy. Kennedy did not receive any wages or fees from M&P other than payments under the sale documents. After 18 months of this arrangement, Kennedy negotiated a salary in addition to the payments. First, the IRS argued that KCG, not Kennedy, owned the customer list and without the customer list, Kennedy could not transfer goodwill. Second, the IRS argued that Kennedy had no proof of the existence of any goodwill asset since no appraisal of the personal goodwill was provided to the court. Third, the IRS contended that even if Kennedy was the owner of personal goodwill, this asset should not be considered a saleable asset. Any personal goodwill would be based upon the value of Kennedy’s relationships with his customers, which the IRS maintains would have no value unless Kennedy continued to perform services for the clients. The Tax Court agreed with the IRS that Kennedy did not sell personal goodwill to M&P, but not for the same reasons. First, the Tax Court acknowledged that a payment to an individual who provides ongoing services could be considered a payment for goodwill. However, in the instant case, the Tax Court was convinced the payments to Kennedy were for services rather than personal goodwill since he worked for M&P for five years,
  10. 10. LAW OFFICES GIVNER & KAYE A PROFESSIONAL CORPORATION “C” Corporation Asset Sale – Martin Ice Cream and Bross: Personal Goodwill To Reduce The “Double” Tax February 19, 2015 Page 10 of 23 received little compensation for his services for 18 months, and agreed not to compete for five years. 6. H&M, Inc.7 Harold Schmeets was the sole shareholder of Harvey Insurance Agency, Inc. When people came to Harvey Insurance to buy insurance, they were buying it from Harold Schmeets. He had far more name recognition as an individual than Harvey Insurance did as a firm. Harvey Insurance sold its biggest asset, the insurance-brokerage business, to its main competitor, a local bank, in '92. Schmeets went to work for the bank that bought the brokerage business. Under the purchase agreement, Harvey Insurance agreed to sell all files, customer lists, insurance agency or brokerage contracts, the name of Harvey Insurance, and all the goodwill of Harvey Insurance to the bank for $20,000. The agreement was contingent on the execution of an employment agreement with Schmeets. It also contained a noncompete clause which provided that Harvey Insurance and Schmeets wouldn't compete with the bank for 15 years. Schmeets became the manager of the bank's insurance agency for a six-year term. The bank promised to pay Schmeets a base wage of $38,936, annual variable compensation equal to the greater of $50,000 or 45% of net adjusted income for the year, and deferred compensation of $74,000 at the end of the six-year term. The total compensation under the agreement was over $600,000 for his services during the six years. Schmeets kept the corporation (renamed H&M, Inc. after the sale) active to exploit his two patented inventions. On audit, IRS contended that much of Schmeets' wages were actually disguised purchase price payments to his corporation. IRS argued that a substance-over-form analysis showed that the value of the assets that the bank bought should include not only the $20,000 purchase price, but also the $38,936 annual base wage and $74,000 deferred compensation under the employment agreement. It claimed that only the annual variable compensation (the greater of $50,000 or 7 T.C. Memo 2012-290.
  11. 11. LAW OFFICES GIVNER & KAYE A PROFESSIONAL CORPORATION “C” Corporation Asset Sale – Martin Ice Cream and Bross: Personal Goodwill To Reduce The “Double” Tax February 19, 2015 Page 11 of 23 45% of net adjusted income for the year) actually represented payment for Schmeets' services. IRS contended that this allocation more accurately reflected the FMV of Schmeets' services to the bank and took account of goodwill and the corporation's other intangible assets. IRS argued that the parties undervalued the assets of Harvey Insurance in the sale so that the bank could deduct the compensation it paid to Schmeets, and he could avoid being taxed twice on the proceeds of the sale. H&M argued that recharacterizing all of the compensation payments as purchase price payments was inappropriate because the allocation didn't reflect the economic realities of the transaction. It maintained that Schmeets' compensation under the agreement was reasonable because the bank needed him to keep the insurance business going, and he had significant responsibilities as the manager of the bank's agency. H&M further contended that any goodwill of the business was attributable to Schmeets personally. And it pointed out that neither party focused on the tax consequences of the transaction. Instead, both parties wanted to create an employment relationship and both consistently treated the deal as if they had. The Tax Court found that the payments to Schmeets weren't disguised purchase price payments to H&M. It was satisfied that Schmeets and the bank were genuinely interested in creating an employment relationship and weren't just creating paperwork to produce the tax consequences they wanted. The court concluded that, in light of Schmeets's personal relationships, his experience in running all facets of an insurance agency and his responsibilities as manager of the bank's insurance agency, the compensation that the bank paid him was reasonable. The employment agreement contained an extensive list of duties that Schmeets was required to perform. Not only was Schmeets an insurance salesman, he also had significant management and bookkeeping responsibilities. He went from working around 40 hours per week before the sale to double that afterward. IRS failed to specify what other purchased intangible assets, other than the name Harvey Insurance, it thought weren't accounted for in the purchase price. It didn't provide any
  12. 12. LAW OFFICES GIVNER & KAYE A PROFESSIONAL CORPORATION “C” Corporation Asset Sale – Martin Ice Cream and Bross: Personal Goodwill To Reduce The “Double” Tax February 19, 2015 Page 12 of 23 persuasive evidence that the name of the corporation had much value other than its connection with Harold Schmeets himself. The Court found that the name Harold Schmeets had by far more name recognition in the community than Harvey Insurance. While the Court disagreed with IRS that the amounts the bank paid Schmeets were disguised purchase price payments for goodwill, it did agree that the payments weren't simply the FMV of his services. Schmeets not only brought his personal goodwill to the bank, he also signed a noncompete provision. However, since Schmeets' individual tax liability wasn't before the Court, it found that it didn't need to determine the exact allocation between what he was paid for his services to the agency, his personal goodwill, and his promise not to compete. 7. Bross Trucking.8 Chester Bross started in the road construction business in 1966. He was extremely knowledgeable about the industry and contributed to nearly all facets of the Bross family businesses. He was responsible for arranging and completing the projects in which Bross Construction participated. He personally developed relationships with the necessary entities to work in the road construction industry. The “family business umbrella” included Bross Trucking which was founded in 1982 and owned 100% by Mr. Bross through his revocable living trust. Bross Trucking engaged in hauling construction-related materials and equipment for road construction projects. Bross Trucking leased most of its equipment from another wholly owned Bross entity, CB Equipment, through yearly leases. Bross Trucking had regulatory problems including maintaining records on drivers and safety. Mr. Bross felt that the company’s reputation with regulatory authorities was causing its trucks to be stopped more often. If the problem continued it could disrupt other aspects of the family business, since the road construction relied on the hauling provided by the trucking company. The solution was to form LWK Trucking which was owned by Mr. Bross’s three sons and a minority shareholder. Bross Trucking continued to exist but no longer operated. No 8 T.C. Memo 2014-107.
  13. 13. LAW OFFICES GIVNER & KAYE A PROFESSIONAL CORPORATION “C” Corporation Asset Sale – Martin Ice Cream and Bross: Personal Goodwill To Reduce The “Double” Tax February 19, 2015 Page 13 of 23 assets were transferred from Bross Trucking to LWK, although that is not how the IRS looked at it. The IRS view was that Bross Trucking had distributed its goodwill to Mr. Bross who then made a gift of the goodwill to his sons. With penalties the IRS was looking for over $2.7 million in corporate income tax and gift tax. The Tax Court followed the logic Martin Ice Cream logic …….. there are two regimes of goodwill: (1) personal goodwill developed and owned by shareholders; and (2) corporate goodwill developed and owned by the company. Bross Trucking’s goodwill was primarily owned by Mr. Bross personally, and the company could not transfer any corporate goodwill to Mr. Bross in tax year 2004. A factual problem for the IRS was that it is difficult to argue that a company facing the possibility of being shut down has much in the way of goodwill. The impending suspension would cause customers to reevaluate whether to trust Bross Trucking and continue to do business with it. This is the antithesis of goodwill: Bross Trucking could not expect continued patronage because its customers did not trust it and did not want to continue doing business with it. 8. Estate of Franklin Z. Adell.9 Franklin Z. Adell died on August 13, 2006, owning a 100% interest in STN.Com, Inc. (“STN.Com”), a cable uplinking company. STN.Com’s sole business purpose was to broadcast an urban religious program channel, “The Word Network” (“The Word”). It was Mr. Adell’s son, Kevin, who created and managed STN.Com. Furthermore, he held all of the key business relationships. Pursuant to the services agreement, and continuing through Mr. Adell’s date of death, The Word paid STN.Com at least 95% of its revenue each month (which was an amount greater than STN.Com’s actual costs). The Word’s only source of revenue was from broadcasting contracts that Kevin negotiated and entered into with the religious community. 9 T.C. Memo 2014-155 (8/4/14).
  14. 14. LAW OFFICES GIVNER & KAYE A PROFESSIONAL CORPORATION “C” Corporation Asset Sale – Martin Ice Cream and Bross: Personal Goodwill To Reduce The “Double” Tax February 19, 2015 Page 14 of 23 STN.Com’s primary source of income came from the program fees it received from The Word. The estate’s first appraiser made a number of adjustments to STN.Com’s reported financial results to more accurately reflect STN.Com’s normalized ongoing operating performance. Among the adjustments was a reduction in officers’ salaries and wages to reflect market rates. He also adjusted STN.Com’s operating expenses to include an economic charge for Kevin’s personal goodwill. The adjustment was appropriate because the success of STN.Com depended heavily on Kevin’s personal relationships with the board of directors of The Word. Kevin did not have a noncompete agreement with STN.Com, and, as a result, a potential buyer would not be expected to acquire STN.Com without the retention of Kevin. The economic charge for Kevin’s personal goodwill ranged from 37.2% to 43.4% of sales over the historical period and from 43.7% to 44.1% of sales over the projection period. After making adjustments to the enterprise value to account for STN.Com’s cash and cash equivalents, interest-bearing debt, and nonoperating assets, Mr. Risius concluded that the FMV of the STN.Com stock on Mr. Adell’s date of death was ≈ $9.3 million. Respondent’s expert witness valued the STN.Com stock using the discounted cash flow method. Mr. Burns addressed the importance of Kevin’s relationship with The Word to STN.Com’s continued business operations. Instead of applying an economic charge for Kevin’s personal goodwill similar to the one found in Mr. Risius’ first valuation report, Mr. Burns concluded that a hypothetical investor would anticipate retaining Kevin as an officer of STN.Com and would need to compensate Kevin at an acceptable rate of 8.1% of sales. He concluded that the Fair Market Value of the STN.Com stock on Mr. Adell’s date of death was $26,341,030. The Tax Court found that the original value of $9.3 million was the most persuasive. The Court also rejected the valuation conclusion of Mr. Burns saying that he not only failed to apply an economic charge for Kevin’s personal goodwill but also gave too low an estimate of acceptable compensation for Kevin.
  15. 15. LAW OFFICES GIVNER & KAYE A PROFESSIONAL CORPORATION “C” Corporation Asset Sale – Martin Ice Cream and Bross: Personal Goodwill To Reduce The “Double” Tax February 19, 2015 Page 15 of 23 The Court agreed with estate’s expert that Kevin’s goodwill was personally owned independent of STN.Com and that STN.Com’s success was heavily dependent on The Word because of their symbiotic relationship. Planning. 1. Valuation. Typically, when planning for transactions involving personal goodwill, an exploratory phase is necessary to determine the existence of personal goodwill by assessing the facts and circumstances. To the extent personal goodwill is likely to exist, later phases may be warranted to estimate the value of the tangible assets, identifiable intangible assets, and personal goodwill to be acquired. While each case is unique, a basic approach to the valuation process usually includes an assessment of the aggregate value of the business and the personal goodwill is captured by considering the “as-is” aggregate cash flows being generated. The value derived in this scenario is contrasted with the value in a scenario in which the key person is no longer participating in the business or, taken to an extreme, directly competes with the existing business. In this scenario, to the extent personal goodwill exists, the “as-is” aggregate cash flows would be negatively impacted. The difference in value between these two scenarios can be characterized as the value of the personal goodwill. 2. Documentation. Non-compete agreements that exist before the transaction have the impact of transferring personal goodwill to business goodwill. Employment and non-compete agreements entered into during the transaction process support the allocation to personal goodwill.
  16. 16. LAW OFFICES GIVNER & KAYE A PROFESSIONAL CORPORATION “C” Corporation Asset Sale – Martin Ice Cream and Bross: Personal Goodwill To Reduce The “Double” Tax February 19, 2015 Page 16 of 23 The documents should clearly state that personal goodwill is being acquired and exactly what the seller’s role/duties are post-transaction to ensure that the seller’s personal goodwill becomes the acquirer’s business goodwill. 2.1. Distribution Agreement. 2.2. Management Agreements. 2.3. License & Franchise Agreements.
  17. 17. LAW OFFICES GIVNER & KAYE A PROFESSIONAL CORPORATION “C” Corporation Asset Sale – Martin Ice Cream and Bross: Personal Goodwill To Reduce The “Double” Tax February 19, 2015 Page 17 of 23 3. “S” Election. If possible, done enough years in advance. EXHIBIT 1 August 2008 • Vol. 28 No. 7 | An E-Publication of the Los Angeles County Bar Association Gimme 5: What Every Lawyer Should Know about Non-Compete Agreements in California By Holly R. Lake, an associate in Paul, Hastings, Janofsky & Walker LLP’s Los Angeles office, who practices employment law; and Cindy J. Morgan, also an associate in the firm’s Los Angeles office, who also practices employment law. They can be reached at Hollylake@paulhastings.com and Cindymorgan@paulhastings.com, respectively. This article is provided for informational purposes only and does not constitute legal advice. Non-compete agreements have been the subject of much debate in California where their application is often contested and somewhat limited. The starting place must always be recognition of the general rule: In California, non-compete agreements are presumptively unenforceable except in very limited circumstances. Despite the general unenforceability of non-compete agreements, in very limited circumstances their use can be beneficial to employers. Before trying to use a non-compete agreement in California, several complex considerations must be fully explored. Here are 5 important issues for California practitioners to consider when contemplating the use of, drafting, or reviewing agreements containing post- employment restrictions. 1. What is a non-compete agreement? A non-compete agreement (also known as a covenant not to compete) is a contract between an employee and employer that, after the termination of employment, restricts the former employee’s ability from working in a similar profession or trade in competition with the former employer in a specific geographic area for a set period of time. In states that recognize the general enforceability of such agreements, the general policy supporting non-compete agreements is an effort to prevent unfair competition that would occur if the former employee were allowed to compete against the former employer for a specific period of time. The legitimate business interest most often cited is “the legitimate interest
  18. 18. LAW OFFICES GIVNER & KAYE A PROFESSIONAL CORPORATION “C” Corporation Asset Sale – Martin Ice Cream and Bross: Personal Goodwill To Reduce The “Double” Tax February 19, 2015 Page 18 of 23 an employer has in safeguarding that which has made his business successful and to protect himself against deliberate surreptitious commercial piracy. Thus restrictive covenants will be enforceable to the extent necessary to prevent the disclosure or use of trade secrets or confidential customer information.” Reed, Roberts Assocs., Inc. v. Strauman, 40 N.Y. 2d 303, 308, 353 N.E. 2d 590, 593, 386 N.Y.S. 2d 677, 680 (N.Y. 1976). 2. Issues with non-compete agreements specific to California. In some states, non-compete agreements may be enforced if they are reasonable in time and geographic scope. However, in 1941, California enacted California Business and Professions Code §16600, a broadly interpreted provision that prohibits many restraints on trade. §16600 invalidates most non-compete agreements on the theory that an individual cannot be barred from seeking employment in a profession in which he or she has been trained. Nonetheless, despite §16600, California courts have recognized very narrow exceptions to the general prohibition against the enforcement of non-compete agreements. 3. Specific areas where non-competes are permitted by statute. Within the California Business and Professions Code, there are a few limited exceptions to the general rule against the enforcement of non-compete agreements, including: 1) in some circumstances where the buyer of a business wants to prohibit the seller from competing with the newly acquired company; and 2) in the context of the dissolution of a business partnership or the dissociation of a partner from a partnership. 4. Judicially created exceptions. In addition to the statutory exceptions, California courts have carved out narrow exceptions to the rule against non-compete agreements. First, a non-compete agreement may be upheld if it is necessary to protect an employer’s trade secrets. Employers rarely prevail under this judicially created exception, and any attempt to craft such a non-compete implicates several complex business and legal concerns beyond the scope of this article. Suffice it to say that trying to enforce a non-compete based on the notion that it is necessary to protect a client’s trade secrets involves the complicated substantive area of trade secret law in California, and brings into play sensitive business concerns.
  19. 19. LAW OFFICES GIVNER & KAYE A PROFESSIONAL CORPORATION “C” Corporation Asset Sale – Martin Ice Cream and Bross: Personal Goodwill To Reduce The “Double” Tax February 19, 2015 Page 19 of 23 Second, the Ninth Circuit created the “narrow restraint” exception to §16600; the California Supreme Court granted review of this issue in Edwards v. Arthur Andersen, LLP, Case #BC 255796, and until that case is decided, California practitioners should be extremely wary of the future vitality of the Ninth Circuit’s “narrow restraint” doctrine. 5. The “inevitable disclosure doctrine.” The inevitable disclosure doctrine is not recognized in California. The Fourth District Court of Appeal expressly rejected the inevitable disclosure doctrine as incompatible with §16600, characterizing it as an “after-the-fact covenant not to compete restricting employee mobility.” Whyte v. Schlage Lock Co., 101 CA 4th 1443 (2002). © 2008 Los Angeles County Bar Association • Disclaimer and Proprietary Notice Privacy Policy • Questions@lacba.org • Contact • Sitemap EXHIBIT 2 Exhibit ____ OWNER FORM NON-COMPETITION AGREEMENT THIS AGREEMENT is made and entered into as of the ____ day of __________, 2000 by and between RUSSELL _______, an individual (“OWNER”), and NATIONAL _______________, INC., a __________ corporation (“Buyer”). BACKGROUND ___, LLC and _______, Inc. (collectively, “Sellers”), OWNER and Buyer are parties to an Asset Purchase Agreement (the “Purchase Agreement”) dated ______ __, 2000, providing for the acquisition by Buyer of substantially all of the assets and certain of the liabilities of Sellers. Sellers are engaged in the business of manufacturing, marketing, distributing and selling _______________ (the “Business”). OWNER is the record and beneficial owner of all of the issued and outstanding membership interests and capital stock of Sellers and a key employee of Sellers, and has been substantially involved with Seller’s operations and management and possesses trade secrets and other confidential information relating to Sellers and their customers. It is integral to Buyer's acquisition of the Business and a condition precedent to the closing of such acquisition that OWNER enter into this Agreement with Buyer to provide for the protection of Sellers’ client relationships
  20. 20. LAW OFFICES GIVNER & KAYE A PROFESSIONAL CORPORATION “C” Corporation Asset Sale – Martin Ice Cream and Bross: Personal Goodwill To Reduce The “Double” Tax February 19, 2015 Page 20 of 23 in existence immediately prior to such acquisition and the trade secrets and other confidential information owned by Sellers immediately prior to such acquisition. All capitalized terms not otherwise defined herein shall have the respective meanings set forth in the Purchase Agreement. NOW THEREFORE, in consideration of the premises and the mutual representations, warranties, covenants and agreements contained in this Agreement and in the Purchase Agreement, the parties hereto, intending to be legally bound, agree as follows: 1. Noncompetition; Confidential Information. (a) For a period of five (5) years from and after the date hereof, unless expressly consented to in writing by Buyer, neither OWNER nor any Affiliate (as hereinafter defined) shall, directly or indirectly: (i) engage, anywhere in the Territory (as defined in Section 1(c) below), in activities which include any aspect of the Business; (ii) be or become a stockholder, partner, owner, officer, director or employee or agent of, or a consultant to or give financial or other assistance to, any person or entity considering engaging in any such activities or so engaged within the Territory; (iii) seek in competition with the Business within the Territory to procure orders from or do business with any customer of either Seller or Buyer whether on OWNER’s behalf or on behalf of another; (iv) hire, solicit, or contact with a view to the engagement or employment of, any person who is an employee of either Seller as of the date of the Purchase Agreement or of Buyer or any affiliate of Buyer; or (v) seek to contract with or engage (in such a way as to adversely affect or interfere with the Business as carried on by either Seller as of the date of the Purchase Agreement or by Buyer) any person or entity who has been contracted with or engaged to manufacture, assemble, supply or deliver products, goods, materials or services to either Seller or Buyer; provided, however, that nothing herein shall prohibit either Seller and Affiliates from jointly owning, as passive investors, in the aggregate not more than 5% of the outstanding publicly traded stock of any corporation so engaged. The duration of OWNER’s and Affiliate’s covenants set forth in this Section 1 shall be extended by a period of time equal to the number of days, if any, during which such OWNER or any Affiliate is in violation of the provisions hereof. (b) From and after the date hereof, neither OWNER nor any Affiliate shall, directly or indirectly: (i) use or procure the use of any name including the words “Flo Control” or any derivative or colorable imitation thereof; or (ii) use in furtherance of any of their business affairs or disclose to any third party any trade secret, client list, supplier list, financial data, pricing or marketing policy or plan or any other proprietary or confidential information relating to Buyer, the Business as conducted by either Seller at any time prior to and as of the date of the Purchase Agreement, any of either Seller’s products, services, clients or suppliers as of the date of the Purchase Agreement, or any of Buyer's products, services, clients or suppliers, so long as the same is not publicly known (other than by the act
  21. 21. LAW OFFICES GIVNER & KAYE A PROFESSIONAL CORPORATION “C” Corporation Asset Sale – Martin Ice Cream and Bross: Personal Goodwill To Reduce The “Double” Tax February 19, 2015 Page 21 of 23 of OWNER or any Affiliate). If OWNER or any Affiliate should use or reveal to any other person or entity any confidential information, this will be considered a continuing violation on a daily basis for so long a period of time as such confidential information is made use of by OWNER, such Affiliate or any such other person or entity. (c) For the purposes of this Agreement, “Territory” means the United States, and “Affiliate” means: (i) any corporation of which OWNER owns or otherwise possesses the power to direct the vote, directly or indirectly, of an amount of voting securities sufficient to elect a majority of the board of directors of such corporation, and (ii) any other person or entity controlled by OWNER. For the purposes of this definition of “Affiliate,” “control” means the power to direct the management and policies of a person or entity, directly or indirectly, whether through the ownership of voting securities, by contract or otherwise; provided, that any person or entity of which OWNER owns beneficially or of record, either directly or through one or more intermediaries, more than 20% of the ownership interests, shall be conclusively presumed to be an “Affiliate.” (d) OWNER acknowledges and agrees that the covenants contained in this Section 1 are fair and reasonable, and that damages alone shall not be an adequate remedy for any breach by OWNER or any Affiliate of the covenants contained in this Section 1 and accordingly expressly agrees that, in addition to any other remedies which Buyer may have, Buyer shall be entitled to injunctive relief in any court of competent jurisdiction for any breach or threatened breach of any such covenants by OWNER or any Affiliate. Nothing contained herein or in the Purchase Agreement shall prevent or delay Buyer from seeking, in any court of competent jurisdiction, specific performance or other equitable remedies in the event of any breach or intended breach by OWNER or any Affiliate of any of their obligations under this Section 1. (e) Notwithstanding the equitable relief available to Buyer, OWNER, in the event of a breach of OWNER’s covenants contained in Section 1 hereof, understands and agrees that the uncertainties and delay inherent in the legal process would result in a continuing breach for some period of time, and therefore, continuing injury to Buyer until and unless Buyer can obtain such equitable relief. Therefore, in addition to such equitable relief, Buyer shall be entitled to monetary damages for any such period of breach until the termination of such breach, in an amount deemed reasonable to cover all actual and consequential losses, and all costs and reasonable attorneys' fees incurred by Buyer in enforcing this Section 1. (f) If any court shall find either the duration or geographical limit of any restriction contained in this Section 1 to be unenforceable in accordance with its terms, it is the intention of the parties that the restrictive covenant set forth herein shall not be terminated but shall be deemed to be amended to the extent required to render it valid and
  22. 22. LAW OFFICES GIVNER & KAYE A PROFESSIONAL CORPORATION “C” Corporation Asset Sale – Martin Ice Cream and Bross: Personal Goodwill To Reduce The “Double” Tax February 19, 2015 Page 22 of 23 enforceable, such amendment to apply only within the jurisdiction of the court that has made the adjudication. 2. Arbitration (a) All disputes arising out of or relating to this Agreement which cannot be settled by the parties shall promptly be submitted to and determined in arbitration in Los Angeles, California, by a panel of three arbitrators (unless otherwise agreed to by the parties), of whom Buyer shall select one, OWNER shall select one and the third shall be selected within 10 days of the appointment of the second arbitrator by the two previously selected, pursuant to the rules and regulations then obtaining of the American Arbitration Association; provided, that (i) nothing herein shall preclude the Buyer from seeking, in any court of competent jurisdiction, damages, specific performance or other equitable remedies in the case of any breach or threatened breach by OWNER or any Affiliate of Section 1 hereof and (ii) if either party shall fail to select an arbitrator within 10 days of receipt of a written request to do so by the other party containing the name of the arbitrator selected by such other party, the American Arbitration Association shall select the arbitrator for the party that failed to do so. The decision of the arbitrator shall be final and binding upon the parties and judgment upon such decision may be entered in any court of competent jurisdiction. (b) It is the intent of the parties that the arbitrators be knowledgeable in the irrigation products industry. Such arbitrators shall be required to apply the contractual provisions hereof in deciding any matter submitted to them. 3. Costs of Enforcement. If any party hereto incurs any costs or expenses in connection with any dispute arising under this Agreement, the prevailing party to such dispute shall be entitled to recover from the non-prevailing party such prevailing party's reasonable costs and expenses, including, without limitation, reasonable attorneys' fees and costs incurred in prosecuting or defending such dispute, as the case may be. 4. Notices. All notices hereunder shall be in writing and shall be sufficiently given if hand delivered, sent by documented overnight delivery service or registered or certified mail, postage prepaid, return receipt requested or by telegram, telex, fax or telecopy (confirmed by U.S. mail), receipt acknowledged, addressed as set forth below or to such other person and/or at such other address as may be furnished in writing by any party hereto to the other. Any such notice shall be deemed to have been given as of the date received, in the case of personal delivery, or on the date shown on the receipt or confirmation therefor, in all other cases.
  23. 23. LAW OFFICES GIVNER & KAYE A PROFESSIONAL CORPORATION “C” Corporation Asset Sale – Martin Ice Cream and Bross: Personal Goodwill To Reduce The “Double” Tax February 19, 2015 Page 23 of 23 To Buyer: With a copy to: If to OWNER: 5. Assignment and Benefit. Buyer may assign this Agreement in whole or in part to any subsidiary of Buyer or to any person, firm or corporation which becomes a successor in interest (by purchase of its assets or stock, or by merger or otherwise) to Buyer in the business being acquired by it pursuant to the Purchase Agreement. Subject to the foregoing, this Agreement and the rights and obligations set forth herein shall inure to the benefit of, and be binding upon, the parties hereto and each of their respective permitted successors and assigns. 6. Entire Agreement and Modification. This Agreement constitutes the entire agreement between the parties hereto with respect to the matters contemplated herein and supersedes all prior agreements and understandings with respect thereto. Any amendment, modification, or waiver of this Agreement shall not be effective unless in writing. Unless expressly provided, the waiver by a party of any breach of any provision of this Agreement shall not constitute or operate as a waiver of any other breach of such provision or of any other provision hereof, nor shall any failure to enforce any provision hereof operate as a waiver of such provision or of any other provision hereof. 7. Governing Law. … 8. Severability. … 9. Counterparts. … 10. Further Assurances. Each of the parties hereto shall execute such further instruments and take such other actions as the other party shall reasonably request in order to effectuate the purposes of this Agreement. [Signature Page Follows]

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