Last week, the Internal Revenue Service (the “IRS”) released Revenue Ruling 2014-18 (the “Ruling”), which holds that nonstatutory stock options (“NSOs”) and physically-settled stock appreciation rights (“SARs”) are not nonqualified deferred compensation plans under section1 457A. The Ruling should provide fund managers with more flexibility to structure multi-year compensation arrangements with their offshore funds and tax-exempt investors such as state pension plans in a more tax-efficient manner. Accordingly, as discussed below, fund managers that were previously advised by their tax counsel against using NSOs or SARs in structuring their compensation plans should find comfort from the Ruling in using such devices without worrying about unfavorable tax consequences under section 457A. We note that, while there is a certain amount of tax deferral inherent in the use of NSOs or SARs, the use of these instruments has different economic results than the typical pre-2009 deferral arrangement. Further, we also note that the exercise of the instruments will result in ordinary compensation.
Background on Taxation of Deferred Compensation
Generally, sections 409A and 457A limit a service provider’s ability to defer the recognition of income from deferred compensation, i.e., compensation that is paid by a service recipient (e.g., an offshore fund) in one year in respect of services performed by the service provider (e.g., a U.S. investment advisor) in a prior year.
Under section 409A, a service provider may defer the recognition of income with respect to a “nonqualified deferred compensation plan” (i.e., a deferred compensation plan other than a qualified plan such as a pension plan or section 401(k) plan) so long as such plan meets certain distribution timing, anti-acceleration and election timing requirements. If a nonqualified deferred compensation plan fails to meet any of the foregoing requirements, the service provider generally must immediately recognize as income the entire amount of compensation, and will be subject to a penalty tax equal to 20% of the amount of the deferred compensation and interest.
Section 457A, which was enacted in 2008, greatly restricts the ability of service providers to defer compensation. Generally, under section 457A, compensation which is deferred under a “nonqualified deferred compensation plan” of certain tax-indifferent entities (e.g., a foreign corporation that is not subject to entity level net income tax, such as an offshore private investment fund) may not be deferred unless such amounts remain subject to a “substantial risk of forfeiture” (meaning the service provider must continue to provide services through the date of payment). Any such deferred compensation is subject to a penalty tax in an amount equal to 20% of the deferred compensation and interest.
Prior to the enactment of section 457A, fund managers often deferred their management fees and incentive fees. Under a transition rule, Section 457A required that all amounts deferred prior to December 31, 2008 would be required to be included in income no later than December 31, 2017. Although section 457A was designed to prevent such deferrals, it also made multi-year incentive compensation arrangements difficult to implement. In the wake of the financial crisis (and just as section 457A was enacted), these types of multi-year incentive compensation arrangements were frequently requested or required by certain types of institutional investors such as state pension plans.
Treatment of NSOs and SARs under Sections 409A and 457A
Treasury Regulations under section 409A provide that NSOs and SARs with respect to a fixed or specified number of service recipient stock will not be treated as a “nonqualified deferred compensation plan” if their strike prices are not less than the fair market value of the underlying stock at the time of the grant, they do not include any feature of the deferral of compensation, and other requirements prescribe under the Treasury Regulations are met.
Prior to the Ruling, it was unclear whether NSOs and SARs were exempt from section 457A in the same manner as section 409A.
Revenue Ruling 2014-18
The Ruling holds that certain NSOs and SARs that are exempt from section 409A are also exempt from section 457A.
Under the facts of the Ruling, the service recipient, a tax indifferent entity treated as a corporation for U.S. tax purposes, grants to the service provider, as incentive compensation, NSOs and SARs with respect to the service recipient’s common shares that are exempt from section 409A. The SARs must be, and are actually, settled in stock of the service recipient (rather than in cash). Furthermore, with respect to both NSOs and SARs, the Ruling specifies that service provider has the same redemption rights with respect to common shares acquired upon exercise as other shareholders of the common shares.
The Ruling holds that NSOs granted as incentive compensation that are exempt from section 409A are also exempt from section 457A. The Ruling also holds that SARs that are physically settled, whose strike price is not lower than the fair market value of the underlying stock at the time of their grant, are exempt from section 457A because such rights do not constitute compensation made under a “nonqualified deferred compensation plan” for purposes that section. The rationale employed in the Ruling is that such physically settled SARs are functionally identical in all material aspects to NSOs to purchase service recipient stock and therefore, to the extent that NSOs are exempt from section 457A, functionally identical SARs should also be exempt.
NSOs and SARs for the most part are taxed identically (under section 83) in that they are generally subject to tax as ordinary income at the time of their exercise, to the extent of the spread between the strike price and the value of the shares at that time.
SARs that are cash settled and SARs with a strike price that is less than the fair market value of the underlying stock (i.e., in-the-money), however, still remain subject to section 457A.
Implications for the Fund Industry
In light of the Ruling, fund managers that want to structure multi-year incentive compensation arrangements with respect to their offshore funds may want to consider using NSOs or SARs as a tax-efficient option. Other types of incentive compensation arrangements may also be possible using NSOs or SARs (i.e., those that allow a manager to get a compounding effect).
It is important to note that the Ruling appears to limit its holding to cases where the shares acquired upon exercise of NSOs or SARs have the same redemption rights as shares held by other shareholders. The Ruling may not apply to NSOs or SARs with respect to shares that do not have the same redemption rights as (or more favorable redemption rights than) common shares of the service recipient.
In designing an incentive compensation plan or deciding between using NSOs, SARs, or other equity compensation structures, fund advisors should take into consideration other provisions of the Code, such as those under section 83 and the PFIC regime.
If you have any questions regarding this memorandum, please contact Jon Brose at (212) 574-1615, Ron Cima at (212) 574-1471, Jim Cofer at (212) 574-1688, Daniel Murphy (212) 574-1210 or Peter Pront at (212) 574-1221.
____________________________________________________
1 All section references made herein are to the Internal Revenue Code of 1986, as amended, unless explicitly stated otherwise.
