How the New Deferred Compensation Regulations Affect Hedge Funds
David P Simonetti, Senior Compensation and Benefits Manager
Sec 409A of the Internal Revenue Code of 1986 (the Code), as amended, was enacted on 22 October 2004, and made significant changes to the rules governing non-qualified deferred compensation plans. The new rules apply with respect to amounts earned and vested after 31 December 2004. On 10 April 2007, the Internal Revenue Service (IRS) issued final regulations under the Code that will generally become effective as of 1 January 2008. The final regulations address some issues impacting fund managers with respect to their non-qualified deferred compensation plans while leaving many to be resolved in future guidance. The following summarises these issues:
The impact on partnerships. The final regulations do not address how Sec 409A would apply to partnerships but subsequent guidance is expected. However, the limited guidance provided in IRS Notice 2005-1 and the preamble to the proposed and final regulations can be relied upon. This guidance provides that grants of profits interests, which are not included in income, would be exempt from Sec 409A, as would the issuance of capital interests, assuming such capital interests satisfy the rules applicable to grants of stock provided for in the final regulations.
Applicability of the rules to fund managers. The final regulations make it clear that deferral agreements between a fund manager and a fund must comply with Sec 409A unless the fund manager is an accrual basis taxpayer.
Back-to-back arrangements. As was the case with the proposed regulations, the final regulations permit the payment of a fund manager’s portion of a back-to-back arrangement to satisfy obligations that arise when a qualifying distribution event (ie, separation from service, specified time, disability, death, change in ownership or unforeseeable emergency) occurs with respect to an employee. However, the fund manager’s deferral arrangement with the fund must define the time and form of payment as the same as provided under the deferral between the fund manager and employee. It remains unclear how this relief applies to payments to retiring partners of the fund manager. The final regulations also do not address reverse back-to-back arrangements (those arrangements where the deferred fees are paid to the fund manager when an investor terminates his or her relationship with such fund), but the Treasury and IRS continue to study this matter.
Side pockets. In some cases, funds may have investments that are not redeemable by a fund investor until such investment is liquid (these are called side pockets). For those who remain invested in the liquid portion of a fund, any management fees with respect to side pockets are often paid out of such liquid assets. However, for investors who have no interest in the fund other than side pockets, the management fees are often accrued and paid upon the investment’s disposition. Such a structure may violate Sec 409A, which requires deferred amounts to be paid on a specified date. The final regulations do not address this issue, but in the interim, possible alternatives include:
Treating the fund manager as in receipt of such fees and, therefore, taxable in the year such fees accrue.
Reserving an amount to cover the estimated fees attributable to side pockets and to pay them accordingly at the time the investor redeems its liquid interest in the fund.
Requiring redeemed investors to pay such management fees on side pockets directly to the manager on an annual basis.
Amending the fund’s investment management agreement to provide that such fees would be paid upon the earlier of a specified date or an event that is permissible under the Code.
Timing of initial deferral elections for newly established funds. Sec 409A provides that elections to defer compensation must be made in the year prior to the taxable year of the fund manager in which the compensation is earned. Thus, for amounts earned in 2008, the election must be made no later than 31 December 2007. A special rule applies to newly eligible participants. Under the special rule, the election can be made within 30 days of becoming eligible, but such elections can only defer amounts earned after such election. Thus, if a new fund commences operations on 1 July 2007 and the investment management agreement permits the fund manager to defer incentive fees earned during 2007, the fund manager should be able to make an election within 30 days after 1 July 2007 with respect to fees earned after such date.
Timing of deferral elections for performance-based compensation. Sec 409A provides that deferral elections may be made as late as six months before the end of the performance period with respect to performance-based compensation. The final regulations address the requirements for this, but do not clearly indicate whether investment management fees would qualify as performance-based compensation. Although some fund managers have taken the position that incentive fees are performance-based compensation, it may be prudent to rely upon this rule in limited circumstances until further guidance is provided.
Deferral elections for fiscal year funds. The final regulations provide that with respect to fiscal year compensation, the election must be made no later than the last day of such fiscal year preceding the fiscal year in which the services are performed. Thus, if a fund has a fiscal year beginning 1 May 2007, the initial deferral election could be made by 30 April 2007. Fiscal year compensation means compensation relating to a period of service coextensive with one or more fiscal years, of which no amount is paid or payable during the service period. It does not include amounts that would otherwise be paid during the fiscal year. Accordingly, this special rule may be applicable to incentive fees that are based on the fund’s fiscal year and are not otherwise payable during such year. However, it would not apply with respect to fees paid other than on a fiscal year basis, such as quarterly management fees. In addition, it is not certain whether it applies to incentive fees that become payable during the fiscal year upon a redemption of an investor’s interest in the fund.
Redeferral of deferred fees. Sec 409A permits redeferral of deferred fees as long as:
The subsequent election is made at least 12 months before the first scheduled payment date selected in the original election.
Such subsequent election will not take effect until at least 12 months after it is made.
The revised payment date must be at least five years from the date the payment would have been made originally, except with respect to distribution elections related to death, disability or unforeseeable emergency.
Payment dates for deferred compensation. Many deferred compensation plans provide that deferred incentive fees will be paid within a reasonable period of time following the date the fund completes its annual audit. It was unclear whether such a provision would violate Sec 409A’s requirement that payments must be made upon the occurrence of certain events. The final regulations provide that, as long as the deferral election sets forth an objectively determinable calendar year in which the payment will be made following the permissible payment event, no violation of the Code would occur. Therefore, if a deferral agreement provides that deferred compensation will be paid during the year following the year to which the deferral election relates, such provision should comply with the Code even though the payment could be made at any time during the following year.
Offshore funding rules impacting deferred compensation. Sec 409A prohibits funding deferred compensation in offshore trusts or other arrangements, and such prohibition applies to all amounts of deferred compensation, including amounts deferred before 1 January 2005. The final regulations do not address the treatment of offshore funding arrangements of non-qualified deferred compensation. To the extent this rule has been violated, prior guidance that is still in effect gives fund managers until 31 December 2007 to either move assets held offshore or pay deferred amounts to the service provider. But this relief only extends to amounts transferred offshore as of 21 March 2006 and any related investment returns. Anything set aside after 21 March 2006 is not eligible for this transition relief.
Amendment dates for deferred compensation plans. The final regulations require that all deferred compensation plans be operated in “good faith compliance” with the Code as of 1 January 2005, and formal plan amendments are required by 31 December 2007.