IRS Ruling Clarifies Fund Managers’ Ability to Use Certain Tax-Deferred Stock Rights

In its recently issued Revenue Ruling 2014-18 (Ruling), the Internal Revenue Service has clarified that nonqualified entities (typically offshore funds) as defined under Internal Revenue Code section 457A (section 457A) may issue nonqualified stock options and stock-settled stock appreciation rights (SAR) without violating section 457A.  The Ruling provides offshore funds and other entities located in tax-indifferent jurisdictions the ability to provide incentive compensation to services providers (typically an LLC treated as a partnership for U.S. tax purposes) without triggering taxation under section 457A, which effectively eliminated the ability of offshore funds to provide deferred compensation to service providers when it was enacted in October of 2008.

Background

Section 457A provides that any compensation that is deferred under a nonqualified deferred compensation plan of a nonqualified entity is includable in income of the employee or other service provider when the right to the compensation is no longer subject to a substantial risk of forfeiture.  For this purpose, nonqualified entities are typically foreign corporations domiciled in jurisdictions with no income tax or foreign partnerships in which the partners are completely or partially exempt from income tax.  A substantial risk of forfeiture, for this purpose, exists only if the employee’s or other service provider’s right to the compensation is conditioned on the performance of substantial future services.  This definition of a substantial risk of forfeiture is much narrower than the definition under Internal Revenue Code section 409A.

When enacted in 2008, section 457A eliminated the ability of U.S. based fund managers and other service providers to defer incentive fees from their offshore funds.  Until the enactment of section 457A, the fund managers were able to receive their incentive fees on a tax-deferred basis with the deferral stretching over several years and the deferred fees typically reinvested in the offshore fund.

Revenue Ruling 2014-18

With the issuance of the Ruling, the IRS has clarified and expanded on Revenue Ruling 2009-8, Q&As 2 and 3, which indicated that for purposes of section 457A nonqualified stock options and stock settled SARs were exempt from 457A.  However, the guidance under 2009-08 was not clear enough to encourage many, if any, fund managers and their advisors to try to establish a plan using stock options or SARs.  With the Ruling, the IRS has provided a roadmap for how such a plan could meet the exceptions under section 457A.

The Ruling outlines a fact pattern in which the service recipient is a foreign corporation and a nonqualified entity for purposes of section 457A.  The service provider, in this case, is a limited liability company organized under state law and treated as a partnership for tax purposes.  The service recipient establishes an incentive compensation plan for the service provider and grants nonstatutory stock options and SARs under the plan.  In order to be exempt from section 457A, the plan of the service recipient provides that the exercise price of the option or SAR grants will not be less than the fair market value of the underlying stock at the date of grant, the grants do not permit any further deferral of the compensation at exercise, the grants are for a fixed number of common shares of the service recipient, the transfer at exercise must be in service recipient stock, and the SAR grants must be settled in stock of the service recipient.  Further, the service provider has the same redemption rights with respect to the common shares acquired at exercise as other shareholders; i.e., no preferences.  The Ruling goes on to state that stock rights subject to the foregoing restrictions will be not be treated as deferred compensation and, therefore, are not subject to taxation under section 457A until they are exercised.

Conclusion

The Ruling may finally offer a solution for hedge fund managers that have been searching for ways to defer off-shore compensation.  Further, through the design of a plan meeting the requirements of the Ruling, various handcuffs (through vesting provisions) and incentives may be built into the plan as they would be in a typical incentive stock compensation arrangement for key employees.