03 April 2020 - Article
According to the Emergency Economic Stabilization Act of 2008 (the “Act”), compensation received from “nonqualified entities” cannot be deferred past the time that payment ceases to be conditioned upon the performance of future services, regardless of when payment will be received. Section 801 of the Act adds Section 457A to the Internal Revenue Code (the “Code”), which imposes significant restrictions on techniques commonly used by managers of offshore investment funds to defer income. Employees who elected to receive payments for past services sooner than December 31, 2017 may amend their elections during the remainder of 2008 to delay payment until December 31, 2017. This allows them to take full advantage of the transition period provided under the new law. Any such change must be made on or before December 31, 2008.
Payments with respect to prior services that were scheduled to be made after December 31, 2017 can be accelerated to that date without triggering a penalty under existing deferred compensation tax rules. This enables recipients to have access to the funds when they will be taxed on the income.
The New Regime
Under the previous tax regime, a service provider did not have to include deferred compensation in income until actual receipt of the compensation. As a result, the payor of such deferred compensation could not take a deduction until the recipient included the compensation in income. Section 457A changes this process significantly by taxing certain compensation at the time it vests rather than at receipt. Specifically, Section 457A provides that any compensation that is deferred under a nonqualified deferred compensation plan of a “nonqualified entity” will be includible in gross income once the service
provider earns the compensation and the right to payment is no longer conditioned upon the future performance of substantial services by any person. Compensation is not treated as deferred if the service provider receives payment within 12 months following the end of the nonqualified entity’s taxable year during which the right to the payment vested. For purposes of Section 457A, nonqualified deferred compensation plans generally do not include tax qualified retirement plans or other qualified employee benefits. A “nonqualified” entity is essentially any foreign corporation not subject to taxation in a country that is a tax treaty partner with the U.S., or any U.S. or foreign partnership, unless substantially all of the partnership’s income is allocated to taxable investors. The definition of nonqualified entity is very broad and, as a result, may include entities that Congress did not intend to treat as nonqualified entities.
Under this new section of the Code, deferred compensation payable to U.S. taxpayers by nonqualified entities is taxable when it is no longer conditioned upon the future performance of substantial services. Where the amount of the deferred compensation is not determinable at the time of such vesting, the compensation will be taxed when it is finally determinable and it will then be subject to an interest charge and a 20% penalty.
Section 457A generally applies only to deferred compensation attributable to services rendered after December 31, 2008. Amounts deferred on account of services performed before January 1, 2009 may continue to be deferred under existing arrangements, but must be included in income on or before December 31, 2017. Note that between now and the end of this year it may be possible to amend previous deferral elections to delay payment dates to December 31, 2017 to take maximum advantage of this transition period. It may also be possible to accelerate payments that were scheduled to be made after December 31, 2017 to that date without triggering a violation of Section 409A. This will enable taxpayers to have access to the funds at the time they will be taxed on the income.
Who is affected?
The principal targets of Section 457A are U.S. managers of offshore investment funds. Congress intended that the Section curtail the ability of investment fund managers to defer income recognition of management and incentive fees due from offshore funds organized in tax havens. Initially, Congress attempted to pass two new tax sections that would increase the tax liability for investment funds. Section 457A was one of these provisions but the other provision, Section 710, was ultimately not included in the final version of the Act. Section 710 would have denied long-term capital gains treatment on incentive fees to partners who supplied investment services to the partnership. Section 710 applied only to investment advisors, which included not only investment fund managers but also all partnership
interests involving investment management, including real estate developers. Section 457A, on the other hand, is not limited only to investment managers. As a result, Section 457A applies to a much broader group. We expect that the Treasury will issue new regulations that will narrow the scope of Section 457A to fit more within the scope of proposed Section 710. Until the Treasury provides guidance, it is difficult
to know whether Section 457A will have application beyond the investment fund context.
Effect on other nonqualified entities
Although Section 457A was aimed at the deferred compensation of hedge fund and private equity fund executives who manage offshore funds, it has much broader applications. This means that some unintended organizations could be picked up under Section 457A, such as certain publicly traded partnerships. Publicly traded partnerships are any partnership if the interests in the partnership are traded on an established securities market or are readily tradable on a secondary market. These partnerships are generally treated as corporations for federal income tax purposes. However, exception exists for partnerships that are involved in the exploration or development of any mineral or natural resource. These publicly traded partnerships are treated as partnerships, not as corporations, for U.S. tax purposes. Since they are likely to have shareholders that are either foreign or tax-exempt persons, they would likely constitute nonqualified entities for purposes of Section 457A. They may owe deferred compensation payments to employees involved in active operations, not investment management. It is unlikely that Congress intended for these companies be subjected to Section 457A and we expect clarifying legislation or regulations will be enacted in the future.