Grandfather and non-compete clauses

[KJohnson]

To be grandfathered there must not be a substantial risk of forfeiture under Section 83 concepts. The Section 83 regs seem to state that there is a presumption that a non-compete does not create a substantial risk of forfeiture, but that presumption can be rebutted based on certain facts or circumstances (Compared to a substantial risk of forfeiture under 409A in general which can never be created by a non-compete)

Has anyone given any thought on whether the IRS would ever try and rebut the regulatory presumption and argue that a non-compete does create a substantial risk under Section 83 for purposes of saying that amounts deferred under a NQ plan are not grandfathered? I would think that they would be hesitant to make such an argument since it could come back to haunt them in "normal" Seciton 83 disputes.

[QDROphile]

Most noncompete provisions in support of forfeiture are abusive. You don't find them much in responsible "normal" section 83 situations because they are not supposed to be used much, as the regulations state. The IRS probably won't be very aggressive about going after them but I wish they would. A few hammer blows to scumbags would be very satisfying. If not for all of the abusive activity, promoted heavily by accounting and consulting firms, we would not have section 409A to vex us.

[KJohnson]

QDROphile--For a number of NQ plans I don't think that non-competes are put in to create a risk of forfeiture under Section 83--these plans relied on lack of constructive receipt notions to avoid current taxation. I agree if you are trying to use non-competes for an economic benefit/Seciton 83 argument as your sole means of avoiding taxation the regs severely limit you in this regard.

I take it from your answer, though, that you think it is unlikely for the IRS to argue that there is a substantial risk of forfieture created under a NQ plan based on a non-compete and therefore no amounts are grandfathered?

[QDROphile]

Thank you for providing the opportunity to claify my intemperate remarks. I was thinking mostly of 457(f) arrangements that do rely on noncompete for the substantial risk of forfeiture.

I don't have an opinon about your question in other contexts. It would be interesting to hear arguments about whether or not the risk is or was intended to be a substantial risk. Will people change tune?

[mbozek]

Most non compete agreements are signed at temination of employment where the employee agrees not to complete in return for receiving a payment from the employer. The employees right to the payment is vested when the agreement is signed subject to repayment if the employee violates the terms of the non compete agreement. The repayment would be deductible as a misc expense in the year it is repaid. Termination agreements contain other contingency clauses such as non disparagement and confidentality clause in addition to non competition.

[GBurns]

What happens if the non compete is unenforceable or declared invalid by Court as a violation of law etc ? This should be a very common ocurrence.

[Guest ksuhre]

KJohnson--

I've been puzzling over the same question. At one point I thought the IRS was saying they were going to take a very narrow view of the grandfather clause and not allow grandfathering if there were any possibility of forfeiture at all, but Notice 2005-1 doesn't seem to go that far.

Forfeiture for competition clauses tend to be upheld by the courts, as they are distinguishable from true non-compete covenants. Some employers actually enforce such a forfeiture where the employee goes into competition before his non-qualified benefits are paid. Others add such a clause to a plan to try to create the illusion of risk of forfeiture, without any intent or expectation that it will ever be enforced. So there are many perspectives on this.

The FICA rules under 3121(v) adopt the section 83 standard for substantial risk of forfeiture. If the employer has already paid the FICA tax on the amounts in question, shouldn't that be good evidence that the risk of forfeiture due to competition was not viewed as substantial at the time the benefits were otherwise earned?

[KJohnson]

Ksuhre--Good point. I think if you have been paying the Medicare portion of FICA this would be strong evidence that even before you knew of the grandfathering provisions of 409A you did not treat the non-compete as creating a substantial risk of forfieture.

[Guest Harry O]

mbozek -

Why would the repayment be considered a miscellaneous itemized deduction in the year of repayment? This would be a tax disaster to the former employee since this deduction is subject to the 2% of AGI haircut and the phaseout of itemized deductions and, most important, would not be deductible for AMT. I would take the position that this is a claim of right adjustment under section 1341. The obvious benefit is that this adjustment is not subject to the various itemized deduction limitations. This is a much better tax result for the former employee.

My two cents . . .

[mbozek]

According the US Master Tax guide its a misc deduction. However, like many misc deductions it is not subject to the 2% threshold and the amount of the deduction is subject to modifications under IRC 1341 which is why you need to see a tax advisor.