IRS Ruling Means Taxpayers Should Examine Deferred Compensation Arrangements

On June 23, 2017, the IRS issued Chief Counsel Memorandum (CCM) 201725027 which analyzes applying IRC section 409A to a back-to-back deferred compensation arrangement between an investment fund manager, its employees, and one of its investment funds. To avoid the additional taxes, penalties and interest under IRC section 409A, deferral arrangements between the asset managers, their employees and their managed funds must be designed to comply with or be exempt from IRC section 409A. The IRS outlined several reasons why this particular arrangement failed to meet the requirements of IRC section 409A.

IRC Section 409A Generally

IRC section 409A imposes requirements on nonqualified deferred compensation plans, including requirements regarding the timing of elections to defer compensation and the timing of distributions of compensation previously deferred. If the requirements are not satisfied, all compensation deferred under a nonqualified deferred compensation plan is includible in the service provider’s gross income to the extent the compensation is not subject a substantial risk of forfeiture. The service provider must also pay an additional tax of 20% on the amount to be included in gross income, and in certain cases, a premium interest tax that equals the interest at the underpayment rate, plus one percentage point.

Application of 409A to ‘Back-to-Back’ Arrangements

There are two nonqualified deferred compensation arrangements between three separate parties in a back-to-back arrangement: (1) between the fund and the asset manager; and, (2) between the asset manager and its employees. These arrangements are designed to align employee compensation with compensation provided to the manager by the fund. For example, if employees are awarded 5% of total fees deferred by the fund manager, and the employees elect to receive the amounts on December 31, 2016, then the fund manager would also elect to defer its fees until that time.

It’s clear how issues may arise with this type of an arrangement given the strict requirements of IRC section 409A. For example, when an employee of the fund manager decides to terminate its employment and separate from service. The separation from service would generally not be an event permitting payment by the fund of deferred compensation owed to the asset manager.

CCM 201725027 is significant to taxpayers who hold deferred compensation arrangements subject to IRC section 409A. Generally, a service provider must make its initial election to defer compensation under a nonqualified deferred compensation plan in the year preceding the year in which the related services will be performed. Compensation deferred under a nonqualified deferred compensation plan generally may not be distributed earlier than: (1) separation from service; (2) disability; (3) death; (4) a specified time or pursuant to a fixed schedule; (5) an unforeseeable emergency; or (6) a change in the ownership or effective control of a service recipient corporation. When nonqualified deferred compensation is payable on a specified event, the plan may provide for distributions to be made on an objectively determinable date or year following the specified event.

In CCM 201725027, the manager was compensated for investment advisement for the fund while employees were awarded for providing services to the manager. At the heart of the IRS ruling is that under this arrangement, the manager received payments due to separation of service with the employee despite the employee terminating employment prior to their awards vesting, thus forfeiting compensation.

Although IRC section 409A states that separation of service by a manager’s employee cannot trigger payment from the fund to the manager, an exemption exists in Treas. Reg. § 1.409A-3(i)(6), which permits such payment. The IRS, however, ruled that the treasury regulation states that in back-to-back arrangements, when there is separation of service from the employee, the payment from the fund to the manager cannot exceed the employee’s compensation. This rendered the back-to-back arrangement in CCM 201725027 as non-compliant, according to the IRS. The IRS also calculated what the expected payments from the fund to the manager throughout the plan should have been, concluding the actual payments were inconsistent with what they anticipated. 1

Because of those failures to comply with IRC section 409A, the plan’s deferred payments for the tax year when the failures occurred plus all tax years prior were included in gross income and subject to tax.

The ruling underscores the need for anyone who holds back-to-back deferred compensation arrangements to contact a tax professional to review the terms of their plan.


References

  1. Office of Chief Counsel: Internal Revenue Service. “Memorandum #20175027.” Released June 23, 2017.
    https://www.irs.gov/pub/irs-wd/201725027.pdf
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