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Employee Benefits Law Report

Reporting on recent trends and developments affecting employee benefits

ERISA preemption of state law regarding multiemployer health, welfare and retirement benefits

Posted in ERISA Fiduciary Compliance, ERISA Litigation

The Pennsylvania General Assembly has given us another opportunity to expand our employee benefit plan boundaries discussion. This time, the discussion applies to multiemployer plans in the construction industry. It has been reported that Rep. William Keller, D-Philadelphia, introduced a bill in the General Assembly to amend the state’s Mechanics’ Lien Law to classify union benefit fund trustees as subcontractors allowed to pursue claims for nonpayment against employers and property owners. This action followed a Pennsylvania Supreme Court ruling that unions and benefit fund trustees do not qualify as subcontractors as a result of collective bargaining agreements with employers.

There is one small problem with this bill: the Employee Retirement Income Security Act (ERISA). ERISA sets forth the procedure for fund trustees to collect for nonpayment, and would seemingly preempt such a state law. Federal courts have exclusive jurisdiction over these cases, and there are many such cases filed every day. The law is very favorable to the fund trustees, incidentally.

What happens if the Pennsylvania General Assembly amends its state law to allow benefit fund trustees to pursue claims as subcontractors? Pennsylvania employers get into a boundary dispute with fund trustees regarding ERISA preemption, parties argue over whether the cases can be removed to federal court, and Pennsylvania state courts potentially issue erroneous rulings that fail to recognize ERISA preemption. In the last Pennsylvania state court ERISA preemption case I blogged about, it took 19 years to establish ERISA preemption. While I root for the Cleveland Browns and Johnny Football, I don’t wish that hardship even on Pittsburgh Steelers fans.

The ESOP sponsor / fiduciary boundary dispute, employer contribution edition

Posted in ERISA Fiduciary Compliance, ESOPs

As a follow up to our blog on the ERISA sponsor / fiduciary boundary dispute, here is another case, Coulter v. Morgan Stanley & Co. Inc., from the Second Circuit. The employer decided to make contributions in the form of company stock, rather than cash. Then the employer’s stock price plunged in conjunction with the economic downturn. Plaintiffs alleged the employer breached its fiduciary duty by making the investment in stock. The district court dismissed the claims on the basis of the Moench presumption of prudence.

The Appellate Court affirmed the dismissal of the claims, but on a simpler basis. The Court found that the employer acts as a fiduciary when administering a plan, but not when designing the plan or making business decisions about the plan, even if those decisions may impact negatively on participants. The employer’s stock and cash were not plan assets prior to the time they were contributed to the trust. Further, the employer does not have a conflict of interest when it is making a business decision because it does not have a fiduciary duty to the ESOP participants with respect to a business decision. These are hardly groundbreaking holdings, but they demonstrate the importance of recognizing and respecting boundaries with respect to ERISA plans, especially ESOPs.

The ESOP sponsor / fiduciary boundary dispute, accounting fraud edition

Posted in ESOPs

A common theme in many of our blogs is that of respecting boundaries. ERISA contains many examples of boundaries and compromises that are designed to balance on one hand the goal of encouraging employers to adopt employee benefit plans while on the other hand protecting the benefits of employees who participate in those plans. A common example of a boundary is the distinction between “settlor,” or general business decisions, and “fiduciary” decisions related to plan administration. Sometimes it is difficult to know which side of the boundary line a particular decision falls upon. When employers sponsor an ESOP, the boundary lines often become even more blurry. A recent decision from the District Court of Indiana provides an example of this issue. Malcolm v. Trilithic, Inc., 2014 WL 1324082; No. 1:13-cv-00073-SEB-DKL (S.D. Ind. Mar. 31, 2014)Trilithic does not raise any novel issue of law, but it provides a great example of how what otherwise would seem to be general corporate decisions risk becoming ERISA fiduciary decisions.  That discussion will be the focus of this blog.

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New wrinkle for the Delinquent Filer Voluntary Compliance Program—trap for the unwary

Posted in ERISA Fiduciary Compliance, ERISA Litigation, Retirement Plans, Tax Issues

Plan administrators who fail to timely file Form 5500 annual returns/reports are subject to penalties under both Title I of the Employee Retirement Income Security Act of 1974 (“ERISA”) and the Internal Revenue Code (the “Code”). The Department of Labor (the “DOL”) has the authority to assess civil penalties of up to $1,100 per day against plan administrators that fail to file complete and timely returns/reports. In addition, the Internal Revenue Service (the “IRS”) may impose further penalties of $25 per day up to a maximum of $15,000 per return against administrators that fail to file complete and timely returns/reports.

As a means to encourage voluntary compliance with ERISA’s annual reporting requirements, the DOL adopted the Delinquent Filer Voluntary Compliance (“DFVC”) Program. The DFVC Program was adopted by the DOL in 1995 and thereafter was updated in 2002. The DFVC Program allows plan administrators that fail to file timely returns/reports to pay reduced civil penalties. In 2002, the IRS formally embraced the goals of the DFVC Program with the issuance of IRS Notice 2002-23, which stated that the IRS would not impose penalties under the Code on any plan administrator that satisfies the filing requirements of the DFVC Program with respect to a late Form 5500 filing. Accordingly, filing with the DOL under the DFVC Program in effect got plan administrators off the hook both as to the DOL and the IRS—and things were good.

Things are becoming less good. Recently, the DOL updated the procedures for the DFVC Program again. Among other things, the procedures were updated to reflect final regulations from the DOL mandating electronic filing of annual returns/reports. The regulations were part of the overall transition to a wholly electronic ERISA Filing Acceptance System (“EFAST2”). Generally, the regulations became effective for filings made in 2010 and thereafter—and thus first applied to filings with respect to 2009 plan years. Accordingly, under the DFVC Program delinquent annual returns/reports since that time also had to be filed using EFAST2.

When updating the DFVC Program in 2013, the DOL also announced that late filers no longer would be permitted to submit information regarding terminated participants under the DFVC Program (even for 2008 and prior plan years). By way of background, before the 2009 plan year plan administrators had to report information regarding terminated participants on a Schedule SSA to a Form 5500. However, with respect to 2009 plan years and thereafter the IRS replaced Schedule SSA with Form 8955-SSA (“Annual Registration Statement Identifying Separated Participants with Deferred Vested Benefits”). Form 8955-SSA is designed to be filed separately with the IRS only.

The DOL’s position that information regarding terminated participants reported contained in Form 8955-SSA (or, for plan years before 2009, Schedule SSA) no longer could be submitted as part of a DFVC Program filing in effect forced the IRS to create a new procedure for obtaining needed relief from the late-filing penalties imposed under the Code. In IRS Notice 2014-32, the IRS acted to do that. Under this new notice, relief from penalties under the Code no longer is available only by completing a DFVC Program filing. A plan administrator that is required to file information regarding terminated participants now must also file a separate filing with the IRS. Notice 2002-23 was superseded by this new notice. Plan administrators will not be happy about this development.

According to the new notice, the IRS will not impose penalties for late filings if the following conditions both are satisfied:

(a) the plan administrator completes the requirements of the DFVC Program with respect to a delinquent report/return for a given year; and

(b) unless already provided to the IRS, the plan administrator files a complete Form 8955-SSA for that year (in the form and within the time prescribed by the notice) by the later of:

(i) 30 calendar days after the filer completes the DFVC Program filing, or

(ii) December 1, 2014.

This new filing requirement applies to all DFVC Program filings submitted under EFAST2 (i.e., generally all such filings on or after January 1, 2010). The fact that this new rule thus has retroactive application will make plan administrators even less happy.

In the category of “you can’t make this up,” a problem created because of a shift to electronic filing obligations can only be resolved by filing a paper copy of the Form 8955-SSA with the IRS. In IRS Notice 2014-32, the IRS explained that systems needed to allow a delinquent Form 8955-SSA to be filed electronically currently are not in place. When a paper copy of Form 8955-SSA is filed under this new rule, the filer must check the box on Line C, Part I (Special extension) of the Form 8955-SSA and enter “DFVC” in the space provided on Line C. Any late filer is not required to file a separate application for relief with the IRS.

So what does all of this mean practically? Here are some of the practical implications:

  • Plan administrators who were not required to file information regarding terminated participants as part of a delinquent annual return/report appear to be unaffected by the new rule.
  • Plan Administrators who already have obtained relief from the DOL penalties under the DFVC Program under EFAST2 (generally, filings made in 2010 and thereafter) and thus reasonably thought their work was done now must file an appropriate Form 8955-SSA in paper form with the IRS no later than December 1, 2014.
    • In some of these instances, it is possible that copies of the Form 8955-SSA already may have been filed with the DOL as part of the DFVC Program. While any such filing is not enough to guarantee IRS relief, it should at least make it easier for this form to be located in files and then submitted to the IRS in paper form.
  • Obviously, any plan administrators seeking to take advantage of the protections of the DFVC Program in the future must be careful to satisfy the separate filing obligation with the IRS, if applicable.

The $36,500 per employee, per year, per mistake PPACA penalty

Posted in Health Care Reform

And the gloves are off! The IRS has threatened employers with PPACA penalties of $36,500 per employee, per year, nondeductible. Makes those $2,000 and $3,000 penalties look like small potatoes, right?

The targets of this particular Q&A are employers who maintain “non-integrated” “employer payment plans.” These are new terms, which include reimbursement plans such as health reimbursement arrangements (HRAs, excluding retiree-only and excepted benefits HRAs). Those should generally have been eliminated by January 1, 2014, or amended to be integrated with group health coverage. The federal agencies dropped this bomb on employers on the cusp of open enrollment season last year, and many employers had to scramble into compliance. You could have done the math on the $100 per day excise tax. But the IRS puts this $36,500 figure into a Q&A for a reason: it wants to scare you. And employers need to know that a non-integrated employer payment plan is just one of many potential triggers of these potentially devastating excise taxes.

When I first blogged about health care plan self-audit, self-correction, and self-reporting compliance issues on Form 8928, no one seemed too interested. It’s time to get interested.

 

 

 

 

 

 

ERISA Section 510: wanting to be a participant, versus being a participant

Posted in ERISA Litigation, Retirement Plans

My assistant informed me that my patience is shot and I need to do something about that, so I am channeling my energy into one issue. Since health care reform was enacted, I have been hearing about how we should anticipate a flood of ERISA Section 510 (29 U.S.C. Section 1140) discrimination cases from people who are not participants under the plan terms, but want to be participants. I don’t get it.

ERISA Section 510 provides, “[i]t shall be unlawful for any person to…discriminate against a participant or beneficiary…for the purpose of interfering with the attainment of any right to which such participant may become entitled under the provisions of an employee benefit plan.” ERISA Section 3(7) defines “participant” as “any employee or former employee of an employer, or any member or former member of an employee organization, who is or may become eligible to receive a benefit of any type from an employee benefit plan.”

In Firestone Tire & Rubber Co. v. Bruch, the United States Supreme Court first considered Section 3(7) (29 U.S.C. Section 1002(7)) in the context of standing. It found this term to include “employees in, or reasonably expected to be in, currently covered employment,” or former employees who “have . . . a reasonable expectation of returning to covered employment” or who have “a colorable claim” to vested benefits.  The Court held that in order to establish that he or she may become eligible for benefits under ERISA Section 502, a claimant must have a colorable claim that (1) he or she will prevail in a suit for benefits, or that (2) eligibility requirements will be fulfilled in the future. The Court applied the same standard to Section 104(b)(4), the provision that requires providing plan documents that indicate whether or not an individual is eligible to participate to a person who claims to be eligible.

As Justice Scalia explained in an opinion concurring in part and concurring in the judgment, this definition ignores the fact that some of these supposed participants and beneficiaries are not actually participants and beneficiaries. Consider competing claimants to a 401(k) plan death benefit:  a same-sex spouse not designated as a beneficiary, and a parent designated as beneficiary. One of these will ultimately be found to be a beneficiary, and the other will not. But both will be treated as beneficiaries for purposes of making their case.

In Fleming v. Ayers & Assoc., the Sixth Circuit held that where an employer hired a part-time employee with the [employer’s] intent that she would become full-time when a position opened up, the employee was a participant under ERISA Section 3(7) and for purposes of Section 510. The Court did not further explain this conclusion, or discuss Firestone or Justice Scalia’s caution. A number of courts have distinguished Fleming, explaining that ERISA Section 510 does not require employers to make a part-time employee who is ineligible for benefits a full-time employee and thereby eligible for benefits. See, e.g., Geist v. Gill/Kardash P’ship, LLC, 671 F. Supp. 2d 729  (D. MD 2009) (plaintiff was not a full-time employee and was not eligible for benefits under the plan terms; plaintiff rejected a forty hour per week full-time schedule on more than one occasion and seems to have understood that this decision disqualified her for benefits); Pine v. Crow, 2001 U.S. Dist. LEXIS 8629 (S.D. IN 2001) (ERISA does not require an employer to make an employee full-time); Shawley v. Bethlehem Steel Corp., 784 F. Supp. 1200, 1203 (W.D. Pa. 1992) (concluding ERISA does not expressly prohibit a refusal to hire based on the employer’s potential benefit liability), aff’d, 989 F.2d 652 (3rd Cir. 1993).

Now let’s consider the ERISA claims in Sanders v. Amerimed, Inc., a recent decision in the Southern District of Ohio. Sanders was a part-time employee and not a participant in the health care plan, because the plan’s eligibility provisions provided that only full-time employees were eligible to become participants. Sanders wanted to be a full-time employee, and he wanted to be a participant, and quit. He then argued that the defendant violated ERISA Section 510 by not hiring him into a full-time position. The Court held that under Firestone and Fleming, Sanders had a colorable claim to benefits and standing to pursue his claims. The Fleming decision seems to be overreaching; it does not explain the significance of “intent” in the context of case law. But even if we assume the conclusion was valid, it does not appear to provide authority for treating Sanders as anything other than a participant want-to-be. Sanders was well aware he was not a plan participant: that is why he quit. So I do not understand how he even had a colorable claim to benefits, but for the sake of argument, let us move on to the Section 510 claim itself.

The definition of “participant” in Section 3(7) is just the beginning; ERISA goes on to develop this concept in Section 202 (29 U.S.C. Section 1052) and other provisions. The steps require asking whether under the plan terms, as limited by law:

  1. Is the employee a member of a classification that is eligible to participate?
  2. Has the employee satisfied any age requirement?
  3. Has the employee satisfied any service requirement?
  4. Has the employee reached an entry date?

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Sixth Circuit retiree health care case to be heard by the U.S. Supreme Court

Posted in Health Care Reform, Retirement Plans

The U.S. Supreme Court has agreed to hear a Sixth Circuit retiree health care case, M&G Polymers USA, LLC v. Tackett. The issue is:

Whether, when construing collective bargaining agreements in Labor Management Relations Act (LMRA) cases, courts should presume that silence concerning the duration of retiree health-care benefits means the parties intended those benefits to vest (and therefore continue indefinitely), as the Sixth Circuit holds; or should require a clear statement that health-care benefits are intended to survive the termination of the collective bargaining agreement, as the Third Circuit holds; or should require at least some language in the agreement that can reasonably support an interpretation that health-care benefits should continue indefinitely, as the Second and Seventh Circuits hold.

The decision to take this case was announced within two weeks of the Sixth Circuit’s publication of its retiree health care decision in United Steel, Paper and Forestry, Rubber, Manufacturing Energy, Allied Industrial And Service Workers International Union, AFL-CIO-CLC v. Kelsey-Hayes Company. Coincidence? I don’t think so. In a concurring and dissenting opinion in Kelsey-Hayes, Judge Sutton expressed concern that the Court was improperly handcuffing employers, and that is a concern shared by many. In its Yard-Man inference line of cases, the Sixth Circuit has handcuffed employers to providing free lifetime health care benefits in a manner that no other circuit has followed. M&G Polymers is not going to resolve the issue of what benefits must be provided (Judge Sutton’s concern), but it will resolve the inconsistency among the circuits regarding the most basic presumption about collective bargaining agreements. This will be an important decision for employers struggling to manage costs while implementing health care reform.

Participant document requests under ERISA: throw the crystal balls away! Sixth Circuit adopts “clear notice standard”

Posted in ERISA Litigation

“Can I have all documents related to my retirement plan benefit?” If you are involved with administering an ERISA-governed plan, you have probably received this type of vague request. After reading your crystal ball, you might assume the participant wants a summary plan description and perhaps a copy of the plan document. While that seems reasonable, the problem with these types of vague requests is that if your crystal ball happens to be foggy on a particular day, you could face penalties of up to $110 per day for not providing the requested materials. Thankfully, the Sixth Circuit Court of Appeals has taken a common-sense “clear notice standard” approach to resolving these issues, which helps eliminate the need to rely on clairvoyance and crystal balls.

These types of broad document requests are often made during the formal claim/appeal process, as was the case in Cultrona v. Nationwide Life Ins. Co. At issue in Cultrona was whether the participant was entitled to statutory penalties under ERISA Section 502(c)(1)(B), which gives courts discretion to penalize plan administrators up to $110 per day if they fail to provide certain plan-related documents within 30 days of receiving a written request. Following the denial of her claim for benefits under the company’s death benefit plan, the claimant’s attorney requested “all documents comprising the administrative record and/or supporting [the plan’s] decision.” While the plan administrator provided some documentation, it did not provide a copy of the written plan document until seven months after the initial request. Because the terms of the plan document were the primary basis for the claim denial, the district court determined that the administrator should have provided a copy in response to the request. The court then imposed a penalty of $55 per day ($8,910 total) on the plan administrator for failure to timely provide the document.

On appeal, the plan administrator argued that the court should adopt the “clear notice standard” for determining if it was required to provide the plan document to the claimant. Under this standard, individuals requesting plan-related documents that they are entitled to under ERISA must “provide clear notice to the plan administrator of the information they desire.” The key question here is whether the plan administrator knew, or should have known, which documents were being requested. If so, the plan administrator has a duty to provide the documents and faces penalties of up to $110 per day if it does not provide the documents within 30 days of the request. Even though the claimant’s request was broad, the Court ultimately agreed with the district court that the plan administrator should have known that the claimant wanted a copy of the plan document under the circumstances. Thus, the plan administrator was required to pay the statutory penalties.

While the adoption of the “clear notice standard” is not particularly enthralling or surprising, there are a few nuggets of wisdom buried in this decision. First, while courts do not expect plan administrators to rely on crystal balls, plan administrators should use some common sense when responding to participants’ document requests. It seems like a no-brainer (at least to this court) that a claimant would want a plan document when that was the basis for the claim denial.

Second, when in doubt, ask for clarification. Even more compelling than the adoption of the new standard was the Court’s logical statement that “a plan administrator is free to place the burden of clarity squarely on the requester simply by replying to an ambiguous demand for . . . documents with the administrator’s own request for greater specificity.” In elementary school, we were all told that there are no stupid questions. While some may argue with that old adage, I would submit that the same applies when trying to figure out what a participant is asking for. If you do not know, it is better to ask for clarification then to face potentially steep penalties for not providing the right documents.

We have seen situations where participants really need documentation; they just cannot find the right words to adequately describe what they need. In these situations, we believe the plan administrator has a duty to help the participant. But we have also seen abusive situations. For example, a participant (or more likely, the participant’s legal counsel) makes an ambiguous request that appears to be designed to try to seek penalties later. This is an example of where it is perfectly appropriate to ask for clarification before embarking on a photocopy project.  Another scenario is where a participant makes an overly broad demand as a form of harassment.  In that scenario, we would suggest that you provide what the participant is entitled to, and explain the limitations of the disclosure. In any scenario where you suspect an abusive purpose, you may want to consider asking the participant (or his counsel) to write back if he believes he is entitled to any additional documentation that was not provided, and to provide an explanation as to why he is entitled to this additional documentation. Abusive situations like this are fairly unusual, but requiring a participant to play by the rules rather than inappropriately drive up costs is in the best interests of all plan participants.

Health reimbursement accounts failed to satisfy collective bargaining agreement provisions: is the Sixth Circuit handcuffing employers?

Posted in Employment Issues, Health Care Reform

We have a new Sixth Circuit decision regarding “vested” retiree health care benefits that is likely to be of concern to many employers, United Steel, Paper and Forestry, Rubber, Manufacturing Energy, Allied Industrial And Service Workers International Union, AFL-CIO-CLC v. Kelsey-Hayes Company. You may recall that in the last significant Sixth Circuit decision on this topic, Reese v. CNH America LLC, the Court recognized that health care had changed over the years, and concluded that the employer could unilaterally modify a retiree health plan, provided that the modifications were reasonable.  That decision seemed to put the Sixth Circuit more in line with other circuits that had ruled on these issues, and gave employers some relief.  But it appears that relief was short-lived.

Oversimplifying this a bit, the 2003 Kelsey-Hayes collective bargaining agreement provided that retirees would be provided with establish a health insurance plan, “either through a self-insured plan or under a group insurance policy or policies issued by an insurance company . . . .” and “The Company shall contribute the full premium or subscription charge for health care coverages.”  The agreement contained a provision regarding changing benefits, but those changes were required to be made by mutual agreement. Plaintiffs worked for a plant that was shut down in 2006.  In 2012, TRW Automotive, which had purchased Kelsey-Hayes, announced that it was eliminating its traditional group health care plan coverage. It was establishing health reimbursement accounts (“HRAs”). With respect to this group, it made an initial contribution of $15,000 per retiree and spouse, and promised a $4,800 credit for each retiree and spouse for 2013, with no commitment regarding subsequent years. The company retained the right to cease providing retiree coverage.

In Kelsey-Hayes, the Court (in a majority opinion written by Judge Griffin) concluded that the employer did not have the authority to create health reimbursement accounts that it promised to fund for only two years, and to reserve the right to eliminate all coverage thereafter. The Court found TRW liable as a successor for the collective bargaining agreement commitment. In an opinion concurring in part and dissenting in part, Judge Sutton agreed with this much of the of the opinion. The majority opinion further explained that reasonable modifications were only permitted in CNH America because of the text of the collective bargaining agreement and issued a permanent injunction, “requiring a return to the ‘status quo ante.’” Judge Sutton, who had written the CNH America opinion, by the way, disagreed, reminding us that the Court had said:

Retirees, quite understandably, do not want lifetime eligibility for the medical-insurance plan in place on the day of retirement, even if that means they would pay no premiums for it. They want eligibility for up-do-date medical insurance plans, all with access to up-to-date medical procedures and drugs.

Judge Sutton viewed the injunction as improperly ruling that even if the company had agreed to fund the HRAs for life, and even if the individuals obtained better and more flexible coverage, this would not satisfy the company’s obligation. He characterized this case as highlighting “the perils of handcuffing a company to one mode of providing retiree benefits.” This opinion explains that participants were guaranteed access to an individual insurance plan, and provided with a broker to select an insurance package. It appears that the Treasury, DOL and HHS already handcuffed the company from doing this in 2014 and beyond (see, e.g., IRS Notice 2013-54). But does this decision mean that if the company maintains a defined contribution private exchange, it must maintain a standalone insured plan for this group of retirees? Stand-alone retiree plans are excepted from the Patient Protection and Affordable Care Act (“PPACA”), which means the retirees could lose benefits they would have had (such as coverage of preventive care and coverage of dependents to age 26). Further, presuming the stand-alone plan is affordable and provides minimum value, the retirees will be ineligible to purchase, with a premium credit and cost-sharing reduction, an individual exchange policy that might include better benefits under the minimum essential coverage rules. This brings us back to the question: do retirees really want 2006 health care?

In a concurring opinion in Kelsey-Hayes, Judge Merritt opines that the Court is not handcuffing the employer, as the opinion only applies to the present circumstances, and there are many ways circumstances could change in the future. Like implementation of PPACA, perhaps?

Employers are continuously reviewing their employee compensation and benefits costs, and determining how much total cost they are willing and able to bear. Many employers are exploring, or have already made, significant changes regarding health care benefits. In 2018, the 40% nondeductible excise tax (Cadillac tax) is anticipated to hit many plans maintained pursuant to collective bargaining. Determining how those plans will be redesigned to minimize the tax, or how this tax will be funded, is critical. Employers, especially those in the Sixth Circuit, may be handcuffed by collective bargaining agreements and have trouble extending those changes to employees and retirees protected by those agreements. Accordingly, we continue to urge employers to make health care coverage a priority in the collective bargaining process. Employers may not be able to do anything about collective bargaining agreements that were in existence prior to an acquisition (and this is one of the reasons why due diligence is so important), but they may be able to better protect their interests in current negotiations.

“Substantial risk of forfeiture” clarification impacts tax-exempt and governmental employer non-compete arrangements

Posted in Tax-Exempt/Governmental Employers

One of the more interesting (or frustrating, depending on your point of view) things about language is how sometimes, the same word can have multiple meanings. As Michael Jackson once showed us, “Bad” can sometimes mean bad, and sometimes it can mean good. In the executive compensation world, “substantial risk of forfeiture” is a term that can have different meanings, depending on whether Code Section 83, 409A, or 457(f) is defining it. Understanding this concept is important because regardless of the Code Section, the compensation at issue generally does not become taxable to the employee until the substantial risk of forfeiture lapses. It can get confusing trying to determine whether a condition imposes a substantial risk of forfeiture in one Code Section, let alone in three different Code Sections.

We previously blogged about how the IRS and Treasury recently issued final regulations that clarify the definition of substantial risk of forfeiture for purposes of Code Section 83. These blogs, similar to the final regulations, focus mostly on restricted stock grants and certain stock option grants. An important point that has flown somewhat under the radar is that these regulations also could affect tax-exempt and governmental employers who have entered into non-compete arrangements with current and former employees.

That may sound surprising at first, because Code Section 83 does not specifically address tax-exempt organizations. These types of arrangements are governed instead by Code Section 457(f). The regulations under Code Section 457(f) currently state that “substantial risk of forfeiture” is defined in the manner provided under Code Section 83. Consequently, any change or clarification in the Code Section 83 regulations will impact Code Section 457(f). In particular, the Code Section 83 regulations continue to allow certain non-compete arrangements to be considered a valid tax-deferral mechanism.

Where things become confusing is that several years ago, the IRS issued guidance stating that it intends to issue new regulations under Code Section 457(f) that are more consistent with the Code Section 409A regulations. Code Section 409A also has a substantial risk of forfeiture concept. Unlike Code Section 83, the regulations under Code Section 409A state that a non-compete arrangement will not be considered a substantial risk of forfeiture that will defer taxes. Instead, the IRS will disregard any non-compete when determining whether compensation is subject to a substantial risk of forfeiture.

When the IRS issued this guidance, most tax-exempt and governmental employers began to focus more on the Code Section 409A regulations than on the Code Section 83 regulations with respect to their deferred compensation arrangements. Specifically, they made sure that these arrangements contained service or performance-based vesting conditions that would be considered a valid risk of forfeiture that deferred taxes.

We still encourage this practice. Service and performance-based conditions impose a valid substantial risk of forfeiture under Code Section 83 too. It’s also a smart practice to be forward-thinking rather than reactive. Yet, sometimes these types of conditions may not be appropriate. A common example is where an organization wants a current executive to take a step back to allow a successor to take over his or her position, while still being available for consulting if questions arise. Until the IRS issues final regulations under Code Section 457(f), a non-compete, particularly if it is combined with this type of part-time consulting arrangement, could still be a valid tax-deferral mechanism. One caveat is that in order for a non-compete to impose a substantial risk of forfeiture that defers taxation, the facts and circumstances must show that (i) given the employee’s age and employment opportunities, the non-compete imposes a legitimate burden, and (ii) the employer intends to enforce the non-compete.

A common example is the president or executive director of a large non-profit organization. Often times, these executives will be required to satisfy a service condition in order to receive deferred compensation (e.g., remain continuously employed for a period of 5 years). The executive also will be subject to a non-compete agreement that states that as long as the executive is employed at the organization and for a period of time after termination of employment (typically 1-2 years), the executive will not serve as an executive officer or director of a competitor organization within a certain radius of the employer. Failure to abide by these terms will require the executive to repay the deferred compensation amounts to the employer.

In short, the Code Section 457(f) regulations may one day eliminate any tax advantage of using non-compete arrangements. That day is not yet here, and until then, tax-exempt and governmental employers should remember that the Code Section 83 regulations still preserve some flexibility with using non-compete arrangements.