Proposed 457(f) Regulations Summary: Effective Date and Noncompete Agreements

With the proposed 457(f) regulations released, we will be posting a series of articles summarizing the key provisions and their import. This post summarizes two key features: when these regulations come into effect, and the regulations’ unexpected treatment of noncompete agreements.

Effective Date:

The changes will take effect January 1 of the year following the release of the final regulations. The earliest this could be is January 1, 2017. That said, it will be pushed back to 2018 if the IRS does not issue the final regulations before the end of 2016. The public comment period closes on September 20, with a public hearing on October 18, leaving the IRS two and a half months to consider any issues raised by comments and revise the regulations. If this process takes longer than expected and the final regulations are not released until 2017, the effective date moves back a year.
In the meantime, employers may rely on the proposed regulations while making decisions.

Noncompete Agreements:

457(f) plans are taxable once the benefit is no longer subject to a substantial risk of forfeiture. Before 2007, benefits contingent on a valid noncompete agreement were not taxable until after the term of the agreement had run. When the IRS announced that it would publish 457(f) regulations, it implied that under the new regulations, a noncompete agreement would no longer constitute a substantial risk of forfeiture. In one of the most unexpected provisions of the new regulations, however, a noncompete agreement will be considered a substantial risk of forfeiture if the following conditions are met:

• The right to payment of the amount is expressly conditioned upon the employee upholding the noncompete agreement
• The employer makes reasonable ongoing efforts to verify compliance with all of its noncompetition agreements (including the noncompetition agreement applicable to the employee).
• The employer must have a “substantial and bona fide interest” in enforcing the agreement.
• The employee must have a “bona fide interest in, and ability to, engage in the prohibited competition.”

These last two factors are subject to a “facts and circumstances” test. Factors taken into account include the employer’s ability to show significant adverse economic consequences that would likely result from the prohibited services; the marketability of the employee based on specialized skills, reputation, or other factors; and the employee’s interest, financial need, and ability to engage in the prohibited services.

While making deferred compensation conditional on compliance to a noncompete agreement can still amount to a substantial risk of forfeiture under the proposed regulations, employers must take several steps to certify that an agreement meets the conditions. Specifically, employers must be able to demonstrate that they reasonably monitor employee compliance with the agreement, that the employee has the ability and incentive to violate the agreement, and that the employer has a “substantial and bona fide interest” in its enforcement.