The Future of Noncompetes

Thousands of nonqualified deferred compensation plans use noncompete restrictions as substantial risks of forfeiture (SRFs) to defer taxes under 457(f). If the yet-to-be published 457(f) guidance does as expected and "disallows" noncompetes, the restrictions will still have a role to play in deferred compensation planning:

1. Continued Employer Protection.

It may surprise some, but boards really do value noncompete restrictions. In a nonqualified plan, they protect against unfair competition much more effectively than injunctive noncompetes in employment agreements. Enforcing the noncompete in a deferral plan involves doing nothing—not writing the check. Enforcing injunctive noncompetes often involves lawyers, Latin words and long-lasting litigation. We expect many employers to continue to include noncompete restrictions in their plans, just not rely on them to defer taxes.

Example:  The Deferral Plan provides an annual employer contribution of $10,000. Each year's contribution vests three years after it is made. Upon vesting, the contribution is taxable and the employer distributes enough to pay the taxes due, but retains the balance. It distributes the balance two years after the executive terminates employment, provided the executive does not compete with the employer during the two-year period.

2. Section 83.

So far, the IRS comments about the anticipated guidance indicate it will apply only to 457(f) plans, and not to Section 83 plans. Section 83 governs the taxation of property that is transferred to an employee. Like 457(f), Section 83 recognizes bona fide noncompete restrictions as SRFs that defer taxes. Therefore, it appears that noncompete restrictions will continue to defer taxation under Section 83 arrangements even after the IRS publishes the 457(f) guidance.

Example:  The employer transfers ownership of a life insurance policy to a key physician. The physician must return the policy to the employer if the physician terminates employment prior to age 62 and competes with the employer. The life insurance is property, so its transfer is governed by Section 83. Therefore, assuming the anticipated guidance is limited to 457(f), the physician will not be taxed on the value of the policy until remaining employed to age 62 or satisfying the noncompete restrictions.

If the anticipated guidance concludes noncompete restrictions are not SRFs, we fully expect that well-intentioned advisers will use phrases such as "Noncompete restrictions in deferral plans are illegal."  They will not be illegal. They could not be used to defer taxation in 457(f) arrangements, but they can be used to protect against unfair competition. Depending on the scope of the guidance, they may also continue to defer taxation under Section 83 arrangements, and possibly under some 457(f) arrangements if the IRS decides to grandfather any prior plans.