As Part of the American Jobs Creation Act of 2004 (‘The Act’), signed into law on October 22, 2004, the U.S. Congress enacted Section 409A of the Internal Revenue Code.
The Act addresses many areas of federal taxation, but 409A deals with the design and treatment of nonqualified deferred compensation plans, which might be of interest to many hedge fund managers.
The rules under 409A generally apply to existing plans that are earned and vested after December 31, 2004.
If an NDCP fails to comply with any of the requirements under 409A, all vested amounts of deferred compensation will be currently taxable.
Unless certain technical requirements are satisfied, the tax will increase by interest at the Internal Revenue Service’s underpayment rate plus 1 per cent, which will be measured from the date of the deferral or, if later, vesting, along with a 20 per cent penalty.
The technical requirements that the deferral arrangement must satisfy relate to the timing of distributions, acceleration of payments and mechanics of making deferral elections.
A service provider may only defer compensation if an election was made in the year prior to the year the services are performed. If the compensation is for performance-based services over a period of twelve months, the election to defer this compensation may be made no later than six months prior to the end of the service period.
A special rule applies for the first year in which a service provider becomes eligible to participate in the plan if the election is made within 30 days of becoming eligible and the election correlates to the amounts earned after the election.
On December 20, 2004, The U.S. Treasury Department and The IRS issued Notice 2005-1, which set forth initial guidance with respect to the application of section 409A and also supplied transition guidance.
On September 29, 2005, The Treasury Department and the IRS issued proposed regulations with respect to section 409A and expanded on the initial guidance provided in Notice 2005-1. A number of the provisions contained in the proposed regulations are likely to be relevant to a deferred compensation arrangement between an investment fund and an advisor.
Under The Act, section 409A is effective only with respect to amounts deferred after December 31, 2004.
The proposed regulations, however, extended the date in which plan documents must be amended until December 31, 2006, making the regulations effective for tax years starting on or after January 1, 2007.
Notice 2005-1 provided that a plan adopted on or before December 31, 2005 would not be treated as violating the requirements of section 409A if the plan operated in good faith compliance. Notice 2005-1 allowed deferred compensation arrangements to be amended to provide service providers with the ability to terminate their participation in such arrangements before December 31, 2005.
This transition relief will not be extended to 2006, therefore if a participant wishes to terminate their participation, the arrangement must be amended and their deferred amounts paid out before December 31, 2005.
Notice 2005-1 left many doubts as to whether 409A would apply to a deferred compensation arrangement between a fund and its advisor if the advisor provided services for multiple funds (and the funds were not related to each other or the advisor). The proposed regulations released in September clear any doubts, stating that section 409A would apply to a deferred compensation arrangements between a fund and its advisors. The proposed regulations clearly provides that when the service recipient is purchasing an independent contractor’s management services, amounts deferred should not be excluded from coverage under The Act.
The Proposed Regulations are only proposed and therefore taxpayers will have until January 3, 2006 to provide comments to the IRS.
It is expected that The Department of Treasury and the IRS will be providing additional guidance throughout 2006.
Anthony Fantasia is the Tax Manager for Deloitte in Grand Cayman. He has five years of public practice experience concentrating on the U.S. taxation of the financial service industry. Deloitte’s Tax practice provides a wide range of tax planning and compliance assistance to hedge funds, captive insurance companies and individuals.