Retirement

FTC Ban On Noncompete Agreements May Undermine Your Estate Plan

Noncompete Agreements and Your Estate Plan

Huh? What do the FTC and its new restrictions on noncompete agreements have to do with estate planning? Maybe nothing, or maybe everything. If you have a closely held family business and you want to keep it in the family for the next generation, these new restrictions may derail those plans. That could be a huge problem for some family businesses. If your succession plan may be affected, you should immediately review and revise your business succession plan. As the new law is better understood, planning nuances become better understood. The inevitable legal challenges resolved, you should continue to monitor your succession plan in case it can be fine-tuned to protect your business continuation goals. More on this below, but first, a review of the new rules.

What is a Noncomplete Agreement

A non-compete agreement is a restriction on future employment or economic penalties for accepting other employment. It may, for example, be incorporated into an employment agreement that an employee signs in order to accept employment by an employer. The restrictions in these agreements limit or prohibit the employee from accepting new employment other than with the current employer or starting a competing business. These types of contracts can be limited or very broad. For example, an employee may be restricted from accepting employment with a competitor in the same industry within 50 miles of the business location of the current employer for one year after leaving the current employer for any reason. However, noncompete agreements can be much broader, restricting employment for longer durations and over broader geographic areas. Some restrictions are so overreaching that they effectively prevent the affected employee from securing employment elsewhere if they are terminated or quit their current employer. That effectively could handcuff an employee to a job that they are not happy with or face the inability to earn a livelihood. That is why the FTC views these arrangements as an unfair method of competition.

Noncompete agreements can take many forms, not just an obvious restriction in an employment agreement under the caption “Noncomplete.” For example, restrictions on an employee’s ability to disclose or use confidential information relating to their employment might be so broad and restrictive that they could make it difficult for such an employee to secure employment elsewhere. Thus, the banning of non-compete agreements is even broader than just non-compete provisions.

Are Many People Affected?

The FTC estimates that 18% of workers, or 30 million people, are presently restricted by non-compete agreements. That is a lot of people. Likely, however, it will only be a small percentage of high-level employees that could affect business succession planning. But for the family businesses affected, it could have a critical impact.

Anticipated Impact

The FTC anticipates a wide range of benefits from its new restrictions on noncompete agreements. It remains to be seen how realistic these are. The projected benefits include 17,000-29,000 additional patents per year, $400-$488 billion in increased employee compensation over ten years, 8,500 new businesses formed each year, and reduced health care costs of $74-194 billion. Surprisingly, the increase in average compensation for workers is a mere $524 per year. That seems rather limited for a law change that presumes to be eliminating such unfair restrictions on employment. Even if the FTC is correct that most noncompete agreements are unfair restrictions and eliminating them will foster better economic results, the changes, and forecasts do not seem to consider the negative implications to some.

The New FTC Restrictions on Noncompete Agreements on Most Employees

FTC rule creates an all-encompassing ban on new noncompete agreements for all workers. Existing noncompete agreements with employees (not senior executives) will no longer be enforceable after the effective date. The new restrictions will be effective 120 days after the rules are published in the Federal Register. All noncompete agreements, regardless of whether signed decades ago, will no longer be valid for employees who are not senior executives. Consider the impact of this. What if the compensation package negotiated with the affected employee was increased in a bargained-for exchange to include the restrictions on competition? The employer may have intentionally paid more compensation or perquisites to protect itself from the employee learning key skills and then jumping to a competitor. What happens to those arrangements? Merely because the noncompete provision in an employment agreement is invalidated may not give the employer any right to adjust or renegotiate compensation for that change. What will happen? Will employees with vital skills to a business jump to a new employer absent such restrictions to earn higher compensation?

The New FTC Restrictions on Noncompete Agreements with Senior Executives

The FTC defines “senior executive” as employees earning more than $151,164 who are in a “policy-making position.” The FTC estimates that fewer than 1% of employees are in this category. For noncompete agreements that existed before the effective date of the new rules different restrictions will apply for senior executives than for other workers. Existing agreements covering senior executives can remain in force. That may provide family businesses the ability to maintain their succession plans. However, new agreements won’t be permitted. So, restrictions won’t be permitted if there is a turn-over in senior executives, or new key employees are hired as part of an intended succession plan.

Example: A family manufacturing business begins planning its succession and estate planning in mid-2025. Anticipating the reduction in the estate tax exemption the founder of the business wants to make gifts of business interests to an irrevocable trust to avoid future estate taxes that could undermine her ability to bequeath the business to her children and grandchildren. As part of that estate tax planning process her estate planning attorney recommends she formulate a business succession plan. That is vital, as merely avoiding estate taxes if there is no management succession plan is unlikely to facilitate the business’s survival. Two of the founder’s four children and one grandchild work in the business. The founder does not feel that her children are ready to run the business, and she believes two key employees can help transition the business to her children and serve the long-term needs of the business when she, as the founder, retires, dies or is incapacitated. The founder suggests that the key employees be offered more generous employment agreements, bonus arrangements, and profit sharing if they commit to remain with the business following the death, disability, or retirement of the founder. Specifically, she would like to entice and bind the key employees to remain with the company for at least five years after she has to cease involvement to help her two children in the business mature and gain business acumen. The Founder is more than willing to offer an above-market compensation package for the security of knowing she can secure the business transition. But if the key employees are going to assume this role, she needs to provide them with extra training and access to critical confidential information. So, she requests that her attorney include a non-disclosure agreement (NDA) and non-compete provisions so that once that extra training and confidential information is provided neither of the two key employees can use that information to set up a competing business thereby undermining her company and hopes to transition it to the next generation. In the past, the key employees would have hired their own attorney to review and negotiate a bargained-for employment agreement. That would have been a good deal for everyone. However, her attorney informs here that noncomplete agreements, and possibly even the nondisclosure provisions, may not be enforceable because of the new FTC rule. So now the dilemma is how can the founder and employees, all of whom want to enter into a deal to benefit everyone, secure the arrangement for the founder and the business? It may not be possible. It is hard to fathom how highly compensated executives, with independent legal representation, being generously compensated for reasonable and seemingly necessary restrictions should not be allowed. But it appears that the freedom to contract, even in such circumstances, is no longer allowed. Business succession planning, perhaps the key component of an estate plan for many family businesses, will be more difficult to achieve. While it may be feasible to provide some equity to the key employees and leverage the restrictions based on their equity sale, it is unclear whether that exception (discussed below) will suffice. What else will a family business be able to do?

Sale of Business Exception

If an employee sells their business interests in a real or bona fide sale, the restrictions on noncomplete agreements will not apply. Perhaps the concept is that if you are receiving a fair or bona fide price for your business interests, restricting you from competing is part of the price you pay to get that buyout. This exception can also apply if there is a sale of all or substantially all of a business entity’s operating assets.

Initially, the proposed exception for certain non-competes between a business’s seller and buyer applied only to a substantial owner with at least 25% ownership interest in the business entity being sold. Based on comments, the Commission adopts an exception for the bona fide sale of a business without requiring that the seller have at least a 25% ownership interest. Section 910.3(a): Exception for Persons Selling a Business Entity.

A bona fide sale is one made in good faith as opposed to, for example, a transaction whose sole purpose is to evade the final rule. In general, the Commission considers a bona fide sale to be made between two independent parties at arm’s length and in which the seller has a reasonable opportunity to negotiate the terms of the sale. So-called “springing” non-competes and non-competes arising out of repurchase rights or mandatory stock redemption programs are not entered into pursuant to a bona fide sale because, in each case, the worker has no goodwill that they are exchanging for the non-compete or knowledge of or ability to negotiate the terms or conditions of the sale at the time of contracting.

The above seems rather vague, and it may be difficult for a family business to use the above exception to bind a key employee as part of a succession plan. If the employee is given or allowed to purchase equity in the company, something many closely held family businesses will balk at, how can that equity be controlled and also bring in a non-compete without violating the FTCs new restrictions?

It is unclear why the FTC views a sale of a business differently than a bonus compensation arrangement negotiated in good faith with independent counsel, as described in the example above. Conceptually, in both instances the employee is receiving a substantial economic benefit.

The definition of a Non-Compete Agreement is Very Broad

The FTC’s new rules restricting or prohibiting noncompete agreements do not expressly prohibit employee non-solicitation arrangements, confidentiality or non-disclosure arrangements, or customer non-solicitation arrangements. But, the new rules state that other forms of restrictive covenants, such as the above, are prohibited if the functional effect is the same as a non-compete provision. A non-disclosure arrangement or non-solicitation agreement can function similarly to a non-compete if these ancillary arrangements encompass such a broad amount of data that they serve to restrict employees from other employment or starting a business after terminating their employment with the current employer. If they serve to prevent a worker from working for another employer in the same industry, they are analogous to a prohibited non-compete agreement and are, therefore, also restricted. So, recasting a non-compete agreement as other types of restrictions will not permit you to avoid the new rules.

Notice Requirement

The FTC was not content with largely banning noncompete agreements. It also enacted comprehensive informational requirements to ensure that affected employees were given notice by their employers of the new rules.

The employee who entered into a non-compete arrangement must be given “clear and conspicuous notice” that the non-compete arrangement will not be, and cannot be, enforced. The notice the employer must give must: (1) identify the employee who entered into the non-compete arrangement; (2) Be written and hand-delivered to the employee, or by mail at the employee’s last known personal street address, or by email to the employee’s current work email address or last known personal email address, or by text message at the employee’s cellular telephone number. The FTC provides an exception from the notice requirement if the employer has no information about the employee’s physical address, email address, or cellular phone number. The FTC provided sample language employers should probably track in their notice to assure compliance.

Valuation Considerations

At the end of 2025, the estate, gift, and GST exemptions will be reduced by half. Many owners of closely held family businesses will have their business interests appraised as a prerequisite to planning those transfers. Consideration should be given to the potential impact of the loss of the ability to protect the business using non-compete, non-disclosure, and non-solicitation agreements. In some instances, the loss of these safeguards may reduce the value of the business, and that may at least have some positive impact on estate planning.

Conclusion

While the FTC’s restrictions or prohibition on the use of non-compete, non-disclosure, and non-solicitation agreements certainly will help many employees, the impact on many closely held and family businesses could be negative and dramatic. In particular, business owners must evaluate how these new rules may adversely affect succession planning.

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