The sky is [really] still blue…
A Revenue Ruling released by the IRS last week reinforced the
ability of fund managers to use options and stock appreciation
rights in a multi-year compensation arrangement
Introduction
Prior to the enactment of Section 457A1, alternative investment managers were able to structure their
compensation on a tax-deferred basis. As part of the Tax Extenders and Alternative Minimum Tax Relief Act of 2008, Congress passed Section 457A to eliminate many of the typical deferred compensation arrangements. This caused the need to explore substitute compensation arrangements including traditional fees, carried interest allocations and equity awards.
Many investment managers responded by pursuing a carried interest allocation by restructuring to a so-called mini-master structure. Such an arrangement preserved the positive timing (i.e., unrealized) and potentially beneficial character of the income generated by the fund. Others reverted to the traditional annual fee structure. Since the 2008 debt crisis many institutional investors have continued to seek multi-year compensation
arrangements. Without a multi-year vehicle, the fund manager often received inequitable compensation payouts because they were not obligated to reimburse the investors in the loss years for the incentive compensation received in the profitable years. In other cases, investors simply sought to have manager’s compensation align more precisely with their own liquidity terms.
The two primary vehicles for delivering compensation – annual fees and incentive allocations – are not able to cleanly provide for the investor alignment generated through a multi-year arrangement. The use of clawback provisions and hurdle requirements have served as the most generally accepted forms of creating a multiyear alignment but with considerable flaws. For example, even with a multi-year incentive allocation arrangement, taxable income is required to be allocated on an annual basis. This typically can result in a manager receiving an allocation of phantom taxable income even though the incentive allocation does not crystalize until the end of the multi-year period. The prospect of receiving an allocation of taxable income without a distribution of cash to pay taxes causes many managers to shy away from this type of arrangement without a mechanism that requires the fund to make an interim cash distribution to the manager to pay taxes. This in turn creates complications if the incentive allocation ultimately never crystalizes or is subject to a clawback.
Asset Management
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For the past two decades a small fraction of funds have used a third type of compensation vehicle, namely a stock option or other equity vehicle, for delivering incentive income to the fund manager. As legislation was enacted over the past decade in the forms of Sections 409A and 457A, the form of these equity vehicles have adapted. Most practitioners have believed that the use of true options was permitted under the provisions of Section 457A and serve as a viable alternative to the more traditional compensation delivery structures. While considered by many funds, the use of these delivery vehicles has not been widespread due to:
1. Significant administrative challenges and complexities of designing a delivery vehicle to be a “true” stock option or stock-settled Stock Appreciation Rights (“SARs”).
2. The benefits of some alternative structures for many funds – namely an incentive allocation; and 3. Less than complete insistence on the part of investors for a true multi-year vehicle.
A recent IRS ruling confirms that net-settled options and stock-settled SARS can be used in a multi-year
compensation arrangement for fund managers. While the ruling does not significantly change the scope of relief from Section 457A, it will be interesting to see whether the fresh interest it has created will prompt more funds to consider using such a vehicle.
Background
Section 457A prohibits certain nonqualifying entities from providing deferred compensation to their service providers and requires inclusion in gross income when there is no substantial risk of forfeiture of the rights to such compensation. Generally, a non-qualifying entity is a tax-indifferent entity that is based in a tax haven jurisdiction or a pass-through entity with tax-exempt partners.
The legislative history provides that nonqualified stock options are excluded from Section 457A if the options are also excluded from Section 409A. In Notice 2009-8, the Internal Revenue Service indicated that nonqualified stock options are generally not deferred compensation for purposes of Section 409A if 1) the exercise price is not less than the fair market value of the underlying stock on the date the stock option is granted, 2) the stock option does not include any deferral feature, and 3) the option is granted on service recipient common stock. However, stock appreciation rights (“SARs”) that were similarly excluded from Section 409A were not excluded from Section 457A.
Revenue Ruling 2014-18
On June 10th, the Internal Revenue Service issued Revenue Ruling 2014-18 (the “Ruling”) describing a scenario
where the service recipient, a foreign corporation, granted nonstatutory stock options and SARs, which qualified as service recipient’s stock, as an incentive compensation vehicle to the service provider, a limited liability company classified as a partnership for US income tax purposes. Each SAR had an exercise price per share that was equal to or greater than the fair market value of a common share of service recipient on the date of grant. The SARs didn’t include any deferral feature and the terms of the SARs at all times provided that it must be settled in service recipient stock. The service provider had the same redemption rights with respect to common shares acquired upon exercise of the stock rights as other shareholders had with respect to their common shares of service recipient.
In the Ruling, the Service held that such nonstatutory stock options and stock-settled SARs were not subject to Section 409A and consequently were also not subject to Section 457A.
Practical considerations
The Ruling gives comfort to practitioners’ understanding of Section 457A and the basic premise that a stock option or stock settled SAR would not run afoul of these rules. As was the case prior to the issuance of this Ruling, the devil continues to be in the details. Equity arrangements can be designed in an endless number of ways and certain design alternatives may push the arrangement beyond a “true” option and closer to traditional deferred compensation, which would be prohibited by Section 457A. The following are a select number of economic and tax considerations that need to be addressed:
When will options be granted? This can be challenging if the fund is actively bringing in new investors.
When can/will the options be exercised?
What happens to an option when an investor redeems from the fund?
How are the economics different from previous fee or allocation arrangements? Hint – they are very different.
How will the fund manager address the liquidity needs of exercising an option and holding fund shares?
Are the deferral and investor alignment benefits of an option program superior to those of an existing allocation structure which produces some level of character benefit?
Ownership of stock options or stock-settled SARs in a foreign corporation will raise PFIC and CFC issues that will need to be addressed.
Conclusion
Stock options and SARs should continue to be considered as a compensation delivery vehicle for fund investors and their managers. In many cases, an option structure may provide the ideal solution to delivering incentives to managers in direct alignment to fund investors. However, there are considerable design and administrative challenges which need to be considered and closely monitored after implementation to ensure that this type of delivery vehicle does not run afoul of existing legislation. This Ruling should provide many fund managers with the impetus to review the existing arrangements and current alternatives to ensure that the optimal structures are in place – both for the manager and fund investors.
We started this piece with the comment that “the sky is still blue” – alluding to the fact that the recently released Ruling in many ways provided welcome confirmation of a truth that was already self-evident to many. We’ll finish by also pointing out that there have been clouds on the horizon for years in the form of potential carried interest legislation. If these clouds ever reach us and legislation is passed to change the tax treatment of incentive allocations, the use of stock option vehicles may become a much more common solution.
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For additional information, please contact:
Gina Biondo Partner 646 471 2770 gina.biondo@us.pwc.com Miriam Klein Partner 646 471 0988 miriam.klein@us.pwc.com Craig O’Donnell Principal 617 530 5400 craig.odonnell@us.pwc.com Alan Biegeleisen Managing Director 646 471 3588 alan.j.biegeleisen@us.pwc.com Susan Lennon Managing Director 202 414 4625 susan.m.lennon@us.pwc.com Sol Basilyan Director 646 471 0306 sol.s.basilyan@us.pwc.com
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