In summary
Many companies reduce excess parachute payments under IRC Section 280G by using noncompete clauses. A proposed rule released by the FTC on Jan. 5, 2023, would ban noncompete clauses except in very limited circumstances, which could increase tax exposure on excess parachute payments.
IRC Section 280G disallows a deduction for certain compensatory payments made to executives in connection with a company’s change in control (known as excess parachute payments). Executives are subject to a 20% excise tax on excess parachute payments under IRC Section 4999. Private companies can eliminate these negative tax consequences by obtaining an executive waiver and shareholder approval as prescribed in the IRC Section 280G regulations. However, the executive waiver/shareholder approval process is not available to public companies.
Compensatory payments made in connection with a change in control are exempt from the IRC Section 280G rules to the extent that they are deemed to be reasonable compensation for services rendered after the change in control. The IRC Section 280G regulations indicate that reasonable compensation for services rendered after a change in control can include payments made for refraining from performing services pursuant to a noncompete clause. Thus, companies – particularly public companies that are unable to use the executive waiver/shareholder approval process to exempt payments from the IRC Section 280G rules – often make certain compensatory payments to executives in connection with a change in control contingent upon the executive’s compliance with a noncompete clause for a period of time following the change in control as a way to exempt some or all of the payments from the IRC Section 280G rules.
The proposed FTC rule to ban noncompete clauses generally would apply to all employers other than employers that are exempt from the Federal Trade Commission Act, such as:
Crowe observation
Because tax-exempt entities are exempt from the ban, the proposed FTC rule should have no impact on the tax treatment of their compensatory arrangements with service providers under IRC Section 457(f) or IRC Section 4960.
The proposed FTC rule includes an exception to the ban for noncompete clauses entered into by a person who is selling a business entity or otherwise disposing of all ownership interest in the business entity, or by a person who is selling all or substantially all of a business entity’s operating assets, if the person restricted by the noncompete clause is a substantial owner of the business entity at the time the person enters into the noncompete clause. Substantial for this purpose is defined as someone who holds at least a 25% ownership interest.
The proposed FTC rule would become effective 60 days after publication as a final rule. The date by which compliance with the rule would be required is 180 days after publication as a final rule (the compliance date). Any employer that entered into a noncompete clause with a worker prior to the compliance date (including those entered into in the past) must rescind the noncompete clause no later than the compliance date. Within 45 days of rescinding the noncompete clause, the employer must notify the worker in an individualized communication that the worker’s noncompete clause no longer is in effect and may not be enforced against the worker.
If the proposed FTC rule is finalized, it might be necessary for companies to revise prior IRC Section 280G calculations that excluded certain compensatory payments from the calculations if the payments were contingent upon an executive’s compliance with a noncompete clause and the period of the noncompete clause extends beyond the compliance date.
The proposed FTC rule should have no effect on the taxation of deferred compensation under IRC Section 409A because IRC Section 409A regulations explicitly indicate that a noncompete clause does not constitute a substantial risk of forfeiture.
Crowe observation
In addition, the proposed rule should have little effect on property transfers under IRC Section 83 or Federal Insurance Contributions Act taxation of deferred compensation under IRC Section 3121 because of the limited use of noncompete clauses to delay taxation under these sections.
While the proposed FTC rule has the potential to increase tax exposure on excess parachute payments, employers with compensation arrangements that include noncompete clauses and employers considering these clauses don’t need to panic just yet. It likely will be a while before the final rule is published, and once published, it could be significantly different from what has been proposed. It also is possible that opposition to the proposed rule could be so overwhelming that the FTC takes additional time to consider whether to finalize it at all. Even if the FTC publishes a final rule banning noncompete clauses, significant legal challenges could, at the very least, delay implementation of the rule.
Because the fate of the proposed FTC rule is uncertain, it likely is too early to make changes to any existing arrangements. However, employers might want to take inventory of their compensatory arrangements that contain a noncompete clause. Employers entering into new compensatory arrangements might want to consult with legal counsel regarding any potential noncompete clauses. Also, employers that will be going through a transaction requiring an IRC Section 280G analysis – particularly public companies for which the executive waiver/shareholder approval process is unavailable – might consider strategies other than a noncompete clause for reducing or eliminating any excess parachute payments.
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