In January, the Federal Trade Commission (FTC) proposed a new rule that will likely be made final and will effectively prohibit non-compete agreements other than in very limited circumstances. The proposed rule, which would supersede all contrary state laws, is remarkable for its sweeping definition of “non-compete clauses” that fall within the ban.
The ban would extend to “de facto” non-compete clauses — that is, other contractual provisions that have the effect of prohibiting workers from seeking or accepting employment or operating a business after the conclusion of the worker’s current employment. In this regard, the ban may implicate broadly drafted non-disclosure-of-confidential-information restrictions and repayment-of-training-costs provisions. The ban also could implicate customer non-solicitation restrictions, depending on the surrounding facts.
By removing the non-compete “stick,” employers will be forced to rely on “carrots” to entice key talent to stay put. Cedar Point Financial Services LLC works with business owners to design and implement executive benefit strategies to retain key executives and other top talent.
Time is of the Essence
The “stick” could disappear imminently. When adopted, the proposed rule will require all employers that use any agreement with a non-compete clause (or with a clause that could be deemed to be a non-compete clause under the expansive definition in the proposed rule) to take action to rescind the non-compete clause. Remarkably, any provision negotiated in exchange for the non-compete (for example, a severance provision or executive benefit arrangement) would remain intact. This recission action will require individualized communications from the employer to all current employees, as well as former employees.
This communication requirement means that employers will need to move quickly to put into effect alternative plans to keep executives from thinking twice about leaving, potentially going to a competitor, with the company’s customers possibly following suit. Fortunately, there are a number of executive benefit plans that can help and have an instant impact, depending on the structure of the company.
“Non-compete provisions often come at a cost and are a consideration in an executive’s total compensation,” says Todd N. Robison, CLU®, President & Founder of Cedar Point Financial Services LLC. “The current trend is to redeploy this capital into cost-effective benefit strategies to retain talent who used to be subject to contractual non-complete clauses. There are a lot of flexible options available here.”
While Robison and his team consider a variety of arrangements depending on client fact patterns, four executive benefit strategies are most common:
1. Restricted Executive Bonus Arrangements (REBAs)
2. Nonqualified Deferred Compensation (NQDC) Plans
3. Supplement Executive Retirement Plans (SERPs)
4. Split Dollar Arrangements
Choosing The Carrot
Restricted Executive Bonus Arrangement (REBA)
A REBA using cash value life insurance can provide a simple yet powerful retention and recruitment incentive to top performers. A key advantage here is that the business may be able to take a current tax deduction for the bonus paid in the executive bonus plan. Here is how a REBA works:
1. A business pays a tax-deductible bonus to fund premiums for a cash value life insurance policy owned personally by the employee.
2. The employee designates a beneficiary for the income tax-free death benefit and may have access to policy cash surrender values subject to a restriction, such as a vesting schedule, determined by the employer. In the future, the employee will have access to the policy’s cash surrender values on a tax-favored basis to address personal needs such as supplemental retirement income. 1
3. The employee pays income tax on the bonus received. The employer has the option of grossing up the bonus payment to cover the employee’s taxes. This is known as a “double bonus.”
4. At death, the employee’s beneficiary receives the death benefit proceeds, generally income tax-free.
Nonqualified Deferred Compensation Plan (NQDC)
NQDC plans allow corporate executives to defer a much larger portion of their compensation than can be deferred in a qualified plan, and to defer taxes on the money until the deferral is paid. Here is how a NQDC plan works:
1. The employer and employee sign an agreement that lays out the ability of the employee to defer compensation and for the employer to make a match, if any. The agreement also addresses the conditions under which the employer will grow the deferred balance and at a later date, pay out the balance to the employee.
2. The employer purchases cash value life insurance to use to meet the liability of the NQDC plan. The employer owns the life insurance policy, pays a non-deductible premium, and is named the policy beneficiary.
3. When the employee is due a taxable distribution, the employer can access the life insurance policy for tax-free withdrawals and loans to use to pay for the distribution.
4. Should the employee die during the deferral or distribution periods, the employer can make a death payment to the employee’s family using the insurance policy’s income tax-free death benefit.
5. The employer can purchase additional life insurance than needed to pay distributions in order to recover all plan costs, including the time value of money.
Supplement Executive Retirement Plan (SERP)
A SERP is an employer paid deferred compensation agreement that provides supplemental retirement income to a participant, based on the employee meeting certain vesting or other specified conditions. A SERP functions similarly to a NQDC but with only the employer making contributions. Here is how a SERP works:
1. The employer enters into a SERP agreement with selected employees. The employer purchases a life insurance on the lives of the employee participants as an informal funding mechanism that the employer may use to provide benefits outlined in the SERP agreement.
2. The employer owns the life insurance policy, pays non-deductible premiums for it, and is named the policy beneficiary.
3. Upon a specified triggering event such as retirement, the employer pays the promised benefit. This payment is generally tax-deductible to the employer, and taxable to the employee at that time. Payments may be made from policy withdrawals and loans, corporate investment, or cash flow.
4. At the death of the employee during employment or during the distribution phase, the employer may use the income tax-free death benefit proceeds from the life insurance policy to make a death payment to the employee’s family, creating a tax deduction for the business.
5. The employer can purchase additional life insurance than needed to pay distributions in order to recover all plan costs, including the time value of money.
Split Dollar Plan
In a split dollar plan, the employer and its employees, which can also be an owner of the business, agree to share the benefits and costs of a life insurance policy. Here is how a split dollar plan works:
1. The employer enters into a written split dollar agreement with each selected employee. The agreement specifies the rights and responsibilities of each party.
2. The plan can be designed to leverage the amount of control the employer would like to have over the policy. Policy ownership and beneficiary arrangements will be determined by the selection of loan regime or endorsement/economic benefit regime split dollar plan.
3. Depending on the type of split-dollar arrangement, the employee may pay income tax on the economic benefit received or on the imputed interest income of the loan.
4. At retirement or separation from the employer, the split dollar plan is unwound and, depending on the arrangement, the employee receives the life insurance policy from which the employee can take tax-free withdrawals and loans for supplemental retirement income, or the employee can make use of the policy’s death benefit for the employee’s personal estate planning.
Your Partner in Executive Benefit Planning
Cedar Point Financial Services LLC helps employers select the executive benefit plan(s) that best meets the unique retention goals determined for each employee/participant. Without an ability to utilize contractual non-compete clauses, employers need to take steps to retain top talent. Rewarding talent for achieving specific benchmarks in performance and years of employment can put a halt to the revolving door that a competitive labor market fosters.