NONCOMPETES AS TAX EVASION.

Author:Morrow, Rebecca N.
 
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Al Capone famously boasted of his criminal empire: "Some call it bootlegging. Some call it racketeering. I call it a business. " Treasury Agent Frank Wilson and Prosecutor George Johnson put Capone behind bars not by disputing his characterization and pursuing murder or assault or RICO charges, but by accepting it and enforcing its tax implications. Irrespective of their legality, Capone's businesses were profitable, and Capone had not reported their profits for tax purposes. A simple application of bedrock tax law achieved what other legal routes failed to achieve and sent Capone to Alcatraz. The trick was to see the tax argument.

Policymakers should use a similar approach to curtail the excessive, exploitative, and anticompetitive use of employment noncompete agreements. Currently, nearly one in five (or thirty million) American workers is bound by an employment noncompete. Employers claim that they adequately compensate employees for noncompete restrictions with higher wages, bigger raises, and/or more generous bonuses. Policymakers scoff at this claim and use contract law to attack them. Unfortunately, employment noncompetes are like Al Capone in that they have flourished despite the law's efforts to restrain them. Recently, the largest study of noncompetes in U.S. history paradoxically found that their prevalence is unaffected by their enforceability. In states like California that refuse to enforce employment noncompetes, they are as common as in states that uphold them. Contract law has proved ill-equipped to respond to the pervasive, expanding, and damaging use of noncompetes.

This Article is the first to shift the focus and to argue that employment noncompetes, as employers currently use them, constitute tax evasion and should be attacked as such. If employers pay employees for noncompetes through compensation, then by employers' own account, this compensation is not purely an expense associated with immediate benefits; rather, it is an expenditure associated with future benefits--benefits that the employer will enjoy years after payment. Thus, the IRS should stop allowing employers to fully immediately deduct the compensation they pay to employees subject to noncompetes and instead should require that an adequate portion of total compensation be allocated to the noncompete and amortized over the restricted period, beginning when employment ends.

TABLE OF CONTENTS INTRODUCTION I. PREVALENCE AND HARMS OF EMPLOYMENT NONCOMPETES A. Prevalence B. Harms 1. Negative Growth Effects 2. Negative Distributional Effects 3. Negative Ethical Effects C. State Responses D. Federal Responses II. WHY CONTRACT LAW IS A WEAKER APPROACH A. Tension with Contract Law Principles B. Ignores Business Judgment C. Relies on Private Enforcement D. Employer-Friendly Judicial Doctrines E. Empirical Evidence of Failures F. But Contract Law Offers a Hint to Tax Law III. CURRENT TAX TREATMENT OF NONCOMPETES A. Employers Quietly, and Without Resistance, Immediately Deduct Payments for Employment Noncompetes B. Violates Expense vs. Expenditure C. Violates Burden of Proof Rules D. Subsidizes that Which We Oppose IV. PROPOSAL V. WHY TAX LAW Is A STRONGER APPROACH A. Consistency with Tax Law Principles B. Powerful Enough to Change Employer Behavior C. Encourages Employers to Narrow Scope and Application D. Resolves Uncertainty in Favor of the Vulnerable E. Provides Employer-Funded Information to Guide Reform F. Properly Rejects Accelerated Recovery G. Properly Reflects the Value of Noncompetes CONCLUSION INTRODUCTION

An employment noncompete is a contract between an employer and employee by which the employee agrees not to work for a competitor or open a competitive business for a specified period following the termination of her current employment relationship. (1) It restricts competition "for a specified period of time in a designated geographical area." (2) Often, an employee becomes subject to a noncompete as a condition of obtaining employment, continuing employment, receiving a promotion, or receiving a bonus. (3)

Employment noncompetes are unlike and should be distinguished from businesssale noncompetes, (4) a type of contract that is not the subject of this Article. (5) Unlike a business-sale noncompete, which begins to run immediately, an employment noncompete does not begin to run immediately. (6) Rather, the restricted period of an employment noncompete begins only upon termination of the employment relationship. (7) While the "exact terms of [employment] covenants not to compete will vary widely ... [the] unifying element is that once the employment is ended (by either party and under any circumstances in some cases) the employee is, in theory, not allowed to compete against the former employer" (8) for the restricted period, often twelve months, (9) or eighteen months, (10) or twenty- four months," following termination. Thus, while employment noncompetes typically are signed pre- or mid-employment, they limit "the post-employment mobility of an employee." (12)

The need to curtail employment noncompetes is great. Employment noncompetes have been used, and have attracted judicial and political skepticism, for over half a millennium. (13) Recently, however, their use has become more common, (14) causing "a near explosion in the attention being paid to [employment] noncompetes and their effects" by media outlets, policymakers, economists, and legal scholars. (15) While policymakers, economists, and legal scholars generally acknowledge that employment noncompetes can encourage training and innovation by protecting employers from the risk that their employees will "misappropriate trade secrets or other legally-protected intellectual properties," they overwhelmingly conclude that the harms of noncompetes far outweigh their potential benefits, particularly as noncompetes are currently overused. (16) Employment noncompetes are deliberately anti-competitive contracts that undermine important public policy goals like economic growth and knowledge-sharing while locking employees out of employment opportunities and making them susceptible to exploitation by the employers to whom they are bound. (17) At a minimum, studies indicate that employment noncompete agreements are significantly overused. (18)

The political will to curtail employment noncompetes is also great. Courts, federal policymakers, and state legislatures have attempted to limit the harms caused by employment noncompetes by advocating and, in various jurisdictions, implementing resistance grounded in contract law. Most states will only enforce a noncompete if it is judicially determined to be reasonable in duration, scope, and geographic reach. (19) Further, most states have sought to protect employees with a variety of additional procedural and substantive safeguards. (20) California and North Dakota have gone so far as to prohibit judicial enforcement of employment noncompetes.

Despite the need and political will to curtail employment noncompetes, however, courts overwhelmingly find that they are supported by adequate consideration. When employers are forced to defend employment noncompetes as valid, enforceable contracts that comply with judicially- imposed reasonableness standards, they consistently and successfully argue that they adequately compensate their employees for being subject to noncompete restrictions through enhanced employment benefits. Employers have successfully argued to courts across the nation that an employer's decision to hire an employee, retain an at-will employee, promote an employee, pay a salary to an employee, award a raise to an employee, pay a bonus to an employee, grant stock options to an employee, or otherwise to provide or increase compensation to an employee constitutes adequate consideration provided by the employer to the employee in exchange for the noncompete. These findings prevent contract law from being a more effective approach to curtailing employment noncompetes. However, as this Article aims to show, they also suggest a new--and potentially far more effective--approach.

While well-intentioned and varied, efforts to curtail employment noncompetes through contract law have failed. Employment noncompetes have flourished despite contract-law-based efforts to restrain them. Recently, the largest study of employment noncompetes in American history found that, paradoxically, the prevalence of employment noncompetes is unaffected by their enforceability. In states like California that refuse to enforce noncompetes, they are as common as in states that uphold them. Contract law has proved ill-equipped to respond to the pervasive, expanding, and damaging use of noncompetes.

This Article is the first to propose a new and potentially far more effective approach--a tax-law-based approach--to curtailing employment noncompetes. When viewed through the lens of tax law, an employment noncompete is not simply a contract to be challenged by the employee and upheld, modified, or set aside by the court. It is also an intangible asset of the employer, increasing that employer's future market share and future business opportunities. (21) According to employers' own accounts, and the vast case law upholding their accounts, employers pay their employees for becoming subject to noncompetes through compensation. In other words, employers buy employment noncompetes with a portion of the compensation that they pay to employees subject to noncompetes.

One innovation of this Article is to expose that, when an employer pays for a noncompete, it is a long-term expenditure. An employment noncompete is an intangible asset that primarily benefits employers in future tax years, beginning when the employment relationship ends. Tax law dictates that when a long-term expenditure is paid for with employment compensation, payments for long-term expenditures are not immediately deductible. Rather, payments for long-term expenditures must be...

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