An Appreciation for Hedging Your Bets on Deferred Compensation

by Dechert LLP
Contact

Under Section 457A of the U.S. Internal Revenue Code of 1986 (the “Code”), certain offshore and other entities are limited in their ability to provide tax-effective deferred compensation to providers of services to those entities. Recently, in Revenue Ruling 2014-181 (the “Ruling”), the Internal Revenue Service (the “IRS”) confirmed that certain equity-based compensation arrangements are not subject to Section 457A. This article will discuss how the Ruling may present an opportunity for investment funds and their sponsors and managers to explore the use of certain types of equity-based compensation arrangements as a workable solution to avoid the restrictions of Section 457A and simultaneously accomplish their compensation-related goals.2

Background

Prior to the enactment of Section 457A, managers of various investment funds had been permitted to receive all or a portion of their compensation on a tax-deferred basis, often with the deferred amounts being effectively reinvested in the fund. In 2008, Congress added Section 457A to the Code to curb the use of deferred compensation arrangements by certain offshore and other entities not subject to a comprehensive tax regime. Section 457A effectively eliminated the ability of U.S. service providers to defer taxation on compensation paid by certain tax-indifferent service recipients. Many investment funds are subject to Section 457A and, as a result, efforts to defer fund-related compensation generally needed to be structured to avoid Section 457A. 

Following the enactment of Section 457A, a number of approaches have developed in the market to accomplish the payment of tax-deferred compensation to certain fund managers. Some approaches have involved the use of partnership interests, which generally are not subject to Section 457A. Certain other approaches involve the use of compensation that is subject to vesting requirements, with the intention that the compensation not be considered “deferred” for Section 457A purposes.3 As a practical matter, however, Section 457A has, in a variety of cases, dramatically curtailed the ability of fund managers of offshore funds to defer compensation for tax purposes. 

Revenue Ruling 2014-18

After the enactment of Section 457A, the IRS attempted to clarify that certain equity-based compensation is not subject to Section 457A. Specifically, in Notice 2009-084 (the “Notice”), the IRS indicated that certain types of stock options and stock appreciation rights (“SARs”) settled in stock are not subject to Section 457A.5 As a practical matter, in the context of fund-related compensation, SARs, rather than options, may be the more relevant type of compensatory interest. 

After the Notice, there still seemed to be a general reluctance on the part of investment funds and their sponsors to adopt option or SAR arrangements intended to avoid the reach of Section 457A. It appears that, in light of the substantial adverse tax consequences under Section 457A, some in the market were unwilling to proceed absent further clarification. 

Now, with the issuance of the Ruling, the IRS has confirmed that certain stock options and stock-settled SARs are indeed not subject to the restrictions of Section 457A. In addition, the principles discussed in the Ruling with respect to stock options and stock-settled SARs could be read in conjunction with the Notice to apply to other equity appreciation rights (“EARs”) that are settled in non-stock equity interests in non-corporate entities.6 In light of the foregoing, it would appear that the clarification provided by the IRS in the Ruling may be relevant to corporate and non-corporate entities alike, and therefore potentially relevant with respect to a wide range of investment funds. 

Next Steps

While SARs and other EARs are not necessarily appropriate for all funds as a business matter, there may be funds for which such interests indeed accomplish the compensation-related goals of the fund, its sponsor and the manager. Indeed, there are indications that EARs may well also be desirable from the perspective of fund investors, as they can tend to align the interests of managers and investors.  

If stock-settled SARs or other equity-settled EARs make sense from a non-tax business perspective, it now may be possible, with a greater level of comfort, to structure a tax-efficient program that permits a manager to defer its compensation. The following features are among those that funds and their managers may wish to consider:  

  • In the case of an entity manager organized as a partnership for tax purposes, income from the exercise of SARs/EARs may be able to be allocated to the entity’s principals under their partnership (for tax purposes) interests. 
  • There may be a wide range of vesting and other ancillary features that can be incorporated into the SAR/EAR arrangement, thereby potentially further increasing the utility of the arrangement from a design perspective. The breath of the possible design features that can overlay the basic SAR/EAR structure could be substantial, constrained primarily by non-tax business considerations. 
  • It may be possible to cap upside returns, if there is a concern that the SAR/EAR could provide payments considered excessive as a business manner.
  • It may be possible to flow the economics of the underlying SARs/EARs to employees of an entity manager, using a plan involving short-term deferrals for Section 457A purposes (i.e., using a plan that does not provide “deferred compensation” for such purposes).
  • It may be worthwhile to consider whether investment relationships structured as separately-managed (or similar) accounts could be restructured through use of an entity (e.g., a “fund of one”). 
  • Footnotes

    1 2014-26 I.R.B. 1104 (June 23, 2014). 

    2 For additional discussion of Section 457A and its application to certain equity-based compensation, see Oringer, Braid and Lee, “An Appreciation for Fund-Based Deferred Compensation,” BNA Pension & Benefits Daily (June 20, 2014). 

    3 Under Section 457A(d)(3)(B), compensation is generally not considered “deferred” if it is paid no later than 12 months after the end of the service recipient’s taxable year during which the compensation vests.

    4 2009-4 I.R.B. 347 (Jan. 26, 2009).

    5 In general terms, (i) a stock option is the right to buy a specified number of shares of stock of the employer or other service recipient at a fixed price during a stated time period, and (ii) an SAR is a right to compensation based on the appreciation in value over a limited time of a specified number of shares of stock of the employer or other service recipient. One possible way to look at an SAR could be that the SAR is the economic equivalent of an option, where on exercise the option’s exercise price is netted out of the proceeds of the exercise of the option. Regarding SARs, Q&A 2(b) of the Notice states, in relevant part, that “the exception from coverage under [applicable principles] may be applied so that [an SAR] which by its terms at all times must be settled in service recipient stock, and is settled in service recipient stock (and otherwise meets the [applicable requirements]), will be excluded from coverage under § 457A.”

    6 Q&A 2(b) of the Notice states, in relevant part, that, for purposes of determining whether Section 457A applies to “an equity interest in a non-corporate entity (meaning a right to purchase actual equity in such entity, and not a mere right to an amount equal to the appreciation in such equity),” the otherwise applicable rules “are applied by analogy.” See also Preamble, Application of Section 409A to Nonqualified Deferred Compensation Plans (final regulations), 72 Fed. Reg. 19,234, 19,243, § III.G (Apr. 17, 2007), corrected, 72 Fed. Reg. 38,477 (July 13, 2007), 72 Fed. Reg. 41,620 (July 31, 2007), modified in part, Notice 2007-86, 2007-2 C.B. 990.

 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Dechert LLP | Attorney Advertising

Written by:

Dechert LLP
Contact
more
less

Dechert LLP on:

Readers' Choice 2017
Reporters on Deadline

"My best business intelligence, in one easy email…"

Your first step to building a free, personalized, morning email brief covering pertinent authors and topics on JD Supra:
Sign up using*

Already signed up? Log in here

*By using the service, you signify your acceptance of JD Supra's Privacy Policy.
Custom Email Digest
Privacy Policy (Updated: October 8, 2015):
hide

JD Supra provides users with access to its legal industry publishing services (the "Service") through its website (the "Website") as well as through other sources. Our policies with regard to data collection and use of personal information of users of the Service, regardless of the manner in which users access the Service, and visitors to the Website are set forth in this statement ("Policy"). By using the Service, you signify your acceptance of this Policy.

Information Collection and Use by JD Supra

JD Supra collects users' names, companies, titles, e-mail address and industry. JD Supra also tracks the pages that users visit, logs IP addresses and aggregates non-personally identifiable user data and browser type. This data is gathered using cookies and other technologies.

The information and data collected is used to authenticate users and to send notifications relating to the Service, including email alerts to which users have subscribed; to manage the Service and Website, to improve the Service and to customize the user's experience. This information is also provided to the authors of the content to give them insight into their readership and help them to improve their content, so that it is most useful for our users.

JD Supra does not sell, rent or otherwise provide your details to third parties, other than to the authors of the content on JD Supra.

If you prefer not to enable cookies, you may change your browser settings to disable cookies; however, please note that rejecting cookies while visiting the Website may result in certain parts of the Website not operating correctly or as efficiently as if cookies were allowed.

Email Choice/Opt-out

Users who opt in to receive emails may choose to no longer receive e-mail updates and newsletters by selecting the "opt-out of future email" option in the email they receive from JD Supra or in their JD Supra account management screen.

Security

JD Supra takes reasonable precautions to insure that user information is kept private. We restrict access to user information to those individuals who reasonably need access to perform their job functions, such as our third party email service, customer service personnel and technical staff. However, please note that no method of transmitting or storing data is completely secure and we cannot guarantee the security of user information. Unauthorized entry or use, hardware or software failure, and other factors may compromise the security of user information at any time.

If you have reason to believe that your interaction with us is no longer secure, you must immediately notify us of the problem by contacting us at info@jdsupra.com. In the unlikely event that we believe that the security of your user information in our possession or control may have been compromised, we may seek to notify you of that development and, if so, will endeavor to do so as promptly as practicable under the circumstances.

Sharing and Disclosure of Information JD Supra Collects

Except as otherwise described in this privacy statement, JD Supra will not disclose personal information to any third party unless we believe that disclosure is necessary to: (1) comply with applicable laws; (2) respond to governmental inquiries or requests; (3) comply with valid legal process; (4) protect the rights, privacy, safety or property of JD Supra, users of the Service, Website visitors or the public; (5) permit us to pursue available remedies or limit the damages that we may sustain; and (6) enforce our Terms & Conditions of Use.

In the event there is a change in the corporate structure of JD Supra such as, but not limited to, merger, consolidation, sale, liquidation or transfer of substantial assets, JD Supra may, in its sole discretion, transfer, sell or assign information collected on and through the Service to one or more affiliated or unaffiliated third parties.

Links to Other Websites

This Website and the Service may contain links to other websites. The operator of such other websites may collect information about you, including through cookies or other technologies. If you are using the Service through the Website and link to another site, you will leave the Website and this Policy will not apply to your use of and activity on those other sites. We encourage you to read the legal notices posted on those sites, including their privacy policies. We shall have no responsibility or liability for your visitation to, and the data collection and use practices of, such other sites. This Policy applies solely to the information collected in connection with your use of this Website and does not apply to any practices conducted offline or in connection with any other websites.

Changes in Our Privacy Policy

We reserve the right to change this Policy at any time. Please refer to the date at the top of this page to determine when this Policy was last revised. Any changes to our privacy policy will become effective upon posting of the revised policy on the Website. By continuing to use the Service or Website following such changes, you will be deemed to have agreed to such changes. If you do not agree with the terms of this Policy, as it may be amended from time to time, in whole or part, please do not continue using the Service or the Website.

Contacting JD Supra

If you have any questions about this privacy statement, the practices of this site, your dealings with this Web site, or if you would like to change any of the information you have provided to us, please contact us at: info@jdsupra.com.

- hide
*With LinkedIn, you don't need to create a separate login to manage your free JD Supra account, and we can make suggestions based on your needs and interests. We will not post anything on LinkedIn in your name. Or, sign up using your email address.