Deferrals Based on Non-Compete Payments?

[Christine Roberts]

Can a former owner of a company make salary deferrals based on compensation received under a non-compete agreement, after his active employment terminates.

Presuming the answer is a resounding "no" is there any specific authority for that answer.

[mbozek]

C : must read plan document to determine if (1) payments are defined as comp eligible for contributions to plan and (2) whether former owner is considered eligible to participate in plan. Although rare some plans allow employees who receive severance payments to contribute to 401(k) plan. U may also need to read the non compete agreement- Most amounts received under non compete are taxed as income but are not considered comp for services but u never know until u read it.

[IRC401]

I thought that only employees could make 401(k) elections and don't recall anything in the Code or regs that includes former employees as employees.

[mbozek]

IRC: How do u know he is a former employee unless you read the relevant documents. Also need to read his non compete agreement/ severance agreement/employment contract to see if he is eligible to participate in the 401(k) plan. I have represented people in termination cases where individual provisions were agreed to by the employer which were outside the provisions of a qualified plan. It is conceivable that the owner could be regarded as an employee under the severance agreement during the period that the non compete is in effect and the payments could be defined as compensation.

[KJohnson]

You may want to look at this discussion:

http://benefitslink.com/boards/index.php?showtopic=462

and this

http://www.benefitslink.com/links/20010724-012097.shtml

[Guest And another thing ...]

This is a lot like the issue about deferrals on severance pay. IRS employees have said verbally (which isn't authority of course) that severance pay is not deferrable because it is not paid to an employee (i.e., an individual who performs services for the employer) for services. By analogy, I think non-compete pay is not deferrable because it is not paid for performing services. In contrast, it is paid for not performing services.

[mbozek]

Thanks for your comments. I am well aware of the IRS statements but I again restate my central thesis: You must look to the documents which govern the non compete payments to see how they are defined for the purposes of compensation and secondly the agreement may contain provisions regarding contributions to the 401(k) plan by the former owner which contradict the plan document. The fact the IRS may not consider the payments to be eligible for contribution to a 401(k) plan may not be controlling where the agreement says otherwise and the employer does not want to breach a contract with a former employee.

[Guest b2kates]

in line with the flow of the answers, I too chip in the answer is no.

I am familiar with the IRS position. It makes sense, the plan is only for employees. This person has ceased to be an employee.

Further contributions are based on earned wages, generally compensation subject to OASDI. These type payments are not subject to the social security tax, therefore not earned wages.

[mbozek]

b2: Consider this: an employer can designate a person as an employee without any duties and pay that person a salary to stay home. The employee is eligible for all benefits of the employer including 401(k) deferrals and benefits under a DB plan.

[Guest And another thing ...]

I disagree. If the plan document and the agreement are contrary to the law (i.e., an illegal act), the plan document and the agreement do not control. The IRS employee's personal opinion is based on the 401(k) regulations. Albeit that regulations are not law, but only the Treasury Department's opinion of the law, the regulations carry about the weight of the law. In their opinion, the law is that only an individual who performs services (that is, an employee) may benefit from a cash or deferred arrangement of a plan. A logical extension of that is that an individual who does not perform services may not benefit from a CODA. If the plan document or agreement says that that individual may benefit from the CODA, that provision is unenforcable. The court will not enforce an illegal act required by a contract.

[BFree]

For those saying that a person not performing services cannot be an employee (and a result cannot contribute to a 401(k) plan):

What would be the result for the employer, plan or "employee" if the "employee" deferred into the plan?

As an aside, I and several dozen of my co-workers were that "employee" a few years back, laid off from a large actuarial consulting/recordkeeping firm.

[mbozek]

Last time I looked the IRS had no authority to determine what is the functions of performance that a person designated as an employee should perform. Many people are employed on retainer and are paid a stipulated salary to be available if requested by the employer and are subject to withholding taxes. They perform no duties and are told to stay at home until they are called. In fact the IRS prefers that persons receiving retainer payments from employers be designated as employees so that there is automatic witholding of taxes instead of designating them as independent contractors.

[Guest And another thing ...]

I think the IRS could challenge paying and giving benefits to a former employee as unreasonable compensation and alowing a qualified plan to benefit a non-employee. Whether an individual is an employee is subject to a facts and circumstances test (think about the independent contractor analysis). Simply calling an individual an employee does not make that individual an employee. That DB plan (and its sponsor) is taking risk.

[Guest b2kates]

mbozek, i understand your position from a legal standpoint. yes and ER can pay someone to stay home. But then it would not be payments for a noncompete.

Also those payments to be wages would be subject to FICA taxes

p.s. where in NJ are you located?

[mbozek]

bfree: Thanks for your candor -- I have had many client situations like yours in my career where I have given the necessary caveats and the client goes ahead and ignores my advice.

But on another note: I remember a few years ago during a recession GM made a deal with the UAW to place thousands of auto workers on paid furlough for 3 years at 95% of salary subject to recall by GM. Well GM never recalled the workers and it cost a bundle to keep them on and then fire them at the end of the furlough. Do you think these people were terminated from GM's benefit plans? Given the accepted practices of employers in certain industries keeping employees who perform no services in its benefit plans I think it would be arbitrary and capricious conduct for the IRS to audit employers for this violation.

[mbozek]

b2- North. NJ near morristown - but I also work in NYC.

[IRC401]

See 1.401(k)-1(g)(5), which sends you to 1.410(B)-9. "Employee means an individual who performs services for the employer..."