Interim Guidance Issued Under New Internal Revenue Code Section 457A
Section 457A was added to the Internal Revenue Code (Code) on October 3, 2008, by the Emergency Economic Stabilization Act of 2008 to prevent the tax-free deferral of income earned by offshore entities and funds. The section imposes significant restrictions on the ability of such entities to defer income beyond 12 months following the year in which compensation is earned. On January 8, 2009, the Internal Revenue Service issued interim guidance on Section 457A (Interim Guidance).
Application. Section 457A as originally drafted on October 3, 2008, applies to agreements or arrangements that defer income and (1) are “non-qualified deferred compensation plans;” (2) are maintained by a “non-qualified entity;” and (3) do not include a “substantial risk of forfeiture” (such agreements or arrangements, Section 457A Plans).
- Non-Qualified deferred compensation Plans. Section 457A defines non-qualified deferred compensation plans with reference to the broad definition in Code Section 409A—essentially any compensation vested or earned in one year but paid in a subsequent tax year.
- Non-Qualified entities. Section 457A defines non-qualified entities as any foreign corporation unless substantially all of the corporation’s income is connected to a United States trade or business or is subject to a comprehensive foreign income tax scheme. Entities or funds located in the Cayman Islands, Bermuda, the Bahamas or a similar jurisdiction that does not impose income or capital gains tax on an entities’ earnings would not have income connected with a U.S. trade or business and would not be subject to a foreign income tax scheme (because such jurisdictions do not impose income tax on such funds) and therefore fall within this definition.
- Substantial risk of forfeiture. Section 457A provides that a service provider’s rights to compensation are subject to a substantial risk of forfeiture only if they are conditioned upon the future performance of substantial services by the service provider. Section 457A also defines service provider with reference to the broad definition in Code Section 409A, which includes both individuals and corporate entities.
Requirements of Section 457A. Section 457A prohibits Section 457A Plans from paying compensation more than 12 months following the year in which compensation is earned—i.e. it permits the deferral of income only for 12 months following the tax year in which it was earned. However, for many hedge funds with illiquid assets where fees are based on the performance of such assets, it can be difficult to determine what compensation, if any, has been earned in a single tax year. Section 457A essentially requires a valuation of fund assets (and a corresponding calculation of income earned) be completed within the 12-month period following the tax year in which the compensation is earned: Section 457A provides that if the compensation cannot be determined and paid out within this time period, the compensation becomes includable in the service provider’s income at the time that the compensation becomes determinable and, at such time, is subject to a premium interest charge computed back to the year in which the compensation was earned, plus a 20 percent federal penalty tax (in addition to any other applicable taxes such as ordinary income tax, capital gains tax or tax pursuant to Section 409A).
As such, Section 457A essentially prohibits the deferral of income for Section 457A Plans beyond one year, except in two circumstances. The first, as mentioned above, is if amounts paid pursuant to a Section 457A Plan remain subject to a substantial risk of forfeiture and dependent upon the service provider’s continued employment. Under Section 457A, the compensation is earned when the substantial risk of forfeiture has ended and becomes taxable at that time. The second exception applies with respect to amounts deferred that relate to an investment asset that is: (1) a single asset (other than an investment fund interest), (2) directly held by an investment fund, (3) not actively managed by the fund or a related person, and (4) substantially all of the gain is allocated to investors.
Effective Dates. Section 457A applies to all Section 457A Plans that have amounts attributable to services performed after December 31, 2008. For Section 457A Plans with amounts attributable only to services performed prior to this date, amounts deferred under these plans must be paid out (and correspondingly taxed) in full no later than 2017.
Interim Guidance Under Notice 2009-8
On January 8, 2009, the Internal Revenue Service (Service) issued Notice 2009-8, entitled “Interim Guidance Under Section 457A.” The Interim Guidance provides more detailed instructions, rules and definitions for Section 457A and states that the Service expects to issue additional guidance on Section 457A in the future.
More Detailed Definitions. The Interim Guidance provides more detailed definitions for several terms used in Section 457A, including:
- Nonqualified deferred compensation plan. The Interim Guidance specifies that nonqualified deferred compensation plans under Section 457A include partnership arrangements and equity appreciation rights which are not at all times able to be settled in service recipient stock. Nonqualified stock options granted at fair market value are excluded from the definition. A plan will be a nonqualified deferred compensation plan pursuant to Section 457A if it is sponsored (in whole or in part) by a nonqualified entity as of the last day of such nonqualified entity’s taxable year.
- Substantial risk of forfeiture. The Interim Guidance specifies that a substantial risk of forfeiture per Section 457A will occur only if such service provider’s rights to compensation are conditioned upon the future performance of substantial services by such service provider and that a substantial risk of forfeiture will not exist where:
- compensation is subject only to the occurrence of a condition related to a purpose of the compensation (i.e. the achievement of company performance targets);
- compensation is paid as a result of not performing services (i.e. in the context of a non-compete
- a further deferral of compensation is made following the lapse of the initial substantial risk of forfeiture.
A substantial risk of forfeiture may exist depending on the facts and circumstances if a service provider has a right to compensation in the present, but would be entitled to a materially greater amount in the future and the service provider’s earning the materially greater amount is conditioned upon his future performance of substantial services.
- Short-term deferral. The Interim Guidance specifies that compensation paid within the 12 months following the year in which compensation is no longer subject to a substantial risk of forfeiture are paid within the short-term deferral period. Compensation paid within the short-term deferral period is not subject to Section 457A (although it may still be subject to Section 409A, which defines its short-term deferral period as two and a half months following the later of the service provider’s taxable year or the nonqualified entity’s taxable year).
- Nonqualified entities. The Interim Guidance specifies that independent contractors are not nonqualified entities for purposes of 457A if they would not constitute service providers under Section 409A (which excludes independent contractors with multiple unrelated clients but includes independent contractors that provide management services). Further, the Interim Guidance specifies that a nonqualified entity will include: (1) any foreign corporation unless substantially all its income is (a) connected to a U.S. trade or business or (b) is subject to a comprehensive foreign income tax scheme; and (2) any partnership unless substantially all of its income is allocated to persons other than (a) foreign persons with respect to whom such income is not subject to a comprehensive foreign income tax and (b) organizations which are exempt from tax under Title 26 of the Code. The Interim Guidance provides expanded descriptions and detailed examples of how to determine whether an entity will be a nonqualified entity pursuant to the tests described above.
More Detailed Rules. The Interim Guidance also provides more detailed rules for:
- Determining amounts includable in income. The Interim Guidance specifies that earnings on amounts subject to Section 457A not paid within the short-term deferral period will be includable in and subject to Section 457A. Income that is includable in and subject to Section 457A will be determined pursuant to the rules applicable to the determination of amounts includable in Section 409A. Amounts that are subject to Section 457A and are not paid within the short-term deferral period are subject to a 20 percent federal penalty tax (in addition to any other applicable taxes such as ordinary income or capital gains tax).
- Governing deferred amounts that are not determinable. The Interim Guidance specifies that amounts will not be determinable to the extent the amount payable pursuant to Section 457A Plan is dependent upon factors that are not determinable as of the end of the service provider’s taxable year. Amounts that are not determinable are taxed pursuant to 457A when they become determinable and are subject to an interest charge computed back to the year in which the compensation was earned plus a 20 percent federal penalty tax (in addition to any other applicable taxes such as ordinary income or capital gains tax).
Section 409A. The Interim Guidance provides certain rules for coordinating payments subject to Section 457A with Section 409A when those same payments are also subject to Section 409A.
Effective Date and Prospective Rulemaking. Finally, the Interim Guidance provides that taxpayers may rely on the Interim Guidance effective as of October 3, 2008, and that all further guidance issued pursuant to Section 457A will be prospective only in application.