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Phantom Carry Plan Design


Blackbirch

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I'm having a disagreement with a colleague about a proposed 409A design and wanted some feedback from the forums.

Background

A private equity firm has proposed a "phantom carry" plan for its non-partner employees. The firm creates funds which invest in companies over the course of, for example, 15 years. Periodically, the fund will pay earnings of those companies out to investors. The payment of these earnings is "carry."

Proposed Plan Design

An employee is granted a phantom ownership interest in a specified fund managed by the partnership. As with phantom stock, this is not an actual ownership interest and does not dilute the ownership interests of actual owners. Rather, each time the fund pays carry to its investors, the firm pays an amount to the employee equal to what the carry payment would have been for that employee had their ownership interest been real. The firm would pay cash in the next semi-monthly payroll cycle, and there would be no further deferral. The employee's entitlement extends for the life of the fund; potentially beyond termination of employment.

Is there Deferred Compensation?

As a threshold question, we must ask if there was any deferred comp. When are the amounts earned. If the employee is entitled to nothing until the payment of carry, then there would be no deferred comp as amounts are paid out immediately thereafter. However, if we say that it's the grant of the phantom carry rights that creates the entitlement, then subsequent payment of benefits for years down the road would certainly be deferred compensation subject to 409A. I think we're OK on our end saying it's the latter, but wanted to float this in case anybody felt strongly that there was no deferred comp.

Is the Payment Scheme 409A-compliant?

Alternate Arguments:

No, it is not compliant. In this case, the payment of carry out of the fund triggers payment of NQDC to the participant. Such an event is not a permissible distribution event under 409A.

Yes, it is compliant. Each semi-monthly payroll cycle is a stated date, which is a permissible distribution event under 409A. On most of these dates, there is a zero balance in the account, thus no distribution. Following each payment of carry, the NQDC account has a balance which survives only until the next scheduled distribution date (the semi-monthly payroll).

Any thoughts/feedback?

Thanks.

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  • 7 months later...
Guest jrn2001

I'm curious whether you ever reached a resolution of this question, which I think you've stated exactly right - when is the right to compensation created: when the carry is paid, or when the right to the the phantom carry is granted (or vests)? I would think it's the latter, and that therefore there is a problem under 409A from the lack of a stated date, but would like to know if you reached a conclusion.

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Why isn't this a S-T deferral with respect to each payment? It would be an easier analysis if the employee must be employed on the date earnings are paid to investors, but I'm not sure that's even necessary to fit within the S-T deferral rule.

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Guest jrn2001

Jpod, are you implying there is not even any compensation to defer until the earnings are paid to investors, and at that point the right approach would be to rely upon the short-term deferral rule?

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I think there probably is a "legally binding right" at the time of the grant, but I also think there is no "deferred payment;" consequently, the S-T exemption is available.

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  • 4 months later...

Not sure if you've resolved this yet, but I think jpod is right: There's a "legally binding right" for 409A purposes upon granting the phantom interest, but it remains at a substantial risk of forfeiture until carry is paid to investors (which may never occur, or may be zero). As long as the phantom carry is paid to employees by March 15 of the year following the carry payment to investors, it's a short-term deferral.

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  • 3 weeks later...

Nice to see all the interest! Ultimately, there were too many issues for my client and they decided not to go forward, but here are some thoughts.

Short-Term Deferral: One proposal was to rely exclusively on the short-term deferrals. In this case, benefits would be paid only to those who were actively employed at the time of the carry payment. This creates an ongoing service requirement, and you're in STD land as long as the plan pays out quickly enough. I think this would work provided you're willing to cut participants off entirely upon termination.

Does Vesting on Death/Disability blow STD?: One of the desired feature full vesting upon death or disability. In this case, the participant would be entitled to payments for the life of the underlying investment/fund that the award was tied to. You lose the ongoing service requirement, but there was a thought that perhaps you're still STD because the benefit is contingent on there being a carry payment, which isn't a given. I think this works in theory, but it relies on the likelihood of the payment being made. Ultimately we couldn't get comfortable that, as a factual matter, the likelihood of there being NO payment was high enough to say there was no deferred comp.

How does "Paid upon Carry Payment" satisfy the 409A distribution timing rules? Assuming away the short-term deferral exception, the concern was that the payment here wasn't specific enough to satisfy the 1.409A-3 regs. Here, i think there are two decent arguments you can make. The first is that this falls with in the rule for "payment schedules determined by timing of payments received by the service recipient" under 1.409A-3(i)(1)(iii). The hiccup here is that the reg has caveats for individuals who may have some influence over the timing of such payments, so there's a factual hurdle you'd have to clear, here.

The other approach would be to use the carry payment as an accrual event instead of a distribution. Here, each carry payment triggers a credit to the participant's plan account. Then, there are annual distributions at 12/31 that liquidate any current balance (similar to the original payroll-based distribution date).

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