New IRS Ruling Impacts Hedge Fund Incentive Fees
In Revenue Ruling 2014-18, the IRS clarified that nonstatutory stock options and stock-settled stock appreciation rights (SARs) granted to a service provider from the common shares of a service recipient are not considered nonqualified deferred compensation under the Internal Revenue Code. The effect of this ruling is that these stock options and SARs can be used to pay incentive fees to hedge fund managers on a cumulative basis, rather than annually, which defers income taxation until settlement.
Generally, Section 457A provides that any compensation that is deferred under a nonqualified deferred compensation (NQDC) plan of a nonqualified entity must be included in gross income when there is no substantial risk of forfeiture of the rights to such compensation. Under this Section, an NQDC plan provides a right to compensation based on the appreciation in value of a specified number of equity units of the service recipient.
In addition, under the Section 409A regulations, both stock options and SARs do not provide deferred compensation if the exercise price is not less than the fair market value of the underlying stock on the date the stock option or SAR is granted. Other requirements must also be satisfied.
Revenue Ruling 2014-18
Under Revenue Ruling 2014-18, a service recipient may grant a nonstatutory stock option and stock-settled SAR to a service provider as incentive compensation as long as the exercise price per share is not less than the fair market value of a common share of the service recipient on the date of grant. The ruling explains that the language of Section 457A(d)(3)(A) defining an NQDC plan is intended to refer to a SAR, and a stock option meeting the requirements of the 409A regulations is exempt from Section 457A.
What Does CohnReznick Think?
Most investment managers prefer to earn incentives on an annual basis, generally with a high water mark and no clawback. However, this may be an interesting technique for managers to use if they are willing to consider a multi-year incentive as they will not have to pay income tax until a date in the future when the options or shares are exercised/settled. If an investment manager is looking to raise money under this type of arrangement, then this may be a viable option.
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