In the dynamic landscape of mergers and acquisitions (M&As), M&A attorneys specializing in employee compensation and benefits must continue to be vigilant in keeping current with the evolving legal frameworks affecting their practice. A recent focal point has been the Federal Trade Commission's (FTC) ban on non-competition agreements within the United States, the subsequent court ruling that restricted the FTC ban, and the FTC’s appeal of that ruling. These developments have profound implications for current and future transactions, particularly when contemplating the inclusion of the fair market value of a non-competition agreement as part of the calculation of golden parachute payments under Section 280G of the Internal Revenue Code.
Legal Challenges and Current Status
The FTC made headlines with a proposed ruling aimed at significantly restricting the use of non-competition clauses, citing concerns that these agreements hinder competition and limit worker mobility. Under the final rule issued by the FTC, existing non-competition clauses for senior executives can remain in effect, however, employers are barred from entering into or enforcing new non-competition agreements. The rule defines senior executives as those who earn more than $151,164 annually and hold policy-making positions. Unfortunately, the FTC has not provided concrete or comprehensive guidance on the definition of a “policy-making position,” thus there is a significant level of subjectivity when interpreting the final rule.
Upon issuing their ruling, the FTC faced immediate legal challenges, resulting in a Federal district court vacating the FTC ruling. The FTC has since appealed this decision, creating a state of flux and uncertainty. This is acutely felt by those looking to make payments that could be defined as excess compensation under IRC Section 280G, and therefore subject to additional taxation. This uncertainty necessitates careful consideration ahead of any contemplated transaction and associated executive compensation payment.
Implications for 280G Calculations
Non-competition agreements that provide reasonable compensation for post-change in control services often factor into IRC Section 280G calculations. Under IRC Section 280G, the fair market value of a non-competition agreement can be deducted from the parachute payment when measured against the three-times annual compensation base, the definition of an excess parachute payment. If the FTC's appeal is successful and non-competition agreements are deemed unenforceable for anyone other than a senior executive in a policy-making position, IRC Section 280G calculations may need to be very closely examined for certain individuals. While at first glance it would appear that a senior executive is exempt from the FTC ban - especially considering the minimum compensation criteria is very clear - the arguments as to whether an individual is in a “policy-making position” are far less so. Thus, for each senior executive, there should be an analysis regarding their “policy-making position” status.
In the event there is any uncertainty regarding an executive’s “policy-making position” status, the IRC Section 280G calculation should consider both scenarios where the parachute payment amount both includes and excludes the fair market value of the non-competition agreement. This will provide flexibility for tax planning purposes and clarity under both scenarios.
State-Level Considerations
Adding to the complexity is the possibility that the FTC’s appeal is not successful, and individual States could take action to ban and/or apply restrictions to the enforceability of non-competition agreements. An effect of this potential state-level discretion is that the valuation of the non-competition agreement must consider the specific authoritative guidance in the State for which the non-competition agreement is in effect. This could entail incorporating assumptions in the valuation that may not necessarily be consistent with the specific language in the non-competition agreement. For example, if the duration period in a non-competition agreement is three years but the pertinent State’s authoritative guidance (through court rulings, enacted law, etc.) limits the restriction of competition for a maximum period of two years, then the valuation of the non-competition agreement should assume competition can commence in two years. Another example may be geographic restrictions - those outlined in the non-competition agreement may be deemed to be overly broad based on the State’s authoritative guidance. In this case, the assumptions underlying the valuation must incorporate the narrower geographic scope per the State’s guidance, which may result in a lower fair market value of the non-competition agreement. These are just two examples that demonstrate the importance of understanding and incorporating the pertinent State’s authoritative guidance when estimating the fair market value of a non-competition agreement for IRC Section 280G purposes.
Strategic Considerations
Ultimately the current landscape surrounding the legality and enforceability of non-competition agreements remains challenging across the United States, and while clarity is unlikely to be provided in the immediate future this remains a key area that must be considered in detail as part of any transaction diligence and structuring. The evolving rulings and potential state-level variations demand a comprehensive approach to the valuation of non-competition agreements pursuant to IRC Section 280G in order to ensure that transactions remain compliant and strategically sound amid this uncertainty.
© Copyright 2024. The views expressed herein are those of the author(s) and not necessarily the views of Ankura Consulting Group, LLC., its management, its subsidiaries, its affiliates, or its other professionals. Ankura is not a law firm and cannot provide legal advice.
