This is the fourth part of a multi-part blog post series discussing the implications and fallout from the Final Rule recently adopted by the Federal Trade Commission (FTC) banning the enforcement of almost all noncompete agreements with workers. In Part 1 of this series, we discussed the general parameters of the rule and several threshold questions that it raises. In Part 2, we discussed the types of arrangements that are prohibited by the Final Rule and the alternatives to noncompete clauses that likely remain available to companies following the effective date of the Final Rule. In Part 3, we discussed the impact of the Final Rule on noncompetition covenants entered into by sellers of a business, as well as the application of the Internal Revenue Code (Code) Section 280G golden parachute rules to noncompete covenants affected by the Final Rule.
In this post, we discuss the potential impact of the Final Rule on the timing of taxation under Section 83, Section 3121(v), and Section 457(f) of the Code. The Final Rule is currently expected to be effective on September 4, 2024, unless earlier enjoined, delayed, or invalidated by a court or other government body.
Section 83
Under Section 83 of the Code, transfers of property in connection with the performance of services, including certain equity awards, are generally included in the gross income of the person performing the services at the then-fair market value of the property in the first taxable year in which the property is not subject to a substantial risk of forfeiture (i.e., when it is substantially vested) or is transferable. A person may make an election to accelerate the taxation to the date of grant, based on the fair market value of the property at grant, if such person makes an “83(b) election” within 30 days of the date of grant.
If no 83(b) election is made, based on a facts and circumstances test set forth in the Treasury regulations promulgated under Section 83, a substantial risk of forfeiture can in some circumstances be supported by an enforceable requirement that the transferred property be returned to the employer in the event that the employee breaches his or her postemployment noncompete covenant (without any continuing employment condition required). Currently, if an enforceable noncompete covenant is used to support a substantial risk of forfeiture as permitted under the regulations, the result is that taxation of the property subject to Section 83 would be postponed until the noncompete covenant lapses (or until the property becomes transferable, if sooner).
If the Final Rule becomes effective, companies should reevaluate their reliance on noncompete covenants to create a substantial risk of forfeiture for purposes of postponing taxation on Section 83 transfers. To the extent that the Final Rule invalidates a noncompete covenant that was used to support a substantial risk of forfeiture, such property would cease to be subject to a substantial risk of forfeiture and would become immediately taxable under Section 83.
Section 3121(v)
Pursuant to a special timing rule under Section 3121(v)(2) of the Code, amounts deferred under nonqualified deferred compensation plans are generally taken into account as wages for purposes of Federal Insurance Contributions Act (FICA) taxation at the later of when the services are performed or when the amount is no longer subject to a substantial risk of forfeiture. Section 3121(v)(2) utilizes the same “substantial risk of forfeiture” definition as in Section 83. Accordingly, depending on the facts and circumstances, an enforceable postemployment noncompete covenant can currently postpone FICA taxation on amounts deferred under nonqualified deferred compensation plans until such covenant lapses.
If the Final Rule becomes effective, companies should reevaluate their reliance on noncompete covenants to create a substantial risk of forfeiture for purposes of postponing FICA taxation on nonqualified deferred compensation plan deferrals. To the extent that the Final Rule invalidates a noncompete covenant that was used to support a substantial risk of forfeiture under Section 3121(v)(2), the deferred amounts would cease to be subject to a substantial risk of forfeiture and generally would become includable as wages subject to FICA taxation in the year of such cessation.
While not the focus of this blog post, amounts deferred under “nonaccount balance plans” may be taken into account as wages for FICA taxation purposes on a date that is even later than when the services are performed or the amounts deferred are no longer subject to a substantial risk of forfeiture (i.e., on the first date that the amounts deferred are “readily ascertainable”).
Section 457(f)
Tax-exempt employers may sponsor plans that provide for the deferral of compensation under a plan that is not an “eligible deferred compensation plan.” These ineligible plans are commonly referred to as Code Section 457(f) plans. Under Code Section 457(f), the compensation that is deferred is included in gross income in the first tax year of the participant in which there is no substantial risk of forfeiture of the compensation.
In general, under proposed Section 457(f) regulations, amounts are subject to a substantial risk of forfeiture if the participant’s right to the compensation is conditioned on the performance of substantial services or upon the occurrence of a condition that is related to a purpose of the compensation if the possibility of the forfeiture is substantial. If certain conditions in the proposed regulations are met, an enforceable noncompete covenant may be considered a substantial risk of forfeiture delaying the taxation for the participant.
While many tax-exempt organizations that are nonprofits may be exempt from the Final Rule due to the FTC not having jurisdiction, the FTC’s position on tax-exempt entities, including healthcare organizations, is more nuanced. The FTC has indicated its position that it does have jurisdiction to apply the Final Rule to certain tax-exempt entities, including healthcare organizations. If the Final Rule applies to the tax-exempt organization, then a noncompete may not be applied as a substantial risk of forfeiture under the organization’s 457(f) plan.
Exceptions
As part of any reevaluation of a company’s reliance on noncompete covenants to create a substantial risk of forfeiture and delay Section 83 or FICA taxation, such arrangements should be reviewed to determine whether they could satisfy the “senior executive” exception for agreements in effect on the effective date of the Final Rule or the sale-of-business exception, as discussed in Part 1 and Part 3 of this series. Tax-exempt employers, including healthcare organizations, that sponsor Section 457(f) plans that rely on noncompetes as a substantial risk of forfeiture should review their status to determine if the Final Rule applies to the organization and, if it does, whether the “senior executive” exception can be relied upon for agreements in effect on the effective date of the Final Rule.
Impact
The Treasury regulations provide that postemployment noncompete covenants providing for recoupment in the event of a breach will not ordinarily result in a substantial risk of forfeiture unless the particular facts and circumstances indicate to the contrary. Factors that may be taken into account in this analysis include the employee’s age, the availability of alternative employment opportunities, the likelihood of obtaining such other employment, the degree of skill possessed by the employee, the employee’s health, and the practice (if any) of the employer to enforce such covenants.
Due to the uncertainty and circumstantiality around whether a particular noncompete covenant results in a substantial risk of forfeiture, companies typically do not rely on noncompete covenants alone to support a substantial risk of forfeiture and instead frequently use continued employment conditions to achieve Section 83 or FICA tax deferrals. As a result, if the Final Rule becomes effective, its impact in this area will be limited to those uncommon instances in which a company actually does rely on noncompete covenants to delay taxation under Sections 83 and 3121(v) of the Code. For tax-exempt employers that use noncompetes as a substantial risk of forfeiture for purposes of Section 457(f) plans, the analysis will be dependent on whether the Final Rule is applicable to the employer.
Next Steps
Despite the uncertainty surrounding the Final Rule, including whether it will become effective, companies may take this as an opportunity to evaluate the arrangements that they currently have in place with workers and consider potential alternatives to noncompete clauses that may be appropriate. For additional action items, please see Part 1, Part 2, and Part 3 of this series, as well as Morgan Lewis’s May 13 Insight and April 26 FAQs.
