In a Chief Counsel Memorandum (AM 2016-003) (Memorandum), the IRS addressed a change in accounting method by taxpayers with "grandfathered" deferred compensation that must be included in income in the last tax year before 2018 under the statutory provision that enacted Section 457A. The IRS clarifies in the Memorandum that a taxpayer may not delay the income inclusion of the grandfathered amounts beyond 2017 by requesting a change in method of accounting from cash to accrual and then utilizing an adjustment under the Section 481(a) administrative guidance to spread the income recognition to later years. This Tax Alert provides background on Section 457A and the "grandfather" provisions, and discusses the rationale in the Memorandum.

Background

Deferred compensation

The Tax Extenders and Alternative Minimum Tax Relief Act (the 2008 Act) added Section 457A to the Internal Revenue Code. Section 457A applies to service providers (individuals or entities) who perform services for tax-indifferent parties, regardless of whether the service provider uses the cash-basis method or accrual method of accounting. Under Section 457A, taxpayers that provide services to a tax-indifferent party must include fees and other compensation in gross income in the later of the year when the services are performed or when the compensation is no longer subject to a substantial risk of forfeiture. If, at the time the compensation should otherwise be included in income, such amounts are not determinable (e.g., amounts due are subject to a financial performance hurdle not yet met), the compensation must be included in income when it becomes determinable, and an additional 20% tax is imposed.

Under Section 801(a) of the 2008 Act, Section 457A applies only to amounts deferred for services performed in 2009 or later. Section 801(d)(2) of the 2008 Act provides a transition rule for deferred amounts that are exempt from Section 457A solely because they are attributable to services performed before January 1, 2009. (This provision is commonly known as the Section 457A "grandfather" rule.) Section 801(d)(2) of the 2008 Act requires grandfathered amounts to be included in income in the later of: (1) "the last taxable year beginning before 2018," or (2) "the taxable year in which there is no substantial risk of forfeiture of the rights to such compensation."

Service providers who are cash-method taxpayers may continue to be subject to Section 409A (which governs deferred compensation generally) on grandfathered amounts. Following the 2008 Act, the IRS issued Notice 2009-8, allowing taxpayers to modify the payment dates listed in deferred compensation arrangements in order to comply with Section 801(d)(2) of the 2008 Act without violating Section 409A, which generally limits the ability to change the timing of payments.

Change in accounting method

Questions arose as to whether a grandfathered amount could be included in a tax year after 2017 if the service provider changed its method of accounting from cash to accrual and then utilized the four-year "spread" in income inclusion provided under IRS procedures. These questions have been raised particularly by some US asset managers who are cash-method taxpayers and receive management fees from investment funds sited in low-tax or no-tax jurisdictions, which is the fact pattern addressed in the Memorandum.

When a taxpayer changes its method of accounting from the cash-basis method to an accrual-basis method, it is treated as having used the accrual-basis method of accounting for all prior tax years dating back to 1954. Section 481(a)(2) requires taxpayers to take into account "those adjustments which are determined to be necessary solely by reason of the change." Under Revenue Procedure 2015-13, however, taxpayers are provided a four-year spread for such adjustments. In the case of grandfathered amounts under Section 457A, taxpayers questioned whether they could take the position that the application of the four-year spread could result in income inclusion beyond the 2017 inclusion date set forth in the 2008 Act. For example, under this view, if the change in accounting method became effective in 2017, the taxpayer might have taken the position that only 25% of the deferred grandfather amount would be included in income in the 2017 tax year, and the remaining 75% would be spread ratably over the next three tax years.

Chief Counsel Memorandum AM 2016-003

In the Memorandum, the IRS stated that grandfathered deferred amounts must be included in the service provider's income by the last tax year beginning before 2018, regardless of whether the service provider changes its method of accounting.

The Memorandum states that allowing a taxpayer to apply the Section 481(a) administrative guidance to spread a positive adjustment to include grandfathered amounts in income over a four-year period beyond 2017 would directly conflict with Section 801(d)(2) of the 2008 Act, which provides for a specific deadline when the grandfathered amount must be included in income. Because precedence is given to the terms of a statute with specific application indicating a particular deadline for income inclusion in cases in which there are potential conflicting views on the same issue, the IRS concludes that the 2008 Act's income inclusion deadline governs.

Accordingly, the Memorandum states that taxpayers switching their accounting method from the cash-basis method to the accrual-basis method may not take advantage of the four-year adjustment period under Revenue Procedure 2015-13 to defer income inclusion of grandfathered deferred amounts arising from services performed before 2009 beyond the inclusion date. Rather, taxpayers must include these amounts in income no later than the service provider's last tax year beginning before 2018.

Implications

Taxpayers who have grandfathered amounts and who plan to change or have changed their method of accounting from the cash-basis method to the accrual-basis method should be aware that they will not be permitted to ratably include such payments in income over a four-year period that extends beyond January 1, 2018. Rather, these taxpayers will be required to include all deferred compensation payments in income by their last tax year beginning before 2018 (i.e., the 2017 tax year).

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