New deferred compensation statutes: will it ever end? Private equity fund sponsors need to watch out for section 457A, a new rule in the internal revenue code.

• Author: Furci, Peter A.

Hidden in the October 2008 bail-out bill was a new draconian rule that applies to traditional deferred compensation arrangements of partnerships and foreign corporations, and some performance and management fee arrangements of private equity and hedge funds. Deferred compensation that is subject to the new rule, [section]457A of the Internal Revenue Code, must be included in income when the compensation is no longer subject to a so-called "substantial risk of forfeiture" (meaning that the tax deferral will not be respected and the service provider may have phantom income). However, if the amount of the deferred compensation cannot be determined at that time because of future variable factors (such as the amount of future profits), the amount will continue to be deferred until the amount is determinable, at which time the service provider will include the amount in income and be subject to a 20% penalty tax, plus interest.

Private equity fund sponsors should already be in the process of determining whether this new rule applies to them or any of their portfolio companies and, if it does, should be formulating their compliance strategies.

Who, Me?

Section 457A applies to deferred compensation arrangements of "non-qualified entities." The first step in a private equity fund sponsor's inquiry will be to determine whether there are any "non-qualified entities" in its universe. The term is potentially very broad: unless expressly excluded, a "non-qualified entity" includes any partnership, whether foreign or domestic, and any foreign corporation.

Unlike the other deferred compensation statute, [section]409A, both cash basis taxpayers and accrual basis taxpayers are covered by the statute. Under current IRS guidance, whether an entity is a non-qualified entity is determined on the last day of each year that vested deferred compensation is outstanding, and thus it is possible that an entity's status could change over time. Helpfully, the IRS has limited non-qualified entity status to the "sponsor" or "sponsors" of the deferred compensation arrangement, which generally means the employer(s) for U.S. federal tax principles (i.e., those entities that would be eligible to deduct the compensation if it were paid rather than deferred in the relevant taxable year.).

In general, a partnership will be a non-qualified entity unless "substantially all" (which the IRS has indicated means at least 80%) of its income is allocated to partners that are subject to...