Hedge Fund Managers and Investors May Wish to Re-Evaluate Manager Compensation Approaches After New IRS Ruling

A just-released IRS-published ruling may influence how compensation is paid in the future to hedge fund managers and employees of hedge fund managers with respect to offshore funds and exempt investors.

In Revenue Ruling 2014-18, the IRS confirmed that certain nonstatutory stock options (NSOs) and stock-settled stock appreciation rights (SARs) granted to a service provider by a foreign corporation are not “nonqualified deferred compensation plans” subject to taxation under Internal Revenue Code (“IRC”) Sec. 457A.  Specifically, the exercise price of the NSO must not be less than the fair market value of the underlying stock of the service recipient on the date the stock option is granted and must not include “any feature for the deferral of compensation,” as defined.  And, an SAR must at all times provide that it must only be settled, and is settled, in service recipient stock.  Further, the service provider must have the same redemption rights with respect to the common shares acquired upon exercise of the NSO or SAR as other shareholders have with respect to their common shares of the service recipient.

As background, under IRC Sec. 409A, a service provider may defer the recognition of income with respect to a “nonqualified deferred compensation plan” so long as the plan meets certain requirements; if it does not, the service provider must immediately recognize as income the entire amount of the compensation, subject to a 20% penalty tax, plus interest.  IRC Sec. 457A further provides that any compensation that is deferred under a nonqualified deferred compensation plan of a “nonqualified entity” is includible in gross income when there is no substantial risk of forfeiture of the rights to such compensation.  A “nonqualified entity” for this purpose is (1) any foreign corporation unless substantially all of its income is (A) effectively connected with the conduct of a trade or business in the U.S. or (B) subject to a comprehensive foreign income tax and (2) any partnership unless substantially all of its income is allocated to persons other than  (A) a foreign person with respect to whom such income is not subject to a comprehensive foreign income tax and (B) organizations which are exempt from tax under the Internal Revenue Code.

The effect of IRC Sec. 457A was to effectively eliminate the ability of U.S. service providers (e.g., a hedge fund manager) to defer tax on compensation paid by certain (from a U.S. tax perspective) tax indifferent parties (e.g., an offshore fund).

After the enactment of IRC Sec. 457A, the IRS had indicated in IRS Notice 2009-8 that certain types of NSOs and SARs settling in stock were not subject to IRC Sec. 457A.  Nonetheless, there had been reluctance on the part of many fund managers and advisors to consider NSO and/or SAR based compensation plans, pending further confirmation.  This may now change.

Managers – and investors – may now wish to revisit the use of alternative compensation plans that involve NSOs and SARs and may therefore involve multi-year performance measurement periods (which previously would likely have been treated as deferred compensation).  It should be pointed out that the use of NSOs or SARs may trigger the application of IRC Sec. 83 (e.g., recognizing as ordinary income the value of carried interests at the time of exercise of an NSO or SAR), and, in appropriate situations, the application of the passive foreign investment company (PFIC) rules. While modification of the current compensation model may generate significantly different economic results than those derived from the annual fees and/or incentive allocations that have typically been utilized, the opportunity for greater flexibility in approach may be very positive for both fund managers and investors.