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Asset managers should assess the risk of Section 409A noncompliance in their nonqualified deferred compensation arrangements
In recent months, there has been an increase in IRS audit activity relating to deferred compensation at
asset management firms. Asset managers are being asked to respond to Information Document Requests (IDRs) and provide documentation to substantiate compliance with Section 409A, with regard to both deferred fee arrangements between asset managers and the funds they manage, and deferred compensation arrangements between asset managers and their employees.
This recent audit activity, along with the IRS’
Section 409A Compliance Initiative Project, suggests that asset managers can expect to see more scrutiny relating to compliance with Section 409A going forward. Asset managers should assess the risk of 409A noncompliance in the design and operation of their nonqualified deferred compensation arrangements. Although the IRS has made available
Section 409A correction programs for certain failures, those correction programs are no longer available after the arrangements become subject to an IRS audit.
Section 409A imposes various requirements with respect to
nonqualified deferred compensation (NQDC) plans, including requirements regarding the timing of elections to defer compensation and the timing of distributions of compensation previously deferred. If the requirements of Section 409A are not satisfied, all compensation deferred under the NQDC plan is includable in a service provider’s gross income to the extent that the compensation is not subject to a substantial risk of forfeiture. In addition, the service provider must pay interest at the underpayment rate plus one percentage point, as well as a 20 percent penalty on the amount required to be included in income.
Generally, a service provider must make its initial election to defer compensation under an NQDC plan in the year prior to the year in which the related services will be performed. Compensation deferred under an NQDC plan generally may not be distributed earlier than:
• Separation from service.
• A specified time or pursuant to a fixed schedule.
• An unforeseeable emergency.
• A change in the ownership or effective control of a service recipient corporation.
Where nonqualified deferred compensation is payable on a specified event (e.g., separation from service, disability, death, an unforeseeable emergency or change in control), the plan may provide for distributions to be made on an objectively determinable date or year following the specified event. Re-deferral of previously deferred compensation is permitted in limited circumstances.
There are generally two tiers of deferred compensation within the asset management structure. The first tier exists between asset managers and the funds they manage. The second exists between asset managers and their employees.
Management Company Compensation
Prior to 2009, many asset managers elected to defer the receipt of performance or management fees. However, Section 457A restricted the ability of asset managers to defer compensation earned after Dec. 31, 2008, with respect to “nonqualified entities,” which generally include funds in offshore tax havens.
Section 457A provides that any compensation deferred under an NQDC plan of a “nonqualified entity” is includable in gross income when there is no substantial risk of forfeiture of the rights to such compensation. In addition, if the compensation payable under the NQDC plan is not determinable at the time of vesting, a 20 percent additional income tax on the amount of compensation and interest penalties at the underpayment rate plus 1 percent will apply to the compensation upon distribution.
Deferrals in existence prior to Jan. 1, 2009, are grandfathered and exempt from Section 457A as long as payments are made under the arrangements no later than 2017 under transition relief. Many asset managers modified existing deferral arrangements to provide for payment in 2017.
These deferral arrangements between the asset managers and their managed funds must be designed to comply with or be exempt from Section 409A to avoid the previously described adverse tax consequences.
Compensation for employees of asset managers are generally made up of multiple components and may include fixed salary, bonus, carried interest, phantom carried interest or deferred compensation. Salary, bonus and carried interest are generally exempt from the application of Section 409A. However, phantom carried interest and deferred compensation must be designed to comply with or be exempt from Section 409A to avoid the previously described adverse tax consequences.
The IRS has begun to audit the compliance of deferred compensation with the requirements of Section 409A within the asset management industry. We have seen IDRs issued to asset managers with regard to both the deferral of compensation between the asset managers and the funds they manage, as well as between the asset managers and their employees.
IDRs with regard to deferred management and performance fee arrangements generally request the following information:
• Copies of signed deferred compensation agreements between the manager and the managed funds.
• Copies of signed deferral elections, including elections made pursuant to Sections 409A and 457A transition relief, and other re-deferral elections.
• Dates of payment and identification of the payees.
• Bank or brokerage statements substantiating the payments of deferred management and performance fees.
• Records, wire transfers, banking and brokerage statements that track deferred compensation balances.
• Documents substantiating where deferred compensation amounts are currently invested or held.
• Communications between the asset manager and funds with respect to deferred compensation.
IDRs with regard to deferred compensation arrangements between asset managers and their employees generally request the following information:
• Copies of deferred compensation agreements or plan documents.
• List by recipient of deferred compensation awards.
• Award agreements or other documents used to record the amount of deferred compensation grants.
• Copies of signed deferral elections, including elections made pursuant to Sections 409A and 457A transition relief and other re-deferral elections.
• Communications between the asset manager and its employees with respect to deferred compensation.
• Dates of payments and bank statements substantiating the payment of deferred compensation to employees.
• Payroll records that substantiate wage reporting and withholding on deferred compensation distributions.
On May 9, 2014, the IRS announced that it recently launched a limited audit initiative to review NQDC plans under Section 409A. The IRS has indicated that it will initially send IDRs to fewer than 50 taxpayers, selected from the existing population of employment tax audits. It is our understanding that the scope of this audit will focus on the following three issues:
• Initial deferral elections.
• Subsequent deferral elections.
• Distribution triggers.
The IRS has stated that the scope of this initiative will be limited to deferral elections and payouts scheduled for years under examination for the top 10 most highly compensated individuals. Although the Section 409A Compliance Initiative Project is limited in scope, it is nevertheless an indication that IRS audits of Section 409A compliance will continue.
As discussed above, if the requirements of Section 409A are not satisfied, all compensation deferred under an NQDC plan is includable in a service provider’s gross income to the extent that the compensation is not subject to a substantial risk of forfeiture. In addition, the service provider must pay interest at the underpayment rate plus one percentage point, as well as a 20 percent penalty on the amount required to be included in income. The 20 percent penalty tax can be substantial, particularly with respect to fee deferrals that may amount to hundreds of millions of dollars.
To assess the risk of exposure under Section 409A, asset managers should:
• Assess whether the plans, arrangements and programs that provide for deferred compensation are compliant with the requirements of Section 409A in form.
• Assess whether such plans are administered in a manner consistent with the relevant documentation and with the requirements of Section 409A.
• Ensure that they have the proper documentation in place to support compliance in the event of an audit.
In the event that an arrangement is found to be noncompliant with the requirements of Section 409A, either in operation or in form, asset managers should evaluate whether the noncompliance may be corrected or mitigated under the IRS’ self-correction program.
Notice 2008-113 provides procedures for correcting inadvertent operational failures, and
Notice 2010-6 and
Notice 2010-80 provide procedures for correcting documentary failures that inadvertently cause noncompliance with Section 409A.
The key limitation under the IRS’ self-correction program is that a violation of Section 409A cannot be corrected once the plan is under audit. Therefore, asset managers should pursue a Section 409A risk assessment prior to IRS audit in order to avail themselves of the correction opportunities under the IRS’ self-correction program.
Asset managers should conduct a Section 409A risk assessment of their existing nonqualified deferred compensation arrangements. As discussed herein, the penalties for noncompliance with Section 409A are severe and, although the IRS has made available Section 409A correction programs for certain failures, those correction programs are no longer available after the arrangements become subject to IRS audit.
Michael Schoonmaker is a principal in the human capital practice of Ernst & Young LLP and is based in New York, as is
Rachael Walker, a senior manager in the human capital practice of Ernst & Young LLP.
The views expressed herein are those of the authors and do not necessarily reflect the views of Ernst & Young LLP.
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