• New IRS Guidance Regarding 409A -- Use of Offshore Trusts and Financial Health Trigger Arrangements: "Proceed with Caution"
  • March 31, 2006
  • Law Firm: Orrick, Herrington & Sutcliffe LLP - San Francisco Office
  • Section 409A of the Internal Revenue Code imposes new restrictive Federal tax rules governing "nonqualified deferred compensation plans" and provides significant taxes on individuals who violate them. Among other requirements, Section 409A(b) prohibits:

    • The use of offshore trusts (and other arrangements) in connection with amounts payable under a nonqualified deferred compensation plan; and
    • The use of financial health triggers restricting assets to protect the payment of benefits under a nonqualified deferred compensation plan in connection with a change in the financial health of an employer (or other service recipient).

    As required by the Gulf Opportunity Zone Act of 2005, the Treasury and IRS have issued Notice 2006-33 that clarifies the application of these prohibitions and describes transition relief that is available to taxpayers with prohibited arrangements.

    Application of 409A Prohibitions on Offshore Trusts and Financial Health Triggers

    In accordance with Gulf Opportunity Zone Act of 2005, Notice 2006-33 clarifies that any arrangement that meets the definition of a "nonqualified deferred compensation plan," including those arrangements that are otherwise grandfathered from Section 409A, are subject to Section 409A's prohibitions on offshore trusts and use of financial health triggers to restrict assets. Accordingly, amounts that were set aside or restricted with respect to deferred compensation that were earned and vested on or before December 31, 2004 are subject to these requirements.

    Transition Relief

    Notice 2006-33 does not contain guidance regarding what arrangements will be treated like an offshore trust for purposes of Section 409A and what constitutes a financial health trigger. The Notice states that the Treasury Department and the IRS intend to issue further guidance regarding the application of Section 409A(b) in the future. Until then, taxpayers may continue to rely upon a "reasonable, good faith interpretation" of Section 409A to determine whether the use of a trust or other arrangement is permissible under Section 409A. However, the Notice only sets forth transition relief for assets that have been set aside, transferred or restricted on or before March 21, 2006. These amounts are referred to in the Notice as "Grace Period Assets."

    Taxpayers will have until December 31, 2007 to bring Grace Period Assets into compliance with Section 409A. For example, amounts attributable to deferred compensation that are held in an offshore trust as of March 21, 2006, and any earnings thereon, can be transferred to a U.S.-based trust as late as December 31, 2007 without causing the service providers who made such deferrals to be subject to taxes under Section 409A.

    Amounts transferred to an offshore trust after March 21, 2006 or restricted pursuant to a financial health trigger are not Grace Period Assets and will not have the benefit of the transition relief described in Notice 2006-33.

    Operation until Issuance of Additional Guidance

    Until additional guidance is issued, taxpayers who are contemplating transferring assets attributable to deferred compensation outside the United States or implementing the terms of a financial health trigger should consider the potential taxes that may be imposed under Section 409A - regardless of whether the assets relate to an arrangement that is otherwise grandfathered under Section 409A. In particular, sponsors of hedge funds and private equity funds and non-U.S.-based employers should consider Notice 2006-33 before transferring any assets outside the United States (depending on future guidance, this may also require offshore hedge funds to transfer deferred compensation earned by U.S. investment managers into U.S. accounts or other U.S. vehicles).

    Circular 230 Notice:

    To ensure compliance with requirements imposed by U.S. Treasury Regulations, please note that any U.S. tax advice contained in this communication (including any attachments) was not intended or written 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 herein.