The Emergency Economic Stabilization Act of 2008 (commonly known as the "bailout bill") adds Section 457A to the Internal Revenue Code (the "Code") that effectively shuts down most deferred compensation arrangements with offshore funds and certain US partnerships.
Section 409A Compliance No Longer Sufficient
Section 409A was added to the Code to curb certain abuses involving deferred compensation. With respect to venture capital, private equity and hedge funds ("funds"), Section 409A requires all deferrals, including deferrals of "investment fees" and "management fees," be brought into compliance with Section 409A by December 31, 2008. As a practical matter, this means documenting the time and manner of payment of such deferred compensation and ensuring that elections to defer are timely made, a task most funds have fully or substantially completed. Section 409A compliant deferred compensation arrangements can defer the taxation of vested deferred compensation until a permitted distribution event (e.g., termination of employment, death, disability, a fixed date, or a change in control).
Section 457A changes this regime. Under Section 457A, a service provider will be subject to federal income tax on deferred compensation payable by a nonqualified entity when such compensation is no longer subject to a substantial risk of forfeiture (regardless of the permitted payment event set forth in the arrangement). This new provision will prevent most fund managers from deferring taxes on compensation payable by offshore corporations organized in tax-havens.
Under Section 457A, a "nonqualified entity" is any foreign corporation unless (a) substantially all the corporation’s income is subject to tax by the United States because it is engaged in a US business or (b) the corporation is subject to a comprehensive foreign income tax. A partnership (domestic or foreign) will be a nonqualified entity unless substantially all its income is allocated to partners that are US taxable investors or foreign persons with respect to whom such income is subject to a comprehensive foreign income tax. Many funds are comprised of mostly tax-exempt and foreign investors and such funds will likely be treated as nonqualified entities.
Substantial Risk of Forfeiture
For purposes of Section 457A, compensation will be treated as subject to a substantial risk of forfeiture only if the service provider’s rights to the compensation are conditioned upon the future performance of substantial services. This definition of "substantial risk of forfeiture" is narrower than the definition found in other tax provisions, and, for example, performance-based forfeiture restrictions would not constitute a substantial risk of forfeiture under this 457A definition.
There may still yet be planning opportunities. For example, if compensation is determined solely by reference to the amount of gain recognized on the disposition of an "investment asset," such compensation shall be treated as subject to a substantial risk of forfeiture until the date of such disposition. However, an "investment asset" is narrowly defined by the provision to exclude, among other things, an asset that is actively managed. How this may impact a benchmarking of deferred compensation to a private equity fund’s portfolio company is unclear. The legislative history states that active management is intended to include participation in the day-to-day activities of the asset, but does not include the election of a director or other voting rights exercised by shareholders. It will also be interesting to see how forthcoming regulations address common deferral arrangements such as "cumulative earnings" calculations for fund managers as the Joint Committee Report states that for purposes of the investment asset exception there may be no netting against other assets.
Non Determinable Amounts
A further limited but important exception to the rule of taxation upon vesting applies when the amount of deferred compensation cannot be readily determined at the time of vesting. In such event, the deferred compensation will be taxed at the later date when it becomes determinable, but with an additional 20% tax plus interest from the date of deferral.
Definition of Deferred Compensation
New Code Section 457A references Code Section 409A for its definition of "nonqualified deferred compensation plan" but includes a statement that the term shall include any plan that provides a right to compensation based on the appreciation in value of a specified number of equity units of the service recipient. According to the Joint Committee Report, this definition is intended to pick up stock appreciation rights or "SARs" (whether or not at fair market value), but continue to exclude stock options issued at fair market value – a curious result given the regulatory conclusions under Section 409A that no meaningful difference exists between fair market value options and fair market value "SARs". Importantly, the legislative history also notes that Code Section 457A is not intended to apply to grants of property such as restricted stock in corporations or capital or profits interests in partnerships and LLCs treated as partnerships.
New Section 457A generally applies to the deferral of compensation attributable to services performed after January 1, 2009. Deferrals attributable to services performed before January 1, 2009 must be included in income no later than the last taxable year beginning before 2018 (unless taxed earlier). Fortunately, pursuant to regulations to be issued, existing deferred compensation arrangements may be modified to change the scheduled payment for these arrangements (if not otherwise payable before 2018) without causing such changes to be considered an impermissible acceleration or a material modification under Section 409A.