On Oct. 3, 2008, the Emergency Economic Stabilization Act of 2008 (H.R. 1424) was signed into law. The Act, among other things, eliminates the ability of most cash-basis taxpayers1 to defer compensation earned from many non-U.S. corporations (including offshore hedge funds) and certain partnerships comprised primarily of persons non-taxable in the United States ("nonqualified entities"). The legislation is effective for compensation attributable to services performed after Dec. 31, 2008.2

The law adds new Section 457A to the Internal Revenue Code of 1986, as amended (the "Code"), which requires the inclusion in a taxpayer's income of compensation deferred from a nonqualified entity under a nonqualified deferred compensation plan when such income is not subject to a substantial risk of forfeiture. For purposes of this rule, a "substantial risk of forfeiture" is limited only to the taxpayer's continued performance of substantial services (i.e., to avoid Section 457A, the taxpayer must forfeit the deferred compensation if the taxpayer ceases to provide substantial services to the fund prior to the end of the specified deferral period). However, payment of the compensation may be made up to 12 months following the end of the nonqualified entity's taxable year without triggering the income-inclusion rules.

Of particular note is a provision that negatively impacts performance-based fees on “side pocket” arrangements of an offshore hedge fund and certain other offshore fund fees based on performance measured over a period of more than 12 months.3 The amount of such fees is generally not known, and such fees are generally not payable, until the side pocket is realized. However, because fees from a side pocket are typically not subject to a Section 457A "substantial risk of forfeiture" at a time prior to the realization of the side pocket, Section 457A generally imposes (i) an additional 20% tax and (ii) interest on such fees at the underpayment rate plus 1% when the amount of the fee is determinable (i.e., when the side pocket is realized). Although Section 457A authorizes regulations to allow for a limited exception for a fee payable upon the disposition of a single investment asset, Section 457A and its legislative history appear to exempt very few of the typical side-pocket arrangements and specifically would not exempt funds that net the performance of side pockets with the performance of other investments in computing the managers' fees. Managers should consult their advisers regarding their compensation arrangements for 2009 and future years.

Certain offshore funds currently operate in a “mini-master” format, where the offshore fund and the manager, or its affiliate, are partners in an entity treated as a partnership for U.S. tax purposes (the “mini-master”), which makes the investments and allocates profits, including profits from side pockets, to the manager or its affiliate. Such mini-master arrangements, as well as performance-based allocations involving onshore funds, are generally not subject to the adverse rules of Section 457A.

The Treasury Department has been directed to issue transition relief by Jan. 31, 2009, to allow taxpayers to shorten their deferred compensation elections relating to pre-2009 services to the time that Section 457A requires them to include such compensation in their income. Such changes will not violate Section 409A or constitute a "material modification" of compensation not currently subject to Section 409A. The relief will also extend to "back-to-back" deferral arrangements with the managers' personnel.

Please note that Section 409A continues to apply to nonqualified deferred compensation that was not earned and vested as of Dec. 31, 2004 (or that was “materially modified” after Oct. 3, 2004). Any such deferral arrangement must be brought into written compliance with Section 409A by Dec. 31, 2008, in order to avoid significant penalties under that Code section. In addition, Section 409A transition relief that allows taxpayers to change certain payment dates for previously deferred amounts may continue to be used through Dec. 31, 2008. (See “Deadline for Complying with the Final Section 409A Regulations” (SRZ Client Alert, Aug. 28, 2008), regarding the deadline for taxpayers to amend their agreements to comply with Section 409A and to make certain payment change elections.)