The Internal Revenue Service (“IRS”) recently issued Revenue Ruling 2014-18 (the “Ruling”) allowing the deferral of compensation from offshore hedge funds through the use of stock options (“Options”) and stock-settled stock appreciation rights (“SARs”) without running afoul of Section 457A of the Internal Revenue Code (“Section 457A”).
Since the enactment of Section 457A in 2008, U.S. hedge fund managers generally have not been able to defer fee-based incentive compensation paid from offshore hedge funds. Section 457A generally provides that deferred compensation from a “nonqualified entity” (such as an offshore hedge fund) is includable in income at the time the compensation is no longer subject to a substantial risk of forfeiture. As a result, U.S. hedge fund managers have been required to receive incentive fees or an incentive allocation on an annual basis. These current payments also had the potential effect of misaligning the interests of the fund’s investors with those of the fund manager. Because fund managers were paid on an annual basis, in highly profitable years the fund manager could receive the full incentive compensation, with little risk of a clawback of such compensation in any subsequent poorly performing years.
Section 457A generally covers the same “non-qualified deferred compensation plans” as those covered under Section 409A of the Internal Revenue Code (“Section 409A”), except it also includes “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.” Section 409A generally excludes from “non-qualified deferred compensation plan” Options and SARs with an exercise price that is no less than the fair market value at the time of grant. The legislative history to Section 457A and IRS Notice 2009-8 state that Options and SARs that are otherwise excluded from deferred compensation under Section 409A should not be treated as deferred compensation under Section 457A. However, prior to the issuance of the Ruling, many hedge fund managers expressed concern that the exception for Options and SARs under Section 457A would not apply to offshore hedge funds and their managers.
The Ruling amplifies previous guidance issued by the IRS in IRS Notice 2009-8 and confirms that Options and SARs, when properly structured, should be exempt from Section 457A. In the Ruling, the compensation arrangement between the service provider (i.e., the fund manager) and the service recipient (i.e., the fund) was an Option or SAR that could only be settled in stock and that otherwise met the requirements to be exempt from Section 409A. In addition, the fund manager in the Ruling had the same redemption rights with respect to any shares received upon exercise as any other shareholders of the fund (i.e., third party investors).
The service recipient in the Ruling was an entity organized and taxed as a foreign corporation and the service provider was a limited liability company taxed as a partnership with allocations to U.S. taxpayers. Based on these facts, the Ruling should apply to many common hedge fund structures as the parties described in the Ruling reasonably resemble typical structures used by fund managers in connection with offshore hedge funds (or offshore feeders in master-feeder arrangements). Because the Options or SARs described in the Ruling were not treated as deferred compensation arrangements under Section 457A, any inherent gains would be realized and included in income only upon the exercise of the Option or SAR.
The Ruling provides U.S. hedge fund managers with flexibility in structuring their compensation arrangements with offshore vehicles. For example, Options and SARs can be structured to lock a fund manager’s incentive compensation into the value of the fund itself for a fixed number of years or upon the occurrence of certain events (e.g., the exiting of the investor) by agreeing in advance when the Options or SARs will be exercisable. By effectively allowing multi-year fee deferrals, the Ruling permits investors to better align their interests with the fund managers, without investors asking for a clawback of fees.
Although the Ruling clears the way for possible deferred compensation arrangements, there are tax tradeoffs. For instance, the value of the compensation realized when the Options or SARs are exercised will be recognized as ordinary income by the fund manager. In addition, the Ruling does not address other tax issues arising in connection with multi-year incentive compensation structures, such as those arising under the “passive foreign investment company” (PFIC) rules.