On Dec. 20, 2004, the Treasury Department released Notice 2005-1, the first part of what is expected to be a series of guidance notices with respect to the application of new IRC ?409A concerning nonqualified deferred compensation (NQDC) plans. As readers are aware, as a result of the Jobs Act virtually every NQDC arrangement must be reviewed and a significant number will have to be amended in order to avoid adverse tax consequences. However, this guidance provides NQDC arrangements with a generous transition relief period during which plans can be amended to comply with the new rules or elections and plan participation may be terminated.

Notice 2005-1 does not address many of the substantive issues of interest to hedge fund managers. Not addressed is the definition of a plan participant as it related to back-to-back arrangements. The terms “assets set aside to pay deferred compensation,” “offshore trusts” and “other arrangements” have not yet been clarified, and a variety of other questions remain open.

This notice provides certain relief addressing the application of the initial deferral election requirements to compensation attributable to the performance of services after calendar year 2004. Of significance is the ability under certain circumstances to elect calendar year 2005 deferrals until March 15, 2005.

Of particular importance is the reasonable latitude provided to terminate participation in a deferred compensation plan or cancel a deferral election made for 2005. A plan adopted before Dec. 31, 2005, may be amended prior to that date to allow a participant during all or part of the calendar year 2005 to terminate participation in the plan or cancel a deferral election without causing the plan to fail to conform with respect to amounts deferred after Dec. 31, 2004.

The amounts subject to the termination or cancellation must be includible in income of the participant in the taxable year in which the amounts are earned and vested. The notice provides for further flexibility for fund managers and other “plan participants” by allowing partial terminations and cancellations under the same circumstances discussed above.

The notice exempts certain classes of employers and specific types of issuer stock and other equity-based arrangements from the ambit of these new NQDC rules. For example, certain transfers of IRC ?83 restricted property, nonstatutory stock options and stock appreciation rights (SARs) will be governed by IRC ?83 instead of the new rules, provided they meet certain requirements. When the provisions are fully effective, SARs will not be subject to the new rules provided that the following conditions are met:

o The appreciation is measured from an amount no less than the fair market value of the stock on the date of grant.

o The stock is traded on an established securities market.

o The SARs can only be settled in that stock.

o The only deferral allowed is until exercise of the SARs.

Not surprisingly, the notice confirms that the new rules can apply to arrangements with non-employee service providers such as between partners and their partnerships. Pending future guidance, issuance of partnership interests or partnership options for services will be tested to determine whether the deferral is subject to IRC ?409A “under the same principles that govern the issuance of stock.” The notice requests comments on how the new rules should be applied to arrangements between partners and partnerships, between businesses and acceleration of benefits for reasons beyond the control of the recipient.

The notice provides an exemption for arrangements between service providers and recipients if the service provider actively engages in the trade or business of providing such services (other than as an employee or director) and it provides such services to two or more recipients that are less than 20 percent related to both the provider and each other. Further analysis is necessary to determine whether that exemption applies to a particular hedge fund manager that advises more than one fund.

Howard Leventhal is co-national director of Ernst & Young’s Asset Management Tax Practice, is a partner in Ernst & Young’s Global Hedge Fund Practice and is based in the firm’s New York financial services office. Alan Munro is a partner in the National Tax Department leading Ernst & Young’s Lake Michigan-area Asset Management Tax Practice.

Contact Bob Keane with questions or comments at: bkeane@investmentadvisor.com.