Also Hits Funds Focused on Low-Tax Foreign Persons and Tax Exempts; Existing Deferrals Limited to 10 Years

The very last provision of the legislation that included the Emergency Economic Stabilization Act of 2008 will tax managers of offshore funds currently on vested deferred compensation for services performed after 2008 and existing deferral arrangements to the extent of income deferred beyond 2017.[1] The rule also applies to foreign and domestic partnerships where the partners are foreign persons who are not subject to a comprehensive foreign tax or are organizations exempt from the U.S. income tax.

Income for Services to “Tax Indifferent Parties” No Longer Deferrable

New Section 457A of the Internal Revenue Code of 1986, as amended [2], will subject a service provider to current income tax on vested deferred compensation if payable by “tax indifferent parties” regardless of whether or not the service provider is entitled to payment of the deferred amounts at that time. While the term “tax indifferent parties” only appears in the title to new Section 457A, it aptly captures the nature of a “nonqualified entity,” the statutory term for the service recipient from whom compensation that is not subject to a risk of forfeiture can no longer be deferred. In essence, if the entity (or its principal partners to whom fund income is allocated) is not subject to a substantial current tax on the fund’s income, it is a non-qualified entity. Any partnership whose income is effectively connected with a U.S. trade or business would not be a nonqualified entity because its partners are subject to a current U.S. tax on that income. In general, however, a fund whose income is capital gain on the sale or exchange of U.S. securities, including securities of a portfolio company, will be a nonqualified entity if the persons to whom the gain is allocated are foreign persons not subject to a comprehensive tax, or are entities exempt from U.S. income tax.

Limited Exception for Income Based on the Performance of Certain Investment Assets

Income determined solely by reference to gain on the sale of individual investment assets will be excluded from the new rule to the extent provided in regulations. This exception is crafted by deeming the amounts subject to a substantial risk of forfeiture prior to the date of disposition of the asset. The term "investment asset," however, excludes assets that are “actively managed” and it is anticipated that netting will not be permitted.

Vested Variable Deferred Compensation Penalized

If the amount of deferred compensation cannot be determined at the time it vests, the amount will be taxed later when it becomes determinable, but with both an interest charge from the vesting date and an additional tax equal to 20% of the deferred income.

Applying Section 409A Definition, with an Extension to Equity Units

New Section 457A references Section 409A for its definition of “nonqualified deferred compensation plan” but specifically states that the term also covers any right to compensation based on “the appreciation in value of a specified number of equity units of the service recipient.” While restricted stock in corporations will not be covered, this provision will reach the equivalent of stock appreciation rights that are presently not treated differently for Section 409A purposes.

Effective Dates

As noted, Section 457A applies to income deferred for services performed after December 31, 2008. However, deferrals for prior years’ services must be included in income before 2018 or become subject to the new rule. (Regulations will be issued to permit a window to change in the payment schedule of existing deferral arrangements without triggering Section 409A concerns.)