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Guest Article

(From the October 13, 2008 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

New IRC § 457A: Nonqualified Deferred Compensation from "Tax Indifferent" Entities to Be Subject to more Immediate Income Inclusion

Attached as a revenue raiser to the Emergency Economic Stabilization Act (H.R. 1424), new IRC § 457A will impose more restrictive income timing rules on nonqualified deferred compensation from "tax indifferent" entities. Aimed at offshore hedge and private equity funds and at other service recipients that are not subject to U.S. income tax, IRC § 457A requires income inclusion when there is no substantial risk of forfeiture -- which exists only if the right to the compensation is "conditioned upon the future performance of substantial services." IRS officials have indicated that other conditions related to the transfer of the compensation (e.g., the attainment of a prescribed level of earnings or equity value, etc.) that would constitute a substantial risk of forfeiture under IRC §§83 or 409A will generally not constitute such under IRC § 457A.

Services Rendered After 2008 -- Inclusion When No Substantial Risk of Forfeiture

IRC § 457A will be effective for amounts deferred that are attributable to services rendered after December 31, 2008. Under the new provisions, compensation deferred under a nonqualified deferred compensation plan of a nonqualified entity is includible in gross income when there is no substantial risk of forfeiture of the rights to the compensation. For this purpose:

Nonqualified deferred compensation plan is as defined under IRC § 409A. However:
- Phantom units. A plan that provides compensation based on the appreciation in value of a specified number of equity units of the service recipient is included in the definition.
- Payout by close of next tax year. Compensation that is paid within 12 months after the close of the taxable year in which the right to payment is no longer subject to a substantial risk of forfeiture is excluded from the definition.
Nonqualified entity is:
- Any foreign corporation unless substantially all of its income is effectively connected with a trade or business in the U.S., or is subject to a comprehensive foreign income tax; and
- Any partnership unless substantially all of its income is allocated to persons other than: (i) foreign persons with respect to whom such income is not subject to a comprehensive foreign income tax, and (ii) organizations that are exempt from tax under the Internal Revenue Code.
A person is subject to a comprehensive foreign income tax if it is eligible for the benefits of a comprehensive income tax treaty between the foreign country and the U.S., or demonstrates to the satisfaction of the Secretary of the Treasury that the foreign country has a comprehensive income tax.
Substantial risk of forfeiture exists only if the person's rights to the compensation "are conditioned upon the future performance of substantial services." As indicated above, unlike IRC § 83 and to a lesser extent IRC § 409A, the IRC § 457A definition of substantial risk forfeiture is not anticipated to include other conditions related to the transfer of the compensation. However:
- Gain on Investment Assets. An exception exists for compensation that is based on gain recognized on an investment asset. To the extent provided in regulations to be issued by the Secretary of the Treasury, if compensation is determined solely by reference to the amount of gain recognized on the disposition of an investment asset, it will be treated as subject to a substantial risk of forfeiture until the date of disposition. An investment asset is any single asset (other than an investment fund or similar entity) that is acquired directly by an investment fund or similar entity, with respect to which the entity does not participate in the active management and substantially all of the gain on the disposition is allocated to investors in the entity.
  The short-term deferral exception (by which compensation may be paid within 12 months after the close of the taxable year in which the right to payment is no longer subject to a substantial risk of forfeiture) does not apply to deferred compensation treated as subject to a substantial risk of forfeiture under this "investment gain" exception.
- Effectively Connected Income.In the case of a foreign corporation with income taxable under IRC § 882 (i.e., tax on income of foreign corporations connected with United States business), IRC § 457A will not apply to compensation which, had it been paid in cash on the date it ceased to be subject to a substantial risk of forfeiture, would have been deductible by the foreign corporation against such income.

Ideally, the amount of the compensation is determinable at the time it is to be included in income under IRC § 457A. Otherwise, the amount is included in income when it is later determinable -- and a penalty tax applies equal to 20 percent of the amount of the compensation, plus interest (at the underpayment rate under IRC § 6621 plus 1 percent) on the underpayments that would have occurred had the compensation been included income in the year deferred or, if later, the first year the compensation was not subject to a substantial risk of forfeiture.

Aggregation rules similar to those under IRC § 409A (providing for the aggregation of members of a controlled group of corporations and of partnerships under common control under IRC §§414(b) & (c)) will apply under IRC § 457A.

Services Rendered Before 2009 -- Inclusion by 2018 (or When No Substantial Risk of Forfeiture, if Later)

In the case of deferred compensation attributable to services rendered before 2009, IRC § 457A requires the compensation -- to the extent it has not already been included in income -- to be included in income in the last taxable year beginning before 2018 (or, if later, the taxable year in which there is no substantial risk of forfeiture under IRC § 457A).

Treasury Department to Issue Guidance

Within 120 days after the date of enactment of the Emergency Economic Stabilization Act -- or, by January 31, 2009 -- the Treasury Department is required to issue guidance regarding deferred compensation attributable to services rendered before 2009. IRC § 457A requires that the Treasury Department provide a limited period of time during which such nonqualified deferred compensation plans may, without violating the requirements of IRC § 409A, be amended to conform the date of distribution to the date the amounts are required to be included in income under IRC § 457A. The guidance will include, for taxpayers who are also service recipients who maintain back-to-back nonqualified deferred compensation plans for their service providers, the ability to amend those plans to conform the date of distribution to the date amounts are required to be included in the income of such taxpayer under IRC § 457A. Any such amendments will not be treated as a material modification under IRC § 409A.

The Secretary of the Treasury is also authorized to issue regulations necessary to carry out the purposes of IRC § 457A, including regulations disregarding a substantial risk of forfeiture in cases where it is necessary to carry out those purposes.

The information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations.

If you have any questions or need additional information about articles appearing in this or previous versions of Washington Bulletin, please contact: Robert Davis 202.879.3094, Elizabeth Drigotas 202.879.4985, Mary Jones 202.378.5067, Stephen LaGarde 202.879-5608, Erinn Madden 202.572.7677, Bart Massey 202.220.2104, Mark Neilio 202.378.5046, Tom Pevarnik 202.879.5314, Sandra Rolitsky 202.220.2025, Tom Veal 312.946.2595, Deborah Walker 202.879.4955.

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