Introduction

On September 29, 2005, the Treasury Department and Internal Revenue Service (the “IRS”) published Proposed Regulations under Section 409A of the Internal Revenue Code (“Section 409A”). The Proposed Regulations reaffirm the IRS’ position in Notice 2005-1, that beginning on January 1, 2005, an arrangement between a hedge fund manager and a hedge fund where the fund manager defers the receipt of management or incentive fees from one tax year to a future tax year, is subject to Section 409A. If the fee deferral is subject to Section 409A, but the specific requirements of Section 409A are not met, the manager recognizes the fees as current income (as opposed to income in a future tax year) and must pay a 20% penalty tax on the amount currently included in income. In addition, the manager may in some cases be assessed with an underpayment penalty tax.

Action Steps

If they have not done so already, fund managers should carefully examine their advisory agreements with their hedge funds. If the advisory agreements allow for the deferral of fees from one tax year to a future tax year, managers have three choices:

First, in many circumstances, the manager may cancel or terminate the deferral arrangement in the advisory agreement (i.e., not the entire management agreement) by December 31, 2005, without any adverse tax consequences under Section 409A. This is a simple solution to avoiding Section 409A, but is unattractive because it does not allow for the deferral of fees.

Second, if the manager wishes to continue deferring fees under the advisory agreement without being subject to 409A, the fees should be paid to the manager no later than 2 ½ months following the end of the tax year in which the services related to the fees were provided. This is known in tax-parlance as the “short-term deferral” exception to 409A. For example, if the manager is a calendar year taxpayer, fees payable for services rendered in 2005 should be paid to the manager no later than March 15, 2006. If the short-term deferral exception is relied on, the advisory agreement should be amended no later than December 31, 2006, to provide for such a deferral feature. However, documentary compliance (i.e., the amendment of the advisory agreement) should not be confused with operational compliance. The fund manager must still comply with Section 409A or an exception therefrom (i.e., the short-term deferral exception) for 2005, even if the advisory agreement is not amended until December 31, 2006. Thus, a manager who is a calendar year taxpayer must receive its fees for services provided to the fund for 2005 no later than March 15, 2006.

Third, in many cases, managers wish to defer the payment of fees beyond the 2 ½ months allowed under the “short-term deferral” exception to Section 409A. In such case, the deferrals are subject to Section 409A, and therefore, must comply with the requirements of Section 409A to avoid the adverse tax consequences described above. A full explanation of the requirements of Section 409A as applied to investment advisory agreements that provide for fee deferrals is beyond the scope of this article. In general, Section 409A imposes restrictions on when an initial election to defer fees may be made, when a subsequent election to further defer such fees may be made, and when deferred fees must be paid to the manager.

Conclusion

Deferred fee arrangements in advisory agreements are subject to Section 409A. A violation of Section 409A may cause adverse tax consequences to fund managers. Fund managers should carefully examine their advisory agreements and consult with an adviser on the application of Section 409A to their advisory agreements.

IRS Circular 230 NOTICE. To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication is not intended to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed in this communication.

Note:
White & Case LLP represents hedge fund and private equity fund sponsors and advisers, prime brokers, and administrators through its 38 offices in 25 countries around the world. For further information on the White & Case investment funds practice, contact:

Jay B. Gould, Esq.
White & Case LLP
San Francisco, California 94111
415-544-1112 (O)
310-800-6500 (C)
Jgould@whitecase.com

Bruce Parvarandeh, Esq.
White & Case LLP
San Francisco, California 94111
415-544-6356 (O)
214-886-2233(C)
Bparvarandeh@whitecase.com