In a legal advice memorandum (AM 2016-003), the IRS Office of Chief Counsel concluded that a service provider cannot avoid the Dec. 31, 2017, transition relief deadline for including deferred compensation in income under Section 457A by changing its method of accounting.
Section 457A, which was enacted in 2008, imposes significant restrictions on the deferral of management and incentive fees by managers of offshore hedge funds. The restrictions may also apply more broadly to deferral arrangements covering U.S. taxpayers employed by some foreign corporations, including subsidiaries of U.S corporations, and by partnerships with exempt organizations or foreign partners. Under Section 457A, nonqualified deferred compensation can be included in the income of the service provider when it vests, regardless of when it is paid. Transition relief under Section 457A provides that to the extent the deferred compensation was earned and vested prior to 2009, the deferred compensation must be included in income no later than the last taxable year beginning before 2018.
The memorandum addresses a situation where the service provider, which is a partnership, elected each year to defer a portion of its annual compensation under a nonqualified deferred compensation plan for services performed for a foreign corporation, which is a nonqualified entity described under Section 457A(b). The service provider elected to defer compensation for services performed before Jan. 1, 2009, until Dec. 31, 2017. The service provider was a cash basis taxpayer for all taxable years before 2016.
The service provider filed a Form 3115 requesting permission to change its overall method of accounting to the accrual method beginning Jan. 1, 2016. This method change would result in a positive Section 481(a) adjustment and require the service provider to increase taxable income. Normally, the positive Section 481(a) adjustment would be taken into account ratably over a four-year adjustment period beginning Jan. 1, 2016, and ending Dec. 31, 2019. As a result, a portion of the Section 481(a) adjustment related to the deferred compensation would normally be included in income after the Dec. 31, 2017, deadline imposed under the Section 457A transition relief.
The IRS concluded that the transition rules under Section 457A trump the Section 481 rules, and the nonqualified deferred compensation must be included in the service provider's gross income by Dec. 31, 2017. As a result, one-fourth of the deferred compensation can be included in income in 2016 in accordance with Section 481, and three-fourths of the deferred compensation can be included in income in accordance with Section 457A.
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