Quick Hits

• The FTC’s ban on noncompetition covenants has potential implications for several aspects of employee benefits and executive compensation plans and arrangements, such as Code Section 457(f) plans, restricted stock, severance arrangements, golden parachute payments, and garden leave.
• The rule takes effect on September 4, 2024, but a federal district court in Texas recently granted a preliminary injunction staying the enforcement of the final rule as to the parties in the case. The court’s decision, pending a final ruling on the merits by August 30, 2024, has signaled that the FTC’s noncompete rule will not survive judicial scrutiny.

Although the U.S. District Court for the Northern District of Texas recently granted a preliminary injunction staying enforcement of the rule as to the parties to a lawsuit seeking to vacate and set aside the rule, employers whose plans or compensation arrangements utilize noncompetes may want to consider assessing the applicable plans’ compliance with the ban, as well as potential impacts if the noncompetes are rendered invalid.

Here are some examples of plans and arrangements that may be affected by the ban.

Substantial Risk of Forfeiture

Code Section 457(f) Plans

Tax-exempt employers that sponsor Code Section 457(f) plans—a type of nonqualified deferred compensation plan—may have to make changes to such plans. Existing guidance (in the form of 2016 proposed regulations) treats certain enforceable noncompetes as a substantial risk of forfeiture (i.e., violation of the noncompete results in forfeiture of any amount otherwise owed pursuant to the plan), which delays income recognition under a 457(f) plan generally until payment. If the noncompete ban becomes effective, then amounts deferred that are contingent on compliance with a noncompete may become taxable earlier than anticipated. Importantly, because a noncompete is not treated as a substantial risk of forfeiture for purposes of Code Section 409A (relating to nonqualified deferred compensation arrangements), there could be complications with revising these plans to maintain their tax-deferred status.

Restricted Stock

Currently, a noncompete can create a substantial risk of forfeiture under Code Section 83, which addresses the timing of taxation of restricted property. Certain property subject to a substantial risk of forfeiture, such as restricted stock, is not subject to taxation until the substantial risk of forfeiture lapses unless the recipient opts to file an 83(b) election, which treats the fair market value of the property as immediately includible in income on the grant date of the award, with future increases in the award’s value subject to potentially lower capital gains tax rates. If the FTC ban takes effect and causes loss of a substantial risk of forfeiture based on a noncompete, it could affect income recognition timing in the absence of an 83(b) election, and it may be necessary to accelerate income recognition or amend arrangements to avoid unanticipated tax results.

Severance Arrangements

Severance plans, including those set forth in executive severance/employment agreements and those structured as ERISA plans, may have included noncompetes as a condition to receive benefits. In the case of an ERISA severance plan, noncompete conditions may have been included partly with the goal of asserting ERISA preemption of state laws that would otherwise prohibit noncompetes. The FTC ban would establish a federal standard that would not be subject to ERISA preemption. Accordingly, employers may consider assessing whether severance arrangements, including severance plans and separation agreements, include noncompete provisions.

Other Strategic Compensation Considerations in Light of the Ban

Code Section 280G and Excise Taxes

Currently, corporations may minimize excise taxes on, and maximize corporate deductions of, golden parachute payments to certain officers, directors, and shareholders in connection with a change-in-control by attributing a value to noncompetes as reasonable compensation. If noncompetes become unenforceable, this strategy might no longer be viable.

The FTC’s ban, however, includes an exception for certain noncompetes related to a sale of business. Companies may consider reviewing change-in-control transactions to determine if they fall within this exception, which may allow continued use and enforcement of a noncompete to avoid Code Section 280G excise taxes. Otherwise, impositions of excise taxes and changes to deductions may be necessary.

Garden Leave

The FTC suggests garden leave (i.e., a period of time, typically after an employee has resigned or been discharged, during which the employee remains employed but is not expected to perform any duties) as an alternative to noncompetes. Pursuant to Code Section 409A, however, the commencement (rather than end) of garden leave could trigger a separation from service, necessitating distributions from a nonqualified deferred compensation plan. Employers that do not carefully monitor when a separation from service occurs may risk inadvertent violations of Code Section 409A.

Additionally, employers may want to analyze their other benefit plans if they establish the terms of the garden leave. Often, garden leave might not be sufficient to allow continued participation in certain benefit plans, such as health and retirement plans, once garden leave begins (meaning employees on garden leave become ineligible for these benefits).

Next Steps and Timing of Amendments

Employers may consider evaluating noncompetes in their benefit and compensation plans to prepare for potential adjustments if the FTC’s ban takes effect on September 4, 2024. It may be reasonable, however, to opt to maintain current provisions and continue entering into noncompete agreements for now, for two reasons: First, the rule’s implementation likely faces delays or legal challenges that could impact its enforcement (as we saw earlier this month). Second, noncompetes entered into with senior executives prior to September 4, 2024, are excepted from the ban.