Cleveland counsel John Boyd and partner John McGowan were quoted in the January 20, 2010, Hedge Fund Law Report article, "IRS Issues Guidance on Compliance with Section 409A Requirements Applicable to Deferred Compensation Plans of Hedge Fund Managers."
The article focuses on the recently issued IRS guidelines, Notice 2010-6, which provides guidance respective to Internal Revenue Code Section 409A, which generally requires recipients of deferred compensation to elect the time and form of deferred compensation payments in a manner that complies with Section 409A and Sec. 1.409A-1(c) of the Income Tax Regulations. Failure to elect time and form properly, or utilizing an acceleration of deferred compensation payments, can subject a "service provider"—which could be a hedge fund manager—to an additional 20 percent income tax, accelerated taxation of the deferred payments and heightened interest assessments, according to the article.
The scope of 409A is very broad, according to Boyd. "What constitutes deferred compensation for purposes of Section 409A is expansive and can easily bring in forms of payment that would not, in normal parlance, be considered deferred compensation. For example, Section 409A may pick up reimbursement of expenses and car allowances to the extent that they are taxable and paid in a subsequent tax year."
Failure to comply with the requirements of Section 409A has serious adverse tax consequences. According to McGowan, "to say Section 409A imposes substantial penalties bears some amplification. The economic cost of noncompliance may range from substantial to highly substantial."
Notice 2010-6 provides relief and guidance on correcting certain document failures to comply with the requirements of Section 409A or to limit the amount includible in gross income due to the document failure, according to the article. In issuing the Notice, it appears "the IRS is recognizing that the documentation requirements of Section 409A are very technical and inadvertent mistakes will sometimes occur. The correction program is designed to encourage taxpayers to identify nonconforming plan provisions and to correct them promptly," said Boyd.
While the IRS "could tinker with and potentially modify the relief available under the notice, it is unlikely that there will be any substantial changes that would make the notice more lenient for taxpayers, particularly with respect to the transition period," said Boyd. "The comment period is likely envisioned for taxpayers to make the IRS aware of any unintended consequences resulting under the correction program."
In that respect, the Notice and the comment period may be particularly important to hedge fund managers. "For hedge funds, which are formed in multiple ways and which can utilize any number of compensation plans, the potential for unintended consequences is high," said McGowan. "There is not time like the present to double-check any deferred compensation plan to ensure compliance with Section 409A."