United States

New IRS guidance on back-to-back plans

Failure to follow plan terms is a fatal error

TAX ALERT  | 

The section 409A regulations permit arrangements that tie the timing of deferred compensation payments to a service provider to permissible distributable events in another plan in which the service provider is a service recipient.

Example: Corporation B provides consulting services to Corporation C. B and C enter into an arrangement by which B will defer payment of a portion of its fees by C. Simultaneously, Corporation B entered into a deferred compensation plan with Employee A (the person that led B’s service team for the work provided to C). Under the terms of her plan, Employee A is deferring payment of the bonus she earned on the project until Corporation C pays Corporation B. Under the terms of the plan, Corporation C will not pay Corporation B until Employee A has a permissible distribution event under Corporation B’s plan. This is a back-to-back deferred compensation plan.

As noted, back-to-back plans are permissible, however, the time and form of payment must be the same between the two plans, the amount of the payment under the ultimate service recipient plan does not exceed the amount of the payment under the intermediate service recipient plan, and the plans must specify the ultimate service provider(s) involved.

The IRS recently issued technical guidance on a situation involving U.S. employees of a U.S. investment management firm (which was the intermediate service recipient) and a foreign investment fund (the ultimate service recipient).

The general intention was that if an employee became entitled to payment by the investment management firm, the investment management firm would also become entitled to a payment by the foreign investment fund. However, in addition to the normal payment triggers of separation from service, death, disability, a stated time, etc., the plan of the foreign investment fund provided that the U.S. investment management firm would also receive payment anytime a U.S. employee forfeited their right to a payment (e.g., separation from service without full vesting).

The IRS determined that because the foreign deferred compensation plan provided for payments to the U.S. investment management firm that the management firm was not paying to the specified ultimate service providers (the U.S. employees that forfeited benefits), the plan failed to meet the back-to-back plan rules. Thus, all vested amounts deferred by the U.S. investment management firm were taxable income to that firm in its earliest open year and subject to the section 409A penalties.

Takeaways

While back-to-back deferred compensation arrangements are not necessarily common, the IRS will strictly enforce the section 409A regulations, and that strict enforcement applies to all deferred compensation arrangements.

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