On June 23 2017, the IRS issued Chief Council Memorandum (CCM) 201725027 in which it analyzed the application of Section 409A to a "back-to-back" deferred compensation arrangement between an investment fund manager and one of its managed funds and between the investment manager and its employees. Based on the facts presented, IRS chief counsel concluded that the arrangement failed to comply with Section 409A, both in form and in operation.

Background

Section 409A

Section 409A imposes various requirements on nonqualified deferred compensation plans, including requirements regarding the timing of elections to defer compensation and the timing of distributions of compensation previously deferred. Section 409A requires both documentary and operational compliance.

If the requirements of Section 409A are not satisfied, all compensation deferred under a nonqualified deferred compensation plan is includable in a service provider's gross income to the extent the compensation is not subject to a substantial risk of forfeiture. The service provider also must pay an additional tax of 20% on the amount required to be included in income and, in certain cases, a premium interest tax that equals interest at the underpayment rate, plus one percentage point.

Generally, a service provider must make its initial election to defer compensation under a nonqualified deferred compensation plan in the year preceding the year in which the related services will be performed. Compensation deferred under a nonqualified deferred compensation plan generally may not be distributed earlier than: (1) separation from service; (2) disability; (3) death; (4) a specified time or pursuant to a fixed schedule; (5) an unforeseeable emergency; or (6) a change in the ownership or effective control of a service recipient corporation. When nonqualified deferred compensation is payable on a specified event, the plan may provide for distributions to be made on an objectively determinable date or year following the specified event.

Deferred compensation in asset management

Before 2009, it was common for US asset managers performing services for funds established outside the United States to elect to defer the receipt of fees. The enactment of Section 457A however, limited deferral for income earned after December 31, 2008, to the extent that the fund was deemed a "nonqualified entity" because it was located in a jurisdiction that is not viewed as having a comprehensive income tax.

For pre-2008 deferrals, it was common for payments to be structured as part of a "back-to-back" arrangement, designed to align the timing of manager fee income with the manager's liability to make payments to its employees under a corresponding employee deferred compensation plan.

To avoid the additional taxes under Section 409A, the deferral arrangements between the asset managers, their employees and their managed funds must be designed to comply with or be exempt from Section 409A.

Application of Section 409A to 'back-to-back' arrangements

When viewed through the lens of Section 409A, there are two nonqualified deferred compensation arrangements between the three parties in a back-to-back arrangement: one that provides for payments by the ultimate service recipient to the intermediate service recipient (e.g., from the fund to the asset manager), and one that provides for payments by the intermediate service recipient to the service provider(s) (e.g., from the asset manager to the manager's employees).

Generally, "back-to-back" arrangements are designed such that the employee deferral elections are aligned and in sync with the deferral elections between the manager and the fund. For example, if employees are awarded deferred compensation representing 10% of the total fees deferred by the asset manager, and the employees elect to receive these amounts on December 31, 2016, then the asset manager would make a corresponding deferral election for its fees, and designate a payment date of December 31, 2016 for at least 10% of the deferred fees.

An issue arises, however, when an employee of the asset manager separates from service, triggering an accelerated payment of deferred compensation by the investment manager. While separation from service is a permissible payment event for the purposes of the plan between the asset manager and its employee (i.e. the intermediate service recipient and the service provider), absent a special rule, the separation from service of an asset manager's employee would generally not be an event permitting payment by the fund of deferred compensation owed to the asset manager.

Treas. Reg. 1.409A-3(i)(6), however, provides an exception for back-to-back arrangements under which payment from the ultimate service recipient (the fund) to an intermediate service recipient (the asset manager) upon the separation from service of a service provider (the asset manager's employee) is expressly permitted.¹

CCM 201725027

In CCM 201725027, the taxpayer, an investment fund manager, maintained a back-to-back deferred compensation arrangement with one of its investment funds (Foreign Corporation) and its employees.

Under the back-to- back arrangement, the taxpayer earned and deferred fees for investment advisory services provided to the Foreign Corporation, and individual investment professionals (Participants) earned and deferred compensation with respect to services provided to the taxpayer. The CCM refers to the arrangement between the fund and the asset manager as the "USR Plan" and the arrangement between the asset manager and its employees as the "ISR Plan."

The IRS identified three issues with the taxpayer's back-to-back arrangement.

Issue 1: The USR Plan provides for payment to the asset manager in the event of a separation of service by an employee Participant, even when the employee Participant forfeited payment under the ISR Plan by terminating employment with the taxpayer before the awards had vested. The IRS concluded that such a payment provision would violate Treas. Reg. 1.409A-3(i)(6), which specifically requires that payment from the ultimate service recipient (the fund) to an intermediate service recipient (the asset manager) upon the separation from service of a service provider (the asset manager's employee) may not exceed the amount of the payment to the service provider.

We note, however, that the specific plan language has been redacted from the CCA.

Issue 2: The USR Plan was not operated in accordance with the requirements of Section 409A. Although the IRS's numerical calculations have been redacted, it appears the IRS calculated what it expected the payments from the fund to the investment manager to be in various tax years, and compared the results of that analysis to what was actually paid under the USR Plan according to the taxpayer's records. In doing so, it appears the IRS identified instances of over-payment and under-payment.

Issue 3: The USR Plan was not operated in accordance with the requirements of Section 409A when it failed to make a payment to the taxpayer upon the separation from service of a participant in the ISR Plan.

As a result of the three listed failures, the IRS concludes that all amounts deferred under the USR Plan for the tax year of the failures and all preceding tax years were required to be included in the gross income to the extent such amounts were not subject to a substantial risk of forfeiture and not previously included in gross income.

Implications

Some taxpayers have questioned whether the IRS is reviewing Section 409A issues on exams; thus, the publication of the CCM will be of general interest to taxpayers maintaining deferred compensation arrangements subject to Section 409A regardless of whether they are intended to satisfy a "back-to-back" exception.

Taxpayers maintaining back-to-back deferred compensation arrangements may want to further review the terms of their plans and their operation in light of the interpretation set forth in the CCM.

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ENDNOTES

¹ Treas. Reg. Section 1.409A-3(i)(6)(ii) provides the following example of a permitted back-to-back arrangement: Company B (intermediate service recipient) provides services to company C (ultimate service recipient). Employee A (service provider) provides services to B that are closely related to the services B provides to C. Pursuant to a nonqualified deferred compensation plan meeting the requirements of Section 409A, A is entitled to a payment of deferred compensation on a separation from service with B (the intermediate service recipient plan). Under an arrangement between B and C (the ultimate service recipient plan), C agrees to pay an amount of deferred compensation to B on A's separation from service with B, in accordance with the time, form, and amount of payment provided in the intermediate service recipient plan. So long as the intermediate service recipient plan and the ultimate service recipient plan otherwise comply with the requirements of Section 409A (regardless of whether such arrangements are subject to Section 409A), C's payment to B of the amount due under the ultimate service recipient plan on A's separation from service from B may constitute a permissible payment event.