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American Taxpayer Relief Act of 2012, effective January 1, 2013:

Issue Outcome
Individual income tax rates Bush-era rates made permanent for most taxpayers; marginal rates increase to Clinton-era levels for taxpayers making over $400,000 (single)/$450,000 (joint).
AMT patch Individual AMT exemption amount permanently increased to $50,600 (single)/$78,750 (joint) and indexed for inflation.
Capital gains and dividends Bush-era CG/dividend rates (0%/15%) made permanent for most taxpayers; rate increased to 20% for taxpayers making over $400,000 (single)/ $450,000 (joint).
PEP and Pease Personal exemption phaseout (PEP) and "Pease" limit on itemized deductions permanently reinstated for taxpayers making over $250,000 (single)/$300,000 (joint).
New Medicare Taxes: Effective January 1, 2013, taxpayers with incomes above certain thresholds will pay a new 3.8% Medicare tax on their investment income. In addition the 2.9% Medicare tax on earned income increases .9% to 3.8% as well.

Section 457A:

Synopsis: Requires the inclusion in income of any compensation deferred under a nonqualified deferred compensation plan of a nonqualified entity when the compensation is no longer subject to a substantial risk of forfeiture. Amounts that are not determinable at the time there is no substantial risk of forfeiture are includable in income when they are determinable, subject to an interest charge (computed back to the year in which the compensation was deferred or was released from a substantial risk of forfeiture) plus a penalty tax equal to 20% of the amount of such compensation

Effective Date: Applies to nonqualified deferred compensation within meaning of 409A effective January 1, 2009, subject to limited grandfathering of deferred amounts attributable to pre-2009 services

IRS Guidance: IRS Notice 2009-8, issued January 26, 2009, is interim guidance that provides "Until further guidance is issued, taxpayers may rely on the rules in this notice for purposes of § 457A effective from October 3, 2008 (the date of enactment of TEAMTRA). Further guidance that would expand the coverage of § 457A will be prospective and will not apply to a service provider’s taxable years beginning before the issuance of such guidance."

Section 409A:

Synopsis: Provides for immediate taxation and an additional 20% tax on nonqualified deferred compensation that does not conform with specified election, distribution and other requirements

Effective Date: Applies to amounts deferred in taxable years beginning after 2004, and to amounts deferred before 2005 if plan materially modified after October 3, 2004

IRS Guidance: Final Treasury Regs. § 1.409A-1 thru §1.409A-6, issued April 17, 2007 and applicable for taxable years beginning on or after January 1, 2008

Dodd Frank

In 2010, the Dodd-Frank Act mandated that financial regulators jointly develop rules or guidelines governing incentive-based compensation practices at "certain financial institutions" – including certain broker-dealers and investment advisers – with total assets of $1 billion or more. In particular, the Act requires the SEC, the Federal Reserve, OCC, FDIC, OTS, FHFA, and the NCUA, to jointly write rules or guidelines that:
  • Require these covered financial institutions to disclose to their appropriate federal regulator the structure of their incentive-based compensation arrangements so the regulator can determine whether such compensation is excessive or could lead to material financial loss to the firm.
  • Prohibit any type of incentive-based compensation that the regulators determine encourages inappropriate risks by providing excessive compensation or that could lead to material financial loss to the covered firm.
On March 2, 2011, the SEC and other agencies proposed a rule that would require these covered financial institutions to disclose the structure of their incentive-based compensation practices, and prohibit such institutions from maintaining compensation arrangements that encourage inappropriate risks. Specifically, the rule would:
  • Require reports related to incentive-based compensation that they would file annually with SEC.
  • Prohibit incentive-based compensation arrangements that encourage inappropriate risk-taking by providing excessive compensation or that could lead to material financial loss to the firm.
  • Provide additional requirements for covered financial institutions with $50 billion or more in assets, including deferral of incentive-based compensation of executive officers and approval of compensation for people whose job functions give them the ability to expose the firm to a substantial amount of risk.
  • Require covered financial institutions to develop policies and procedures that ensure and monitor compliance with requirements related to incentive-based compensation.

AIFMD

The European Securities and Markets Authority (ESMA) recently published final guidelines (Guidelines) on sound remuneration practices under the Alternative Investment Fund Managers Directive (AIFMD). The Guidelines seek to implement the AIFMD principles, which include the following:
  • Performance-related compensation must be based on the performance of the manager overall, the relevant business unit and the individual (including non-financial criteria).
  • Performance must be assessed in a multi-year framework.
  • Guaranteed variable compensation must be exceptional, only occurring in the context of hiring new staff and is limited to the first year.
  • Fixed and variable compensation must be appropriately balanced.
  • Severance payments must reflect performance over time and not reward failure.
  • Where appropriate, a substantial portion, and in any event at least 50%, of both deferred and non-deferred variable compensation must consist of units or shares of the fund.
  • Such units or shares must be subject to an appropriate retention policy.
  • A substantial portion of variable compensation, and in any event at least 40% (or 60% where compensation is particularly high), must be deferred over a minimum period of three to five years.
  • There must be a power or mechanism to adjust variable compensation to take into account negative financial performance of the manager or fund.
These principles apply to EU managers. US managers marketing funds in Europe will have to disclose certain information about remuneration in the annual report of the fund.

A key feature of the Guidelines is that they apply a "look-through" of the compensation principles to entities in which the portfolio management or risk management activities have been delegated. This means that EU fund of funds managers can delegate only to US managers that are subject to remuneration principles that are equally as effective as those applicable under the Guidelines, or that have entered into contractual arrangements preventing circumvention of the AIFMD.

Law Firms

Childs v. Commissioner, 103 T.C. 634 (1994), aff’d without opinion, 89 F.3d 856 (11th Cir. 1996) – Plaintiff’s attorney taxed as and when attorney receives deferred fees payable by third party assignee of fee obligation; no taxation before receipt because no actual or constructive receipt and no current economic benefit inasmuch as attorney remained general unsecured creditor with respect to fees

IRS Private Letter Ruling 200836019 - Citing Childs, IRS rules plaintiff taxed as and when plaintiff receives deferred payments from third party assignee of the defendant

Section 409A – Generally, law firm deferral of fees not subject to 409A because of "independent contractor" exemption

Commissioner v. Banks, 543 U.S. 426 (2005) – Contingency fees are includible as income to plaintiff

Investment Funds

Rev. Rul. 2014-18 – IRS holds that neither the nonstatutory stock option nor the stock-settled stock appreciation right granted to Service Provider with respect to common shares of Service Recipient is a nonqualified deferred compensation plan subject to taxation under section 457A. To see complete ruling click here.

Section 409A – Generally, cash basis manager’s deferred compensation is subject to 409A, but fair market value options and stock appreciation rights are not

Section 457A – Generally, cash basis manager’s deferred compensation from nonqualified entity is subject to 457A, but fair market value options and stock appreciation rights are not

Dodd Frank – On June 22, 2011, the SEC adopted rules that require advisers to hedge funds and other private funds to register with the SEC, establish new exemptions from SEC registration and reporting requirements for certain advisers, and reallocate regulatory responsibility for advisers between the SEC and states. To date, the SEC and other responsible agencies have not adopted guidelines with respect to incentive compensation.

AIFMD - These principles apply to EU managers. US managers marketing funds in Europe will have to disclose certain information about remuneration in the annual report of the fund. A key feature of the Guidelines is that they apply a "look-through" of the compensation principles to entities in which the portfolio management or risk management activities have been delegated. This means that EU fund of funds managers can delegate only to US managers that are subject to remuneration principles that are equally as effective as those applicable under the Guidelines, or that have entered into contractual arrangements preventing circumvention of the AIFMD.

"[Traditional analysis] proceeds in terms of a comparison between a state of laissez faire and some kind of ideal world. . . . Actually, very little analysis is required to show that an ideal world is better than a state of laissez faire, unless the definitions of a state of laissez faire and an ideal world happen to be the same. . . . A better approach would seem to be to start our analysis with a situation approximating that which actually exists, to examine the effects of a proposed policy change and to attempt to decide whether the new situation would be, in total, better or worse than the original one."

The Problem of Social Cost, R. H. Coase, The Journal of Law and Economics (Vol. III October 1960)