New proposed regulations under Section 83 give the IRS additional opportunity for challenging the use of noncompete restrictions to defer taxes in both Section 83 transfers of property and Section 457(f) nonqualified deferred compensation plans. Rather than reviewing only the likelihood of the employer enforcing the forfeiture if the participant competes, the IRS can also now consider the likelihood of the participant competing. The new rules would apply to amounts deferred after 2012.
It is difficult to assess the actual impact of the proposed rules because they do not provide standards for how likely the competition must be.
Many employers have already taken action to implement alternative designs to noncompete restrictions. Those that have not should again consider whether their situation supports continued use of noncompete restrictions. In particular, do they have either historical evidence of the enforcement of forfeitures in the event of competition, or that executives not covered by noncompete restrictions have left employment and competed? In addressing noncompete restrictions, employers should also keep in mind that any grandfathering under the proposed Section 83 rules may be undone when the IRS issues the promised guidance under Section 457(f).
The IRS has bolstered its ability to challenge the use of noncompete restrictions to defer taxes on nonqualified deferred compensation. The move was not unexpected—the IRS announced in 2007 that it anticipated changing the rules to disallow the use of noncompetes to defer taxes on nonqualified deferred compensation plans. However, the vehicle it used—proposed regulations under Section 83—was surprising.
The two key provisions for taxing deferred compensation are Section 457(f) and Section 83. Section 457(f) applies to nonqualified deferred compensation (e.g., Capital Accumulation Accounts and SERPs) sponsored by a tax-exempt employer, and Section 83 applies where “property” is transferred to the participant (e.g., SSAB plans).
Both sections provide that the compensation is taxable when the dollars are no longer subject to a “substantial risk of forfeiture” (“SRF”). In the absence of regulations under Section 457(f) addressing SRF standards, the IRS and tax advisors have turned to the Section 83 regulations for further guidance. Under the Section 83 regulations, noncompete restrictions are an SRF when supported by all the facts and circumstances.
Over the years, the IRS has viewed noncompete restrictions as “wink wink” arrangements rather than actual risks of forfeiture. In the few cases where it raised the issue on audit, the IRS argued that it was so unlikely that the executive or physician would compete and lose the benefit that the risk of forfeiture was not substantial. However, the IRS had difficulty with this argument based on the holding in Robinson v. Commissioner, where the 1st Circuit Court of Appeals stated that the likelihood of the forfeiture event occurring is irrelevant. The only relevant inquiry is, “If the triggering event occurs, how likely is the forfeiture to be enforced?”
In light of this defense, in 2007 the IRS announced that it “anticipated issuing” new guidance under Section 457(f) that would end the use of noncompete restrictions as an SRF. Those regulations have yet to be issued. However, the recently published regulations under Section 83 may move the IRS toward the same result.
The preamble to the Section 83 proposed regulations states that for deferrals after 2012 (i.e., pre-2013 deferrals are grandfathered), the IRS now is to consider “both the likelihood that the forfeiture event will occur and the likelihood that the forfeiture will be enforced.” Unfortunately, the regulations do not address how high the likelihood of the forfeiture event occurring must be. Given the statutory context, "substantial" seems likely to find its way into the test.
So while the regulations still allow for noncompete restrictions, to meet the new standard an employer may have to demonstrate a history of executives or physicians transferring employment between itself and its competitors, as well as a history of enforcing forfeitures.
Section 457(f) Application
Because the use of noncompete restrictions under Section 457(f) relies on the Section 83 regulations, by changing the latter the IRS has effectively extended the rules to the former as well. This includes the effective date and grandfathering provisions.
Employers still using noncompete restrictions should begin evaluating whether they have strong enough facts and circumstances regarding “likelihood of competition” as well as “likelihood of enforcement” to continue using noncompete restrictions, and if not how to bring their plans into compliance for post-2012 accruals. Alternative plan designs could include cliff vesting, after-tax accruals, and cash payments.
However, in this process employers must remember that the IRS could still issue guidance directly under Section 457(f) that could eliminate the use of noncompetes entirely for both old and new dollars.
INTEGRATED Healthcare Strategies will continue to monitor and analyze these developments, and we're looking forward to assisting our clients to evaluate their plans and explore alternative designs that balance the need to attract and retain key employees with the tax law requirements.