On July 19, 2019, the IRS Large Business and International division (LB&I) announced a compliance campaign for IRC Section 457A deferred compensation arrangements, focusing on compensation deferred with respect to services performed for "nonqualified entities" before January 1, 2009. The IRS will examine whether taxpayers have complied with the requirements of IRC Section 457A.

Prior to 2009, deferred compensation arrangements were prevalent in the asset management industry and, upon enactment of IRC Section 457A, those arrangements generally were required to pay out by calendar year 2017. Asset managers can expect to see examination activity with respect to these deferred management and performance fees under the IRS campaign. The examinations may also lead to further questions about tax compliance for post-2009 compensation arrangements, including whether the deferral arrangements meet various exemptions from the deferred compensation rules.

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 performance and/or management fees. However, the enactment of IRC Section 457A limited the ability for asset managers to defer compensation earned after December 31, 2008 with respect to services performed for "nonqualified entities." A nonqualified entity includes funds located in tax-favorable jurisdictions.

IRC Section 457A provides that any compensation deferred is includible in gross income when there is no substantial risk of forfeiture of the rights to such compensation (vesting). In addition, if the amount of compensation is not "determinable" at the time of vesting, income inclusion is delayed until the amount is determinable, but is then subject to an additional 20% income tax plus interest at the underpayment rate plus 1%.

Deferrals in existence before January 1, 2009 technically were exempt from IRC Section 457A but were subject to a statutory transition rule requiring that they be included in income no later than 2017. As a result, asset managers were required to modify those existing deferral arrangements to provide for payment no later than December 31, 2017. If the asset manager is a cash method taxpayer, these deferrals also continued to be subject to the deferred compensation rules of IRC Section 409A. IRC Section 409A generally governs the timing of deferral elections and payment provisions in deferred compensation plans and imposes additional taxation upon vesting if those rules are not followed (an additional 20% income tax plus interest at the underpayment rate plus 1%.) Thus, for deferrals in existence before 2009, cash-method asset managers were required not only to comply with IRC Section 409A but also to provide for payments no later than December 31, 2017 in order to comply with the statutory transition rule under IRC Section 457A.

Implications of IRC Section 457A compliance campaign

In accordance with IRC Section 457A transition relief, asset managers generally recognized income on all outstanding vested deferred compensation in 2017. Examinations may focus on whether those amounts were properly and timely included in income and whether the amendments and payment conformed to IRC Section 409A.

Further, an examination of deferred compensation arrangements potentially may raise other lines of inquiry with respect to compensation income of asset managers, including reviews of arrangements put in place after 2009 that are designed to either comply with or be exempt from IRC Sections 457A and 409A.

Asset managers may have already been subject to certain state income tax examinations that focus on the state sourcing of deferred compensation. The announcement of the IRS campaign indicates that further scrutiny is likely. Taxpayers may want to further review the terms of their plans and their operations in light of the IRS campaign and perform risk assessments in advance of an IRS examination.

———————————————