Hedge Funds, Deferrals, and Taxes

Hedge fund investment advisors often defer either a fixed amount or a percentage of the foreign incentive fee under a nonqualified deferred compensation arrangement. The advisor usually defers this fee to reinvest the deferred amount in the same manner that the foreign feeder invests its other assets, all tax-deferred. When the advisor ultimately receives the deferred amount, the advisor’s deferred compensation is taxed at ordinary income tax rates.

The determination of when amounts deferred under a nonqualified deferred compensation arrangement are includible in the gross income of a taxpayer earning the compensation depends on the analysis of a variety of tax principles and IRC provisions, including the doctrine of constructive receipt, the economic benefit doctrine, and the provisions of IRC Section 83 relating generally to transfers of “property” in connection with the performance of services.

In general, the time for inclusion of nonqualified deferred compensation depends on whether the arrangement is funded or unfunded. If funded, then income is included in the tax year in which the taxpayer’s rights are transferable or otherwise not subject to a substantial risk of forfeiture. If unfunded, the deferred compensation is generally includible when it is actually or constructively received. An arrangement is considered “funded” when there has been a transfer of “property” under Section 83. The current tax rules provide that “property” excludes an unfunded and unsecured promise to pay money in the future. A nonqualified deferred arrangement is considered an “unfunded and unsecured promise” in situations when the deferred funds are payable from the general corporate funds that are subject to the claims of general creditors.

In the context of advisors’ deferred compensation, the foreign incentive fee is generally set aside in a subaccount of the foreign feeder. However, because the subaccount assets remain in the possession of the foreign feeder, such assets remain subject to the claims of the feeder’s general creditors. Thus, the interest in the sub-account assets is not deemed to be “property” and is not subject to immediate taxation to the advisor unless it is considered “constructively received” by the advisor.

Under the constructive receipt test, income can be immediately taxable if such income is credited to the taxpayer’s account, set apart for the taxpayer, or otherwise made available so that the income can be drawn upon at any time. However, income is not constructively received if its receipt is subject to substantial limitations. Such a limitation exists with regard to an unfunded deferred compensation arrangement if: (1) the arrangement provides for the election to defer payment only before the beginning of the period of service for which the compensation is payable; (2) the arrangement sets forth substantive forfeiture provisions if elections to defer income, other than the initial election, are allowed after the beginning of the service period; (3) the arrangement defines the time and method for payment of the deferred compensation; (4) the arrangement provides that participants have the status of general unsecured creditor of the service recipient and that the plan constitutes a mere promise to the service recipient to make payments in the future; and (5) the arrangement provides that a participant’s rights to benefits under the plan are not subject in any manner to anticipated alienation, sale, transfer, assignment, pledge, encumbrance, attachment, or garnishment by creditors of the participant. Most deferred compensation arrangements of advisors are carefully structured so that a “substantial limitation” exists and, accordingly, the service provider is not considered to be in constructive receipt of its compensation.

Congress Weighs In

On July 25, 2003, the House Ways and Means Committee introduced the American Jobs Creation Act of 2003 (or AJCA), and on September 17, the Senate Finance Committee passed the National Employee Savings and Trust Guarantee Act (NESTEG). The bills seek to amend or repeal the laws that allow advisors to avoid immediate taxation by entering into nonqualified deferred compensation arrangements.

NESTEG seeks to repeal Section 132 of the Revenue Act of 1978, which placed a moratorium on issuing new guidance on when deferred compensation is considered funded or unfunded and whether a taxpayer should be considered in constructive receipt of deferred compensation. As a result, the IRS has been unable to address many perceived abuses regarding nonqualified deferred compensation. By repealing Section 132, Treasury could address three major issues: defining “substantial limitation” under the constructive receipt doctrine and situations under which an individual’s right to receive compensation is subject to substantial limitations, but in fact is not so limited; arrangements that purport to not be funded, but should be treated as so; and arrangements under which assets appear to be subject to the claims of an employer’s general creditors, but practically speaking are unavailable to creditors.

Second, under both NESTEG and AJCA, all income earned under a deferred compensation arrangement would be “constructively received” unless the arrangement provides that: (1) distributions under the arrangement may not be made earlier than separation from service, disability, death, a time specified under the arrangement as of the date of deferral of such compensation, a change in the ownership or effective control of the corporation, or in the ownership of a substantial portion of the assets of the corporation, or the occurrence of an unforeseeable emergency; (2) there shall be no acceleration of the time or schedule specified in the arrangement for distribution of the deferred amount; (3) the initial deferral election must be made at least prior to the beginning of the taxable year in which the compensation is earned; and (4) additional deferral elections must be made not less than 12 months prior to the date of the first scheduled distribution and the additional deferral must be for a period of not less than 5 years. Failure to include such restrictions would render the arrangement ineffective and subject the deferred compensation to immediate taxation and a 10% penalty.

Finally, recall that an arrangement is considered “unfunded” when a taxpayer has received only an unsecured promise as a result of the transfer of a beneficial interest in assets that are subject to the claims of general creditors of the transferor. Under NESTEG and AJCA, however, “assets set aside (directly or indirectly) in an offshore trust (or other arrangement determined by the Treasury)” would be treated as “property” transferred in connection with the performance of services. The phrase “or other arrangement” would probably include a subaccount in the foreign feeder. As a result, when the foreign feeder sets aside the foreign incentive fee by creating a subaccount for the advisor, the foreign incentive fee would be considered “property” and would be immediately taxable unless such fee were subject to a substantial risk of forfeiture.

These bills could effectively eliminate the tax savings associated with an advisor’s deferral of a foreign incentive fee. The IRS could react to the repeal of Section 132 by issuing guidance that the advisors’ subaccounts in the foreign feeder are funded, that the investment advisors’ receipt of the deferred compensation is not subject to substantial limitations, and that offshore accounts are not subject to the claims of general creditors. If the IRS issues such guidance, advisors will be subject to immediate taxation of deferred compensation under the constructive receipt doctrine. Even if the IRS does not overhaul that doctrine, the proposed changes to Section 83 and the economic benefit doctrine could result in immediate taxation of the foreign incentive fee if the IRS rules that subaccounts in a foreign feeder are similar to a trust arrangement, and, therefore, are “property” transferred in connection with services.