Earlier today, President Bush signed the Emergency Economic Stabilization Act of 2008 (the “Act”). Included among the provisions added after the Act’s failure to pass the House earlier in the week are certain limitations on the ability of fund managers and their employees to defer management and performance fees earned in connection with the operation of offshore private investment funds. The House and Senate had each separately adopted slightly different versions of this legislation earlier this year. The Act largely adopts the House’s version (described in our Memorandum dated May 23, 2008, available here).
The Act adds a new Section 457A to the Internal Revenue Code of 1986, as amended (the “Code”), which generally eliminates the ability of US cash basis taxpayers to defer nonqualified deferred compensation earned from a so-called “nonqualified entity” (defined to include certain partnerships and foreign corporations)1. Any compensation that is deferred under a “nonqualified deferred compensation plan” (generally defined by Section 409A(d) of the Code) of such a nonqualified entity will generally be includible in the recipient’s gross income when the right to the compensation is not subject to a “substantial risk of forfeiture.” Compensation is subject to a “substantial risk of forfeiture” only if a person's rights to such compensation are conditioned upon the future performance of substantial services by such person. This definition is less expansive than the definition of the same term under the Section 409A regulations.
The Act also includes a provision that would impose an additional tax on amounts of compensation that are not determinable at the time there is no substantial risk of forfeiture – a provision that is specifically designed to reach performance or incentive fees related to offshore hedge fund side pockets, unless those fee arrangements satisfy certain conditions.2 Side pocket performance fee arrangements that are not structured in accordance with Section 457A’s requirements run the risk of becoming subject to an additional 20% tax when the deferred performance fee becomes determinable plus interest at the underpayment rate plus 1% on the underpayments that would have occurred had the deferred compensation been includible in gross income for the taxable year in which first deferred or, if later, the first taxable year in which such deferred compensation is not subject to a substantial risk of forfeiture.
These provisions of the Act will apply to amounts deferred which are attributable to services performed after December 31, 2008. Amounts deferred that are attributable to services performed before January 1, 2009, will be includible in income on the later of (i) the last taxable year beginning before 2018 or (ii) the taxable year when the amount deferred is no longer subject to a substantial risk of forfeiture.
IRS Circular 230 Disclosure: Any US tax advice herein (or in any attachments hereto) was not intended or written to be used, and cannot be used, by any taxpayer to avoid US tax penalties. Any such tax advice that is used or referred to by others to promote, market or recommend any entity, plan or arrangement should be construed as written in connection with that promotion, marketing or recommendation, and the taxpayer should seek advice based on the taxpayer's particular circumstances from an independent tax advisor.