IRS Issues Guidance on Compliance with Section 409A Requirements Applicable to Deferred Compensation Plans of Hedge Fund Managers

In 2004, as part of the American Jobs Creation Act, Congress amended the Internal Revenue Code to include 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 the employee, director, independent contractor or other “service provider,” which may be an individual, corporation, partnership or limited liability company, to an additional 20 percent income tax, accelerated taxation of the deferred payments and heightened interest assessments.  Section 409A was enacted in response to the corporate scandals of the early Naughts, such as Enron, Tyco and WorldCom, and was intended to curb the practice of executives deferring large amounts of compensation and to eliminate the ability of executives to vary the payment schedule by which they received deferred compensation.  In attempting to curb these perceived “evils,” Congress, in enacting Section 409A, created a statute that is hyper-technical in its application, with harsh penalties for noncompliance.  Hedge fund managers, who may be considered “service providers” under the statute, should examine compensation plans that include any form of deferred compensation, including deferral of management or performance fees, for compliance with Section 409A.  Because the penalties for noncompliance are harsh, the Internal Revenue Service (IRS) has issued guidance on correcting plan failures.  In 2008, the IRS provided guidance on operational failures.  However, on January 5, 2010, the IRS issued Notice 2010-6, which provides guidance on correcting document failures.  Both notices provide guidance relevant to hedge fund managers and should be closely examined.  This article examines the scope of Section 409A and Notice 2010-6 and details the applicability of both to hedge funds and hedge fund managers.

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