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.