Whether a Covenant not to Compete is a Nonqualified Deferred Compensation Plan?

[Guest Edward McElroy]

An employer currently has an agreement with an executive. Provided the executive doesn't compete while employed and for the 12 months following termination, he will receive substantial payments from the employer. These payments will begin 30 days after he terminates. Is this a nonqualified deferred compensation plan? I'm guessing the answer is yes. Any thoughts would be appreciated. Thanks. Ed

[Guest jfsinger]

Ed,

I believe you have a DC plan under the new rules. I'm confused, do the benefit payments begin 30 days after termination, or 12 months and 30 days after termination if he has not competed during that time? If it's the latter, the questions revolve around whether or not payments can be conditioned upon an event (12 months of post-employment non competition). Or would that be considered still part of the termination event?

Joe

[GBurns]

Whereas I would say No, it is not a deferred compensation plan of any sort. Compensation with regard to DC plans is compensation for services of an employee or in a few cases a director to an employer. The payment in this case will not be for services rendered as an employee nor to an employer. The employee/employer relationship would have long ago ended, anyhow.

[JanetM]

Sounds like severance plan to me.

[mbozek]

The conference committe report (P. 524) defines a NQDC as any plan that provides for the deferral of comp other than a qualified plan, vacation, sick leave, comp time, disability pay or death benefit plan which appears to cover any plan that defers comp until employment ends. I dont think an employer can disguise a NQDC plan by calling it a program to pay money for not competing with a former employer after terminaton instead of deferred comp since 409A does not exclude severance payments to prevent employers from disguising NQDC as a payment for not working after termination.

[Guest Harry O]

Note that covenants not to compete are generally not considered to rise to the level of a "substantial risk of forfeiture" for purposes of section 83; meaning that property is "vested" regardless of the presence of a covenant not to compete. I suspect that the same approach will apply for new section 409A -- compensation will be "vested" notwithstanding the continuing covenant and the arrangement will be "deferred compensation" if payments are made in a taxable year following the vesting date (determined without regard to the noncompete obligation). I don't think a condition subsequent like a noncompete will get you out of the new deferred comp rules. My two cents . . .

[GBurns]

That a employment agreement includes a non-compete agreement does not change anything. A large number, possibly the majority, of executive contracts do. To regard an employment contract that has a tie between the severance package and the NCA terms as being "NQDC" would create havoc by causing vasts numbers to now be under 409A.

Severance pay is a continuation of compensation for services. The NCA is not.

The payment of the severance pay is not being deferred. Therefore I do not see any "deferred compensation". For there to be "deferred compensation" there would have to be payment at some future date. If the NCA terms are violated the "severance pay" is not deferred it is forfieted and is not deferred to any future date.

Not competing while employed is a condition of employment and the executive will be getting compensation for services. There is nothing that is being deferred.

Not competing for 12 months following termination is a NCA, but there is no payment for not competing, that I see. Even if there was it is bieng paid on an ongoing basis, there is nothing being deferred to any future date.

[mbozek]

IRC 409A applies to any plan that provides for a deferral of compensation other than the plans specfically exempted and includes arrangements or agreements for one person. The law intentionally applies to employment contracts which defer comp of executives to raise the maximum amount of revenue. However vested amounts deferred prior to 1/1/05 are exempted. The fact that payment of deferred comp is subject to a non compete clause which provides for forfeiture of future payments or liquidated damages if the employee goes to work for a competitor does not take the payments out of 409A. The conference committee report (P 525) specifically notes that a substantial risk of forfeiture cannot be used to manipulate the timing of income inclusion.

[GBurns]

Where or what is the compensation that is being deferred? When is it being deferred until?

[Guest Harry O]

GBurns -

Depends on when the post-termination payments are being made. If the employee is entitled to a lump sum immediately upon termination that he may have to pay back if he competes, I agree there is probably no deferred compensation. If, however, he gets periodic payments over 3 years following his termination, then you have deferred compensation. The original post suggested periodic payments since it said that payments "begin" at termination.

[GBurns]

The periodic payments are periodic severance payments. These severance payments are taxed at disbursement. The payments are being made as a result of the severance of employment, not for not competing, they will cease if the NCA terms are violated. The NCA is a condition for continuity of payment, it is not the reason for payment, not dissimilar to a cease on death clause.

Deferred compensation is compensation that is deferred to some other time and taxed when received at that other time.

There is no other time given in the post to which anything will be deferred. There is only a ceasing.

If the terms of the NCA are not kept, the payments cease, they are not deferred. A payment on condition is not a deferral. If you read most NCAs you will see that the ceasing of payments or return of money etc are "damages".

Edward,

What does the agreement state?

[mbozek]

The Conference Committee report does not exclude conditional payments from taxation under 409A to prevent NQDC from being characterized as an excludible payment. A taxpayer can claim a misc deduction for NCA amounts taxed under 409A which are returned in a later year.

[Guest Harry O]

GBurns -

I think you are giving much more weight to the noncompete than the tax law does. As mentioned above, noncompetes are generally ignored for purposes of determining whether amounts are subject to a substantial risk of forfeiture. For example, if you gave someone 100 shares of stock and said that you can keep the stock as long as you don't agree to compete for 3 years, the employee is taxed immediately upon receipt of the stock. I suspect the same result will apply under 409A where determining when compensation is "vested" is now crucial.

[GBurns]

Harry O

You just made my point. The 100 shares are taxed now because they are received now. In the scheme outlined the payements are made now and taxed now there is no deferral of anything to any future time.

If the executive is going to get $10,000 per month for the 12 months after leaving employment. If he violates the terms the payments stop. Now you tell me how much was deferred and deferred to when.

Notice that this is the same agreement that was in place as part of his employment agreement. Did it make his salary part of a NQDC plan? Of course not. Nothing was deferred and he paid taxes as he was paid.

This is the same agreement that will continue for the 12 months after he leaves employment. What changes it to be a NQDC? What will be deferred?

[TCWalker]

Well, ... what I've seen is the future payment is promised, subject to forfeiture or clawback if the executive competes. It's a negative, restrictive covenant, not a contingent payment.

I think all deferred payment employment and post-employment clauses are going to have to scrutinized under AJCA's rules.