The Federal Trade Commission published a proposed rule Jan. 5 that would effectively prohibit noncompete clauses for employees and other workers in all but very limited circumstances.
This article focuses on the impact the proposed rule could have on employee benefit and compensation arrangements, if it becomes effective in its current form.
Golden Parachute Implications
Sections 280G and 4999 of the Internal Revenue Code may impose excise taxes and a loss of deduction on golden parachute compensation and benefit packages paid out to executives upon a change in control of their employer.
However, Section 280G does not apply to any reasonable compensation for services rendered by the employee after the date of a change in control. This includes compensation for refraining from performing services pursuant to a noncompetition provision.
Thus, noncompetes have often been used to mitigate potential Section 280G excise taxes and deduction losses that would otherwise apply to change-in-control payments and benefits.
The proposed rule would eliminate this strategy.
In such a case, employers that have recently undergone a change in control would also need to consider updating their Section 280G calculations and, potentially, conducting a supplemental Section 280G shareholder vote.
Many employment agreements and incentive arrangements provide that post-termination payments will cease — and, in the case of clawback provisions, that previous payments must be repaid — if the worker violates the agreement. This can apply to noncompete provisions. In many cases, post-termination payments exist, in part, to protect the employer from damaging competition following the departure of the worker.
It is not entirely clear if these employee choice provisions — that is, to either comply with the noncompete requirements or forfeit future payments, and perhaps even repay prior ones — would be permitted under the proposed rule. The rule relies on a functional test to assert that provisions that effectively prohibit post-separation employment or business operation are de facto noncompetes.
In the absence of additional clarification, it would be risky to use such provisions.
Awards Subject to Substantial Risk of Forfeiture
Pursuant to Section 83 of the Internal Revenue Code, the fair market value of property, such as certain equity grants, transferred for the performance of services is generally included in the recipient’s income in the year that the right to the property becomes transferable or not subject to a substantial risk of forfeiture, whichever occurs first.
The Treasury regulations promulgated under Section 83 provide that
An enforceable requirement that the property be returned to the employer if the employee accepts a job with a competing firm will not ordinarily be considered to result in a substantial risk of forfeiture unless the particular facts and circumstances indicate to the contrary.
The Treasury regulations provide a list of factors to be used in this analysis. Therefore, even before the proposed rule, how effective noncompete conditions were in deferring taxation of Section 83 property was questionable. But, even if an employer relies on a noncompete condition alone, without requiring continued employment, to defer the taxation on some Section 83 property, that property will become immediately taxable if the proposed rule takes effect in its current form.
The proposed rule would similarly affect the timing of Federal Insurance Contributions Act taxation of amounts deferred under employers’ nonqualified deferred compensation plans pursuant to a special timing rule under Section 3121(v)(2) of the Internal Revenue Code, which generally follows the timing of tax recognition under Section 83.
Accordingly, if an employer relies on a noncompete condition alone, without requiring continued employment, to defer the FICA taxation of amounts deferred under its nonqualified deferred compensation plan, such amounts will become immediately taxable for FICA purposes if the proposed rule becomes effective.
In our experience, most employers rely on continued employment, rather than a noncompete condition, to achieve Section 83 and FICA deferral. Therefore, the proposed rule would likely have limited impact in this area.
Nonqualified Deferred Compensation Plans of Tax-Exempt Entities
The proposed rule provides that employers exempt from coverage under the Federal Trade Commission Act are not subject to the proposed rule.
Thus, it appears that Section 501(c)(3) entities, including large hospital systems and universities, would not be prohibited from using noncompete clauses by these rules. As long as these organizations are not covered by the FTC Act, their Section 457(f) plans that vest contingent on compliance with a noncompetition agreement should not be adversely affected.
However, various questions remain, including whether broad noncompetes that cover the for-profit affiliates of Section 501(c)(3) entities could be subject to the proposed rule.
Key Takeaways for Employers
It is widely expected that the proposed rule will evolve before it becomes effective, if ever. However, to mitigate future risk, employers can consider taking the following proactive actions now.
Take inventory of existing agreements and arrangements where vesting or payment is tied to compliance with — or a clawback obligation is tied to a breach of — noncompetition provisions. Consider how these agreements would be modified if the proposed rule becomes effective.
In the transactional context, when conducting a Section 280G analysis, consider the economics of the deal and the potential need to model alternative scenarios for a Section 280G shareholder vote if noncompetition provisions can no longer be used to mitigate the adverse tax treatment.
When entering new arrangements, keep in mind that you may not be able to enforce payments that hinge on employees complying with noncompetition provisions. Consider other alternatives, such as linking the compensation amount to how well the enterprise performs, which would indirectly discourage the post-termination employee from behaving in ways that could harm the company.
Tie the payment of compensation to compliance with nondisclosure, trade secret protections and narrowly tailored nonsolicit provisions, which the FTC indicates are not prohibited under the proposed rule.
Make sure that such provisions have a tight scope to reduce the risk of their being characterized as de facto noncompete provisions.
New Compensation Strategies
Develop new compensation designs that would offer creative alternatives to compensating employees for complying with noncompetition provisions.
For example, European-style garden leave may become more popular, along with provisions that, though they don’t affirmatively prohibit competition, offer an incentive to former workers to avoid competitive activity. Still, these would also need to be carefully designed to avoid arguably functioning as noncompetes.
Right to Rescind
Reserve the right in new employment agreements or compensation arrangements to unilaterally rescind — to the extent permitted by law — payments and benefits given in consideration for a worker’s noncompete promise, in the event the noncompete is required to be rescinded.
The proposed rule will face significant pushback and legal challenges before it becomes final and effective — if it ever does — so employers should not rip up their noncompetes just yet.
Still, prudent employers should start thinking of how their compensation and benefits arrangements might differ in a world without noncompetes.
Please contact a Jackson Lewis employee benefits team member or the Jackson Lewis attorney with whom you regularly work if you have questions or need assistance.
This article first appeared in Law360.