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From a new final regulation on basis consistency to Corporate Transparency Act updates and a federal court ruling regarding the review required to determine medical necessity under the Medicaid Act, we have recently seen significant legal developments.
To ensure that you stay abreast of these changes, we have highlighted some noteworthy developments and analyzed how they may impact your estate planning, elder and special needs law, and business law practices.
Estate Planning
IRS Releases Final Rule Addressing Basis Consistency Between Estate and Recipient of Property from Decedent
Consistent Basis Reporting Between Estate and Person Acquiring Property From Decedent, 26 C.F.R. pts. 1 and 301 (2024)
On September 17, 2024, the Internal Revenue Service (IRS) issued final regulations implementing a requirement under the Surface Transportation and Veterans Health Care Choice Improvement Act of 2015 (Act) that the final determination of a property’s value for estate tax purposes (or if the final value has not been determined, the value included on a statement the executor must file with the IRS) and the basis reported by the individuals who inherit the property from the decedent be consistent. The Act also requires the executors of estates and certain other individuals to file a statement of the property’s value as reported on the estate tax return with the IRS and provide the statement to every individual who receives an interest in property included in the decedent’s gross estate.
Proposed regulations were issued in 2016, but the final regulations include significant changes aimed at decreasing the burden on taxpayers and the IRS, including the following:
- The final regulations clarify that the consistent basis rule only applies until the entire property is sold, exchanged, or otherwise disposed of in a recognition transaction for income tax purposes—even if no gain is recognized—or the property is includible in another decedent’s gross estate. In like-kind exchanges, which are not recognition events, substituted property is subject to the consistent basis requirement until the owner’s basis in every portion of the substituted property is no longer related to the final value of the property acquired from the decedent.
- The final regulations do not include a provision that was part of the proposed regulations that property discovered after the estate tax return was filed or otherwise omitted from the return would have a zero basis, resulting in a 100 percent taxable gain if the beneficiary later sold the property.
- The final regulations alter a requirement that was included in the proposed regulations that would have required a statement of the basis of the assets to be furnished to an estate’s beneficiaries within 30 days after the filing of the estate tax return, which is before many estates typically distribute assets to beneficiaries and would have required executors to provide beneficiaries with statements of the value of all assets that could potentially be distributed to them. The final regulations include changes that would enable executors to provide basis information to beneficiaries after they know which beneficiary has received each asset: (1) executors must provide a statement to a beneficiary within 30 days after the filing of the estate tax return of the value of assets distributed to them before the filing of an estate tax, and (2) for assets distributed after the filing of the estate tax return, executors must provide the statement to the beneficiary by January 31 of the calendar year following the year the property is distributed to the beneficiary.
- The final regulation modified a provision included in the proposed regulations that would have required a report by beneficiaries who make a subsequent transfer by gift of property they inherit. In the final rule, the reporting requirement applies only to trustees when they distribute inherited property from a trust.
Takeaways: The statutory basis consistency rules were enacted because the interests of a decedent’s estate and the estate’s beneficiaries may diverge regarding the valuation of property transferred at death. Estates that may be liable for estate tax prefer the decedent’s assets to have low valuations to reduce the amount of estate tax liability. In contrast, the beneficiary of an estate often prefers assets to have higher valuations to achieve a higher basis step-up, which reduces the beneficiary’s income tax liability if the beneficiary sells the asset in the future. The final regulations implementing the statutory basis consistency requirement are less onerous than the 2016 proposed rules. Attorneys representing executors, trustees, and individuals who inherit property from an estate should familiarize themselves with the final regulations.
Value of Interest in Family Limited Partnership Included in Decedent’s Gross Estate
In re Estate of Fields v. Comm’r, No. 1285-20, T.C.M. 2024-90 (Sept. 26, 2024)
In the 1960s, Anne Milner Fields inherited an oil business from her husband, which she ran successfully until she died in 2016. Before her death, Anne educated and mentored her great nephew, Bryan Milner, whom she designated to receive her wealth and take over the business. In 2010, Anne granted Bryan a comprehensive durable power of attorney, and during the following years, he cared for her and managed her assets. About one month before Anne’s death, Bryan, as authorized by the power of attorney, implemented an estate plan. As part of the plan, Bryan formed a limited partnership, naming a limited liability company (LLC) of which he was the sole member and manager as the general partner and Anne as a limited partner. He signed the limited partnership agreement on behalf of the LLC and on behalf of Anne as her agent. Under the power of attorney, he also transferred most of her wealth—assets worth around $17 million—to the limited partnership. Bryan contributed $1,000 to the limited partnership as the LLC/general partner. Anne received a 99.9941 percent limited partner interest as part of the arrangement, and Bryan, as the LLC/general partner, received a 0.0059 percent interest.
After Anne’s death, Bryan obtained an appraisal of her limited partnership interest. The appraiser determined that the $17 million in assets contributed to the limited partnership should be reduced by discounts of 15 percent for lack of control and 25 percent for lack of marketability. Accordingly, Bryan, as executor, filed an estate tax return valuing Anne’s limited partnership interest at $10,877,000.
The IRS filed a notice of deficiency, asserting that pursuant to I.R.C. § 2036(a), Anne’s gross estate included the full date-of-death value of the assets contributed to the limited partnership. Alternatively, the IRS argued that Anne’s estate had undervalued her limited partner interest and that the interest was actually worth $15,388,000.
The United States Tax Court determined that the value of Anne’s limited partnership interest should be included in her gross estate under I.R.C. § 2036(a) based on a three-part test:
- There must be an inter vivos transfer of property. (This was met when Bryan, as Anne’s agent, transferred the assets owned by her to the limited partnership during Anne’s life.)
- The decedent must have retained an interest or a right specified in I.R.C. § 2036(a)(1) or (2) in the transferred property that was not relinquished until their death. This prong, too, was met. The court determined that Anne retained possession or enjoyment of or the right to income from the property because she effectively held the right to all the income from her transferred assets as limited partner. Further, because most of Anne’s assets were transferred to the limited partnership, the court determined that there was an “implicit agreement” between Bryan and Anne that he would make distributions necessary to “satisfy her expenses, debts, and bequests if and when necessary.” In re Estate of Fields v. Comm’r, T.C.M. 2024-90, at *9 (Sept. 26, 2024). The court determined that the facts supported this view, as Bryan had made distributions from the limited partnership after Anne’s death to satisfy her bequests and estate taxes. Further, the limited partnership agreement specified that Anne had the right to dissolve the partnership at any time and held the right to its income and the power to determine who should receive or enjoy it. The court stated: “We emphasize that here there was essentially no pooling of assets in the partnership, which accordingly functioned not as a joint investment vehicle but rather only as a vehicle to reduce estate tax.” Id. at *10.
- The transfer must not have been a bona fide sale for adequate and full consideration. The court noted that “[w]hether a transfer is a bona fide sale is a question of motive, and whether a transfer is for adequate and full consideration is a question of value.” Id. at *16. Although the court determined that Anne received full and adequate consideration, the court rejected the estate’s arguments that there was a bona fide sale because the court determined that the only motive for the transfer was to reduce estate tax.
The court applied the formula set forth in Moore v. Comm’r, T.C.M. 2020-40 (2020) to determine the date-of-death fair market value of the transferred assets. The formula considered various factors, including Anne’s receipt of full consideration for the transfer of assets and a discount for illiquidity of her limited partnership interest. The court determined that the value of the limited partnership included in the notice of deficiency, $17,062,631, must be included in Anne’s gross estate. Further, it held that the estate was liable for a 20 percent accuracy-related penalty for its underpayment of estate tax.
Takeaways: The Tax Court’s decision in In re Estate of Fields is another in a line of cases in which the IRS has successfully challenged a family limited partnership on the basis that the transferor of the assets retained possession or enjoyment of the assets and the partnership was formed solely to reduce estate tax liability using valuation discounts. See Strangi v. Comm’r, 417 F.3d 468 (5th Cir. 2005) and In re Estate of Powell v. Comm’r, 148 T.C. 392 (2017). In re Estate of Fields reminds attorneys of the standards that must be met to avoid inclusion of the value of a decedent’s interest in a family limited partnership in their gross estate.
Children with Remainder Interest in QTIP Trust Made Taxable Gifts to Surviving Spouse When Trust Was Commuted and Assets Distributed Outright to Surviving Spouse
McDougall v. Comm’r, Nos. 2458-22, 2459-22, 2460-22, 163 T.C. No. 5 (Sept. 17, 2024)
When Clotilde McDougall passed away in 2011, the residuary of her estate passed to a trust (Residuary Trust) designating her husband, Bruce, as the income beneficiary and their children, Linda and Peter, as the remainder beneficiaries. Bruce, as the representative of Clotilde’s estate, elected to treat the Residuary Trust property as qualified terminable interest property (QTIP), and the estate claimed a marital deduction of approximately $54 million. In 2016, Bruce and the children, Linda and Peter, entered a nonjudicial agreement to commute the Residuary Trust and distribute all trust assets outright to Bruce. Pursuant to the terms of the nonjudicial agreement, Bruce sold some of the distributed trust assets to trusts established for the benefit of Linda and Peter in exchange for promissory notes.
Bruce, Linda, and Peter filed gift tax returns for 2016, asserting that there was no gift tax because the mentioned transactions were offsetting reciprocal gifts. The IRS filed notices of deficiency, arguing that the commutation of the Residuary Trust was a gift from Bruce to Linda and Peter and that the nonjudicial agreement further resulted in a gift from Linda and Peter of their remainder interests in the Residuary Trust to Bruce.
Bruce, Linda, and Peter filed a motion for summary judgment in the Tax Court, and the IRS filed a motion for partial summary judgment. The court applied the principles set forth in In re Estate of Anenberg v. Comm’r, No. 856-21, 162 T.C. (May 20, 2024), a case with similar facts, holding that the commutation of the Residuary Trust did not result in gift tax liability for Bruce under Internal Revenue Code (I.R.C.) § 2501 because although Bruce had made a transfer, it was not a gratuitous transfer. Rather, under the QTIP tax fiction established under I.R.C. § 2519(a), for gift tax purposes, “any disposition of all or part of a qualifying income interest for life in any [QTIP] shall be treated as a transfer of all interests in such [QTIP] other than the qualifying income interest.” McDougall v. Comm’r, Nos. 2458-22, 2459-22, 2460-22, 163 T.C. No. 5, at 9 (Sept. 17, 2024) (quoting I.R.C. § 2519(a)). Further, the court determined that the transfer of the property held by the Residuary Trust from Bruce to Linda and Peter in exchange for promissory notes was not a gift from Bruce to Linda and Peter.
Notably, in In re Estate of Anenberg, the court explicitly noted that it expressed no view about whether the nonspouse beneficiaries of the trust in that case had made a gift to the surviving spouse for gift tax purposes because the IRS had not determined deficiencies against those beneficiaries. In contrast, in the present case, the IRS did determine deficiencies against Linda and Peter.
The court found that the commutation resulted in a gift from Linda and Peter to Bruce under I.R.C. § 2511, and thus, Linda and Peter were liable for gift tax. The court agreed with the IRS’s position that “[w]ith regard to Linda and Peter, there is no [QTIP] tax fiction at work.” Id. at 12. Their remainder interests in the Residuary Trust were valuable property interests that became part of their estates. Their transfers of those interests to Bruce pursuant to the nonjudicial agreement without receiving anything in return were “quintessential gratuitous transfers and are therefore subject to gift tax under sections 2501 and 2511.” Id. The court emphasized that its ruling was consistent with “the function of the QTIP regime—namely, not eliminating or reducing tax on the transfer of marital assets out of the marital unit, but rather permitting deferral [of that transfer tax] until the death of or gift by the surviving spouse.” Id. Linda and Peter were not permitted to invoke the QTIP tax fiction to escape gift tax liability for their own transactions.
The court also rejected Bruce’s, Linda’s, and Peter’s assertion that the transactions resulted in offsetting reciprocal gifts. As mentioned, the court determined that although Bruce had made a deemed transfer under I.R.C. § 2519(a), it was not a gratuitous transfer because that section does not deem a gift. Because there were no deemed gifts from Bruce to Linda and Peter, they did not receive anything of value from Bruce that offset their relinquishment of their remainder interests in the Residuary Trusts under the nonjudicial agreement.
In addition, the court disagreed with Linda’s and Peter’s argument that they had not transferred anything to Bruce because Bruce was deemed under I.R.C. § 2519(a) to own all of the QTIP. Although Bruce was the deemed owner of all the QTIP under the statutory QTIP tax fiction, Linda and Peter had real remainder interests that they transferred to him, and “Bruce may have already been deemed to hold those rights for purposes of determining his transfer tax liability is of no moment.” Id. The transfers of their remainder interests to Bruce were gifts subject to gift tax consequences, just as a transfer to any other party would have been.
The court also rejected Bruce’s, Linda’s, and Peter’s position that no gift had occurred because their economic positions had not been altered. To the contrary, the transactions had indeed resulted in changes in their economic positions: after the implementation of the nonjudicial agreement, Bruce owned outright the assets that had been held by the Residuary Trust and was free to dispose of them as he wished, and Linda and Peter no longer held remainder interests in assets previously held in the Residuary Trusts.
Takeaways: For a discussion of In re Estate of Anenberg v. Comm’r, No. 856-21, 162 T.C. No. 9 (May 20, 2024), see WealthCounsel’s June 2024 monthly recap of recent legal developments. The IRS recently determined that certain trust modifications, such as the transactions in McDougall and In re Estate of Anenberg, result in gift tax liability. Another example is the IRS’s ruling in Chief Couns. Adv. 2023-52-018, in which the IRS determined that beneficiaries of an irrevocable grantor trust modified to include a tax reimbursement clause were subject to gift tax, discussed in the January 2024 monthly recap.
Elder Law and Special Needs Law
Physician’s Opinion Not Entitled to Deference in State’s Review of Ongoing Need for Skilled Nursing Hours Under Medicaid Act
M.H. by and through Lynah v. Comm’r of the Georgia Dept. of Cmty. Health, 111 F. 4th 1301 (11th Cir. 2024)
The Medicaid Act, 42 U.S.C. §§ 1396–1396w-8, establishes a program under which states create and fund their own medical assistance programs to provide treatment to needy individuals, which the federal government partially reimburses. States that choose to participate in the Medicaid program must meet certain federal requirements, including providing specified categories of care and services. Certain medical services are mandatory, but the state is only required to provide them if they are determined to be medically necessary. Private duty nursing services are among the services that must be provided to Medicaid-eligible children.
In Georgia, the Department of Community Health (DCH) provides skilled nursing services to medically fragile children eligible for Medicaid. Georgia contracts with Alliant Health Solutions (Alliant), a private organization, to review requests for in-home skilled nursing for pediatric patients and determine the number of skilled nursing hours the patient should receive. The patient’s physician provides approval for a nursing agency to request services for patients, who are then approved to receive a certain number of skilled nursing hours per week. Alliant periodically reviews each case to determine the number of hours it views as medically necessary and must provide documentation to the state of Georgia supporting its determination.
In 2015, M.H. and other minor children, through their guardians, filed a class action lawsuit against the Commissioner of the DCH, alleging that the DCH had violated the “early and periodic screening, diagnostic, and treatment” provision (42 U.S.C. § 1396d(r)) of the Medicaid Act by failing to approve the number of skilled nursing hours that were medically necessary to care for the patients. M.H. and other plaintiffs also obtained preliminary injunctions preventing the DCH from approving fewer than a certain number of hours a day of skilled nursing care for them and a court order requiring the DCH to approve the number of hours recommended by their physicians rather than the lower number approved by the DCH. After granting the motion for certification of the class action, the federal district court granted the patients’ motion for summary judgment and entered permanent injunctions in favor of several individual patients.
On appeal, the Eleventh Circuit Court of Appeal reviewed only the individual patients’ summary judgment motions and permanent injunctions, as the district court had not yet ruled on class-wide relief. The court reversed the summary judgments in favor of the patients, vacated the permanent injunctions against the DCH, and remanded the case for further proceedings based in part on the following substantive rulings:
First, the court noted that the Medicaid Act and its implementing regulations allow states to set “reasonable standards” regarding the terms “medically” and “necessary” and broad discretion in adopting standards addressing when medical assistance is necessary. The court rejected the district court’s ruling that the DCH had not given appropriate weight to the recommendation of a patient’s treating doctor. Rather, the state is not required to defer to the treating physician’s prescription; it is sufficient if it evaluates the “medical necessity of the amount of nursing care prescribed by the treating physician” for the patient’s condition or conditions. M.H. by and through Lynah v. Comm’r of the Georgia Dept. of Community Health, 111 F. 4th 1301, 1309 (11th Cir. 2024). The pivotal question is whether the state approved sufficient skilled nursing hours to treat the patient’s conditions. Alliant had developed a score sheet that provided a presumptive range of medically necessary skilled nursing hours to correct or ameliorate a patient’s conditions, which were then discussed by its review team. The court found that the Medicaid Act, relevant regulations, and case law did not require a different review.
Second, the court agreed with the DCH that it may consider a patient’s stability and a caregiver’s training in determining the number of skilled nursing hours that are medically necessary for a patient and may reduce the number of skilled nursing hours considered medically necessary after the patient’s caregiver learns to perform skilled tasks. The DCH may rationally conclude that a patient without a skilled caregiver needs more skilled nursing hours than a patient with a skilled caregiver to further the goal of efficiently using resources. Therefore, if a skilled caregiver can improve a patient’s condition, it is not necessary for them to receive care from a private nurse, even if that care would also improve the patient’s condition.
Takeaways: A Medicaid pediatric recipient’s physician is a key figure in determining the medical necessity of skilled nursing hours initially, but the physician’s opinion is not entitled to deference by the state in reviewing the ongoing need for skilled nursing hours: the state may perform its own review using a scorecard that accounts for the patient’s conditions and skilled nursing needs if its consideration includes an evaluation of the treating physician’s prescription. In this case, Alliant’s review process satisfied the required standard.
Estate Planning Attorney Did Not Owe Duty of Care to Disappointed Nonclient Beneficiaries
Grossman v. Wakeman, 325 Cal. Rptr. 3d 163 (Cal. Ct. App. Sept. 4, 2024)
In September 2011, Richard Grossman met with estate planning attorney John Peter Wakeman. During the meeting, Richard stated that he wanted half of his estate to go to his special needs son, Jeffrey, and the other half to his other son’s children, Alexis and Nicholas. However, in a December 2011 meeting attended by Wakeman, Richard, and Richard’s fourth wife, Elizabeth, Richard stated that he wanted his entire estate to go to Elizabeth and that she should have complete discretion to determine how the trusts established for Jeffrey, Alexis, and Nicholas should be funded. Wakeman, anticipating that this type of estate plan would lead to litigation, advised Richard to obtain a neurological evaluation to document that he had the contemporary capacity to create his desired estate plan. Richard’s longstanding physician performed the evaluation and determined that Richard was of sound mind and competent to make financial and estate planning decisions. In a January 2012 meeting, Richard told Wakeman that he wanted to leave everything to Elizabeth and that she would ensure that Jeffrey, Alexis, and Nicholas were taken care of. Although Richard signed irrevocable trusts for the benefit of Jeffrey, Alexis, and Nicholas, he indicated that he did not want to fund them. Instead, he wanted his assets to go outright to Elizabeth so she could determine if and how to fund the trusts.
After Richard’s death, Jeffrey, Alexis, and Nicholas filed a malpractice suit against Wakeman, asserting that he owed them a duty of care despite the fact that they were not his clients. At trial, the jury found in favor of Jeffrey, Alexis, and Nicholas and entered a judgment for damages in their favor. Wakeman filed a nonsuit on the basis that he did not owe a duty of care to them, but the trial court denied the motion.
On appeal, the sole issue was a question of law: whether Wakeman owed a duty of care to Jeffrey, Alexis, and Nicholas even though they were not his clients. The court relied on Gordon v. Ervin Cohen & Jessup LLP, 88 Cal. App. 5th 543, 564 (2023) in determining that the evidence was insufficient to demonstrate that Wakeman owed a duty of care to Jeffrey, Alexis, and Nicholas. In Gordon, the court acknowledged that although an attorney’s duty typically runs solely to their client, they “can sometimes owe a duty to third parties who are the intended beneficiaries of the lawyer’s legal work for the client, such as when the client retains the lawyer to draft a will, a testamentary trust, or an inter vivos trust or gift.” Grossman v. Wakeman, 325 Cal. Rptr. 3d 163, 171 (Cal. Ct. App. Sept. 4, 2024) (quoting Gordon, 88 Cal. App. 5th at 554–55). This duty to a nonclient third party only arises if the client’s intent to benefit that third party is “clear, certain and undisputed.” Id. (citations omitted). Further, the court determined that a third party must show that the client’s attorney knew or reasonably should have known of this evidence when the alleged malpractice occurred. This heightened standard reduces the possibility of conflicting duties to nonclients because the duty only exists when the client’s intent to benefit the nonclient is “crystal clear,” minimizing the potential for liability to nonclients. Id. (citations omitted). To hold otherwise would impose an undue burden on the legal profession. The court determined that the evidence of Richard’s alleged intent to leave his estate to respondents instead of Elizabeth was not clear, certain, and undisputed. Rather, it was insufficient as a matter of law to show that Wakeman owed a duty of care to them. To the contrary, Richard provided clear instructions of his intention to leave his estate to Elizabeth to Wakeman, who took steps to verify his testamentary capacity. In implementing this estate plan, Wakeman fulfilled his duty to Richard and did not owe Jeffrey, Alexis, and Nicholas a duty of care.
Takeaways: The Grossman case provides a reminder that attorneys typically do not owe a duty of care to disappointed would-be beneficiaries. However, estate planning attorneys must become familiar with the law in their jurisdiction. For example, in the Grossman case, the court stated that an attorney might owe a duty of care to a nonclient if the party had a clear intention to benefit the third party who was injured by the attorney’s failure to carry out the decedent’s intentions. In some jurisdictions, courts apply a strict privity rule limiting an attorney’s liability to nonclients to circumstances in which the attorney has committed fraud or a malicious or tortious act, including negligent misrepresentation. Further, other jurisdictions apply a rule that the attorney may be liable to a nonclient if the attorney knew, or should have known, that the nonclient would rely on their representations in circumstances in which the nonclients are not too remote from the attorneys to be entitled to protection.
Business Law
Corporate Transparency Act Updates
The U.S. Court of Appeals for the Eleventh Circuit heard oral arguments on Friday, September 27, 2024, in the case of National Small Business v. Yellen, in which National Small Business United (NSBU) is challenging the Corporate Transparency Act’s (CTA’s) beneficial ownership reporting requirements as unconstitutional. NSBU won in Alabama federal district court, with the Alabama court enjoining enforcement of reporting requirements against NSBU and its members; the above-referenced appeal followed. Recording of the oral arguments can be found on the Eleventh Circuit’s website.
In addition, in the first federal case to address the constitutionality of the CTA since National Small Business v. Yellen, Firestone v. Yellen, No. 3.24-cv-1034, Dkt. No. 18 (D. Or. Sept. 20, 2024), the United States District Court for the District of Oregon denied the plaintiffs’ motion for a preliminary injunction enjoining enforcement of the CTA, determining that the plaintiffs were unlikely to succeed on the merits because the CTA was likely constitutional.
In early October, the Financial Crimes Enforcement Network (FinCEN) updated its FAQs related to beneficial ownership information reporting requirements. Of special note is FAQ D.18, which indicates that both spouses may be required to report beneficial ownership information to FinCEN in community property jurisdictions.
Takeaways: WealthCounsel members may visit the Corporate Transparency Act webpage for additional information about the CTA.
Franchisor Must Comply with Duty of Good Faith in Terminating Franchise Agreement, but Duty Does Not Override Express Terms of Agreement
Distefano, Inc. v. Tasty Baking Co., 2024 WL 3936920 (D. Md. Sept. 25, 2024)
Tasty Baking Company (Tasty), a manufacturer of prepackaged baked goods, had a franchise agreement with DiStefano, Inc. (DiStefano) to distribute Tasty’s products on a particular route. Under the agreement, DiStefano was obligated to maintain a fresh supply of baked goods on its route and promptly remove outdated products. The agreement specified that failure to meet these obligations would constitute a material breach of the agreement, justifying its termination. To terminate the agreement, Tasty was required to provide DiStefano with notice of its intention to terminate and an opportunity to cure the breach within 10 days. However, the agreement specified that two notices within twelve months constituted a noncurable breach; in the case of a noncurable breach, Tasty was entitled to terminate the agreement with 24 hours written notice.
In July and September 2021, Tasty sent three letters to DiStefano notifying it that it breached the agreement for not removing out-of-date products from retailers’ shelves and providing 10 days to cure the breach. DiStefano acknowledged receiving the letters and did not dispute the breaches. It asserted that the breaches were due to a breakdown of its truck and suggested that Tasty was attempting to unfairly target it. On September 29, 2021, Tasty provided DiStefano with notice that the agreement would terminate as of October 1, 2021. After the termination of the agreement, Tasty operated the route. DiStefano filed a lawsuit alleging in part that Tasty had breached the agreement by violating the implied duty of good faith in terminating it and operating DiStefano’s former route after termination. Tasty filed a motion for summary judgment.
The United States District Court for the District of Maryland granted Tasty’s motion for summary judgment. It noted that under Pennsylvania law, which governed the agreement, there is only a limited implied duty of good faith in the context of termination of a franchise agreement. In addition, it recognized that even if the implied duty of good faith is applicable, it cannot override the agreement’s express terms. The court held that barring bad faith, Tasty’s termination of its agreement with DiStefano fell “squarely within the parties’ agreed terms.” Distefano, Inc. v. Tasty Baking Co., 2024 WL 3936920, at *5 (D. Md. Sept. 25, 2024). Further, DiStefano had not alleged any evidence that the termination was commercially unreasonable, and its assertion that Tasty’s inspectors had unfairly targeted it was merely speculative, particularly because it did not dispute that the breaches occurred.
Takeaways: The Distefano case reminds parties to heed the terms of the contract: the implied duty of good faith will not protect a party that has clearly breached the contract from termination according to its terms.
California Court of Appeals: Enforceability of Noncompetition Provision in Partial Sale of LLC Interest Governed by Reasonableness Standard
Samuelian v. Life Generations Healthcare, LLC, 104 Cal. App. 5th 331 (Cal. App. Ct. Aug. 20, 2024)
Robert and Stephen Samuelian co-founded Life Generations Healthcare, LLC (Life Generations) with Thomas Olds, Jr. The Samuelians eventually sold part of their interest in Life Generations, at which time they entered into a new operating agreement restricting them from competing with Life Generations but retaining certain positions, voting rights, rights to consent to certain amendments, and rights to certain information. Life Generations later asserted that the Samuelians had violated the noncompetition provisions. However, the Samuelians disputed the enforceability of the noncompetition agreement in an arbitration proceeding. The arbitrator determined that the noncompetition agreement was invalid per se under Cal. Bus. & Prof. Code, § 16600(a), and the trial court confirmed its decision.
On appeal, the California Court of Appeals was guided by the California Supreme Court’s ruling in Ixchel Pharma, LLC v. Biogen, Inc. 9 Cal. 5th 1130 (2020). In Ixchel, the court ruled that under Cal. Bus. & Prof. Code § 16600(a), two standards could apply in determining whether noncompetition agreements are void. Noncompetition covenants are either void per se or evaluated under a reasonableness test. The per se standard applies to restraints arising from the “termination of employment or the sale of interest in a business,” and the reasonableness standard applies to “agreements limiting commercial dealings and business operations.” Id. at 1152.
Life Generations acknowledged that the per se standard applies to void noncompetition agreements in cases involving the sale of an entire business interest. Still, they asserted that the reasonableness standard should apply to a sale of a partial business interest. The court of appeals determined that neither the Ixchel case nor § 16600(a) required the application of the per se standard to a sale of a partial business interest. Section 16600 states that “any owner of a business entity selling . . . all of his or her ownership interest in the business entity . . . may agree with the buyer to refrain from carrying on a similar business within a specified geographic area in which the business so sold, . . . so long as the buyer . . . carries on a like business therein” (emphasis added).
The court determined that because the seller of a partial business interest remains an owner of the business and may exercise some control over its operations, under those circumstances, a noncompetition provision should not be invalidated per se because it is not inherently anticompetitive. Rather, it should be evaluated under the reasonableness standard. The court noted that § 16600 does not invalidate noncompetition provisions prohibiting employees from competing with their current employer: its purpose is “not to immunize employees who undermine their employer by competing with it while still employed.” Samuelian v. Life Generations Healthcare, LLC, 104 Cal. App. 5th 331, 356 (Cal. App. Ct. Aug. 20, 2024). A seller of a partial interest in a business could similarly still have a substantial connection with the business, for example, the right to make operational decisions or have access to confidential business information. Therefore, the application of the per se standard to invalidate the noncompetition provision is inappropriate in the case of the sale of a partial interest in a business. In that situation, the noncompetition covenant is not inherently anticompetitive but may promote competition by ensuring that those with a present ownership interest are motivated to work in favor of the business’s interests rather than use their position and knowledge of its confidential information to undermine the business.
The court also addressed a potential conflict between Cal. Bus. & Prof. Code § 16600 and California’s version of the Revised Uniform Limited Liability Company Act, Corp. Code, § 17704.09 (LLC Act), which imposes a duty of loyalty on the members of a member-managed LLC, requiring them “[t]o refrain from competing with the limited liability company in the conduct . . . of the limited liability company.” Corp. Code § 17704.09(b)(3). The court determined that Cal. Bus. & Prof. Code § 16600 applies to “contracts” that restrain competition and does not impact the statutory duty of loyalty imposed by the LLC Act unless the duty is set forth in the operating agreement or another contract. It noted that “adoption of the per se standard to partial sales could create absurd results” because “a statutorily imposed duty of loyalty would be valid if unstated in a contract but would be invalid if repeated in one.” Samuelian, at 357. In contrast, if the reasonableness standard applied to partial sales of an LLC interest, the court could determine that the noncompetition provision was enforceable because the LLC Act mandated it.
The court also determined that the reasonableness standard should be applied to manager-managed LLCs because of the potential pro-competitive effects of allowing companies to restrict their owners from engaging in competitive activities instead of promoting the company’s growth and improvement. This is consistent with the LLC Act, which does not prohibit an operating agreement from imposing fiduciary duties on members in a manager-managed LLC but merely provides a default rule when the operating agreement is silent. Accordingly, the court held that if an operating agreement includes a noncompetition restriction in the fiduciary duties it imposes on members, it should be evaluated under the reasonableness standard. The court reversed the trial court’s ruling in favor of the Samuelians, directing the trial court to vacate the arbitration award in their favor.
Takeaways: The Samuelian case clarifies California law regarding two important issues. First, the reasonableness standard rather than the per se standard applies to determine the enforceability of noncompetition in circumstances involving the sale of a partial interest in a business. In addition, if an LLC operating agreement includes an obligation not to compete among its fiduciary duties, its enforceability should be evaluated under the reasonableness standard, regardless of whether the noncompetition provision applies to a member in a manager-managed or a member-managed LLC.
