The value of a business can depend to a large degree on motivating and retaining key employees. Despite the high stakes, it is remarkably common to encounter owners who rely on informal practices to assure loyalty and solid performance. They only realize the importance of tools like “golden handcuffs” and restrictive covenants, such as non-solicitation and trade-secret protections, when someone leaves to join a competitor. At an earlier stage, when the value of their business is low, many take a penny-wise approach that later costs key employees massive tax benefits when the business succeeds.
The applicable rules change periodically, and, indeed, there have been some recent developments in the world of executive compensation. One involves the so-called “Section 83(b)” election, discussed below. Another, which is beyond the scope of this Alert, involves changes that the IRS and the Department of Treasury proposed on January 14, 2025, to the regulations under Section 162(m) of the Internal Revenue Code of 1986.[1]
Read on for a checklist of some of the executive-compensation and business-protection alternatives that owners may be wise to consider.
Business Protections
Non-competition provisions have emerged in America as a toxic practice in the eyes of some. This trend arguably reflects a public sense of unfairness to workers, spurred on by state laws and recent now-enjoined FTC rule-making efforts[2], and an evolving sense of fairness on the part of lawmakers, the courts and the press. It is noted, however, that, in those jurisdictions in which noncompetes are not actually barred by criminal law or subject to civil penalties, even an ostensibly unenforceable noncompete can effectively impede the later employment (or other retention) of a service provider if the subsequent employer (or other service recipient) is unwilling to proceed with the retention as a result of the noncompete.
In the wake of blowback against non-competition restrictions, some owners may be chilled from pursuing or refining three other related business protections that are generally considered reasonable to establish. In addition, Federal and state laws can impact the allowability and enforceability of the following tools, thus requiring specific evaluation before any measures are implemented.
Trade Secrets, Inventions, and Confidential Information. Key employees almost always have access to the deepest and most critical plans of their employers. Agreements relating to these matters can sometimes have subtle and not-so-subtle implications that effectively amount to noncompete restrictions, depending on the applicable facts and circumstances.
Non-solicitation of Customers. Not all key employees interact with customers. However, business risk comes from those who do develop relationships with customers. These provisions are generally easier to enforce than general noncompetes.
Non-solicitation of Employees. Key employees almost always develop ties and influence over other employees and contractors. While these provisions are generally enforceable, depending on how tightly they are drafted, departing personnel frequently try to avoid or even evade the applicable contractual restrictions.
Business-protection agreements relating to any of the foregoing may sometimes best be complemented by financial enforcement-related incentives in the form of executive compensation that is placed at risk in the event of breached confidences and other agreements. For instance, deferred compensation (subject to applicable tax considerations) may be eligible for payout only after a departing executive has honored post-employment restrictive covenants such as those described above.
Protective measures regarding the foregoing involve tricky issues of law, and should not be undertaken until legal counsel has outlined the legal boundaries and design alternatives. Advance attention is almost always preferable to emergency action after the damage has occurred.
Tax Incentives – Section 83(b) Elections
As the old saw goes,”[N]obody owes any public duty to pay more [in taxes] than the law demands.”[3] Similarly, those who start new business ventures — or deal with struggling ones — may be tempted, understandably, to delay the time and expense associated with implementing tax-advantaged strategies for the benefit of key employees and other service providers.
Plans for restricted stock awards are often efficient to design and implement, where the applicable facts and circumstances make such plans desirable. For start-up and other companies with minimal fair market value, Section 83(b) of the Internal Revenue Code of 1986 provides a potentially special opportunity for executives to lock in capital gains treatment within 30 days after receiving restricted stock awards. Section 83(b) elections require that the recipient of restricted stock recognize ordinary income at the time of the award, which is why Section 83(b) elections generally make real sense for stock that has little value when the awards occur. (It is noted in this regard that the election is almost always extremely well-advised even where the grantee pays fair market value for the stock, if the stock at the time of purchase is unvested.) Section 83(b) elections can also have critical utility in a wide variety of circumstances outside of the start-up context.
The IRS recently released Form 15620 for use in making Section 83(b) elections, thereby reducing the cost of implementing restricted stock programs at an early or low-value stage. At this juncture, while an election is still required, use of the new form to make the election is not, although its use may facilitate electronic submission. It is noted that the new form includes the following two features (which, depending on the structure of any particular grant and the surrounding facts and circumstances, could be relevant to whether using the form is desirable) that appear in neither the regulation nor the previous IRS model (see Rev. Proc. 2012-29): (i) required identification of the service recipient and (ii) execution under penalty of perjury.
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The attorneys at The Wagner Law would be happy to hear from business owners and key employees (and other service providers) who desire further information about any of the alternatives described above.
[1] The fate of the Section 162(m) proposal is uncertain in light of the regulatory freeze provided by the January 20, 2025, Memorandum issued by President Trump.
[2] FTC Announcement, April 23, 2024 (describing efforts “to promote competition by banning noncompetes nationwide, protecting the fundamental freedom of workers to change jobs, increasing innovation, and fostering new business formation.”).
[3] Comm’r v. Newman, 159 F.2d 848, 851 (2d Cir. 1947) (Hand, J. dissenting).