Can't get there from here?

[Guest erisafried]

I don't have much hope for this inquiry, but I'll give it a try anyway just in case anyone on these here interwebs has figured out how to split the atom.

I am working with a non-profit entity that is struggling a bit to come up with a sensible way to provide some long-term incentive compensation to its executives. One of the entity's projects involves making investments in techie start-ups. The entity does not have anything close to a controlling interest in any of the start-ups, each of which are operated independently. However, the entity's executives do have specialized technical and managerial expertise, and they help the start-ups fairly extensively and usually over a period of many years. As is the natural order of things, most of the start-ups fizzle, but every once in a while, one will knock it out of the park. Ideally, the entity would like to be able to allow the executives to share in the upside potential of the start-ups they work with.

Due to the nature of the entity's investment in the start-ups (and some funky securities law issues), we can't just grant stock options or other "real" equity to the executives. In the for-profit world, we'd cook up some sort of phantom equity arrangement and be done with it. Since we have 457 to deal with, things are more complicated.

I am aware that the accounting firms used to market something called a "KEYSOP" (or similar) to the unsuspecting tweedy types in the non-profit world. I gather that the product was designed to look like Section 83 property so as to avoid Section 457. There seems to have been some skepticism about whether these products actually accomplished their intended result, and the IRS was none too happy about them, apparently leading to their premature demise.

Leaving aside the technical niceties, the entity would really like to hand out phantom awards with nominal current value. The value (or not) of the awards would be determined over time based on the performance (or not) of the start-ups. The awards would be subject to a time-based vesting schedule, and following vesting, employees could retain the awards for exercise (i.e., conversion to cash) at an opportune time. It seems like a 457(b) plan could be designed to accomplish some of these goals, but the limitations associated with a 457(b) plan obviously make the whole deal less attractive (although better than a 457(f) plan probably). Since we can't grant real equity, it seems like the Section 83 route is foreclosed, and it is difficult to see how phantom equity would be provided through anything other than a deferred compensation arrangment. With apologies to Henry Ford, we may have our choice of legal regimes here as long as our choice is 457.

In any event, it occurred to me that the non-profits who are especially interested in executive compensation matters (i.e., hospitals and private colleges and universities) might have confronted and resolved similar issues, although danged if I can find any useful descriptions of such alchemy on the net. That led me to wonder if any of the denizens of this fine establishment might have any insights, however small, into this general issue. It may be that we are stuck with the "457 vs. 83" choice, but before I run up the white flag, I wanted to see what I could find out here.

All input is welcome and appreciated.

N.B.: I am aware that the IRS is paying more attention to non-profit compensation matters these days, so my desire to get cute with dubious interpretations of 50 year-old cases and rulings (cf. the KEYSOP) is limited.

[jpod]

Without commenting on (or thinking about) issues pertinent to the entity's tax-exempt status (presumably it is not a ©(3), which might make those issues easier to resolve), or UBTI issues, what if the entity set up an LLC through which it would make those investments, and then take the folks whose duties are related to those investments off the payroll of the entity and make them employees of the LLC and give them phantom interests in the LLC? I suppose you'd have to give someone other than the entity a nominal interest in the LLC in order to kill the disregard entity status of the LLC; otherwise you would be back in 457f land.