The sale of the business – either an asset purchase or a share purchase – is usually a capital event, giving rise to capital income to the seller. In the case of a closely held business, the purchase agreement often includes a covenant not to compete.
Even if executed in connection with complete sale of a business, a covenant not to compete is taxable as ordinary income under the “substitute for ordinary income doctrine.” This is true regardless of whether the covenant to compete is executed as a separate document, or whether it is included in the purchase agreement. The explanation for this treatment was explained by one court as follows: “Compensation paid for refraining from labor [is] taxable income no less than compensation for services to be performed.” Thus, the percentage of the purchase price allocable to the covenant not to compete is taxed as ordinary income in the year received. When the purchase agreement includes a covenant not to compete, the seller should allocate what portion of the purchase price is attributable to the covenant in the purchase agreement. The IRS will generally respect such allocations unless they are “not appropriate.” Failure to do so will leave the allocation up to the IRS who may attribute a higher value to the covenant. From the buyer’s perspective, a covenant not to compete is a “Section 197 Intangible” which allows the buyer to amortize the amount paid over a 15 year period. This treatment is only allowable in the case of an asset sale. The deduction is not available in the case of a sale of stock or partnership interests. Further, the 15 year amortization period must be used, even if (as will ordinarily be the case), the non-compete period is less than 15 years.
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In Beacon Residential Community Assn. v. Skidmore, Owings & Merrill LLP (2014) 59 Cal. 4th 568, the Supreme Court held that design professionals who provided “architectural and engineering services” for a 595 unit condominium project owed a duty of care to the homeowners’ association and its members. The case is significant in that is establishes a black-and-white rule with respect to the liability of architects and engineers to subsequent owners with whom they have no privity of contract.
“Liability for negligent conduct may only be imposed where there is a duty of care owed by the defendant to the plaintiff or to a class of which the plaintiff is a member” (J’Aire Corp. v. Gregory (1979) 24 Cal. 3d 799, 803). Prior to Beacon, there was uncertainty as to whether an architect or engineer owed a legal duty of care to subsequent homeowners. As a result, victims of defective construction were forced to rely on a six-factor test first articulated by the Supreme Court in Biakanja v. Irving (1958) 49 Cal. 2d 647 to determine the existence of a legal duty. As explained in Biakanja: The determination of whether in a specific case the defendant will be held liable to a third person not in privity is a matter of policy and involves the balancing of various factors, among which are [1] the extent to which the transaction was intended to affect the plaintiff, [2] the foreseeability of harm to him, [3] the degree of certainty that the plaintiff suffered injury, [4] the closeness of the connection between the defendant’s conduct and the injury suffered, [5] the moral blame attached to the defendant’s conduct, and [6] the policy of preventing future harm. Most plaintiffs’ attorneys agreed that under the Biakanja factors, an architect or engineer clearly did owe a duty of care to subsequent homeowners. They were supported in this belief by cases like Huang v. Garner (1984) 157 Cal. App. 3d 404, which held that the general contractor and developer owed a duty of care to subsequent purchases. Nevertheless, defense attorneys frequently filed demurrers and motions for summary judgment or adjudication on the basis no legal duty of care was owed to homeowners with whom the architect or engineer had no contractual relationship. Defense attorneys relied on cases like Bily v. Arthur Young & Co. (1992) 3 Cal. 3th 370, which held that an auditor owes no duty of care to its client’s investors. Indeed, the trial court in Beacon, relying on Bily, granted the defendant’s demurrer on this exact basis. The Supreme Court’s decision in Beacon is not a huge surprise. The Biakanja factors strongly support the existence of a legal duty of care between a project architect or engineer and subsequent homeowners. Nevertheless, the case provides much needed certainty. It will reduce law and motion practice and avoid the sometimes inconsistent results which stemmed from the application of the Biakanja factors. Mortgage loans are frequently assigned, sold and securitized. As a part of the continuing fallout from the collapse of the real estate market, some borrower have sought to recover damages for “wrongful foreclosure” on the basis the party who commenced the foreclosure had no authority to do so based on the inability of the foreclosing party to establish a chain of ownership to the mortgage loan and deed of trust. Gomes was followed in Jenkins v. JP Morgan Chase Bank (2013) 216 CA4th 497. In Jenkins, the borrower alleged the “entity who initiated the nonjudicial foreclosure process did not have authority to do so because … the entity was not the owner of the promissory note that was secured by the deed of trust” (id. at 512). Following a demurrer, the court held that “like the appellant in Gomes, she fails to identify legal authority for such a preemptive action in the statutory provisions setting forth the nonjudicial foreclosure scheme. After our own examination of the nonjudicial foreclosure statutes, we agree with the Gomes court that the provisions do not contain express authority for such a preemptive action” (id. at 513). Multiple other cases have reached the exact same result (Keshtgar v. U.S. Bank. (2014) 226 CA4th 1201; Herrera v. Federal Nat. Mortg. Assn. (2012) 205 CA4th 1495; Siliga v. Mortgage Electronic Registration Systems, Inc. (2013) 219 CA4th 75). |
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