In 2008, the Internal Revenue Service attempted to strike a fatal blow against offshore hedge fund deferred compensation plans. Included in the Emergency Economic Stability Act of 2008 is a new provision of the Internal Revenue Code (“IRC”) Section 457A. This new statute makes all non-qualified deferred compensation payable to managers of offshore hedge funds after January 1, 2009 immediately subject to U.S. income tax. It also makes all pre-2009 non-qualified deferred compensation plans subject to U.S. income tax on January 1, 2017. Thus, there are no longer any tax benefits attributable to the deferral of current compensation, and all pre-2009 deferred compensation plans will effectively terminate on December 31, 2016.
Hedge funds that are organized as partnerships (or as entities that are treated as partnerships for tax purposes) may be exempt from IRC Section 457A if substantially all of their income is allocated to U.S. persons, or to foreign persons who are subject to a comprehensive foreign income tax on their hedge fund income, or to tax-exempt organizations.
Offshore hedge funds that do not qualify for exemption may have few or no options with respect to tax planning for current compensation of managers. The news is much better with respect to managers’ pre-2009 deferred compensation plans.
A new tax-compliant strategy has been developed that enables almost immediate access to deferred compensation assets on a tax free basis and provides for death benefits to be paid to a manager’s family free of income and estate tax.
The strategy, which is currently patent pending, combines the use of a new kind of trust, known as a “hybrid” trust, with specially designed private placement foreign life insurance. The hybrid trust is recognized as a U.S. trust for I.R.S. purposes but is recognized as a foreign trust for life insurance purposes. The hybrid trust would be funded with deferred compensation fund assets by the hedge fund. The terms of the trust would provide that in the event of the hedge fund’s insolvency, the trust’s assets (deferred compensation funds) will be available to satisfy the claims of the hedge fund’s creditors.
The hybrid trust would also contain provisions, similar to those found in typical insurance trusts, which empower the trustee to purchase insurance on the life of the hedge fund manager. The trustee would purchase a foreign private placement variable universal life insurance policy that is compliant with IRC Section 7702 (recognized by the I.R.S. as true life insurance). The policy would provide that policy loans may be issued against the policy’s cash value to the manager’s family members after a two year waiting period. Such loans would require the approval of the trustee and would be repayable upon demand of the trustee in the event of the hedge fund’s insolvency. Otherwise, the loans are repayable at the manager’s death by being deducted from the policy’s death benefits. The insurance loans made to the manager’s family members will be tax free.
Upon the manager’s death, the policy death benefit (less outstanding loans) would be paid to the hybrid trust. The trust would, in turn, pay pre-specified amounts in three or fewer payments to the manager’s heirs. These payments will also be income and estate tax free.
Any excess trust assets would be distributed free of estate tax but subject to income tax.
By maximizing insurance cash value loans to the hedge fund manager’s family members, the lethal effects of IRC Section 457A may be avoided with respect to pre-2009 deferred compensation plans. More importantly, early access to deferred compensation plan assets may be enjoyed on a tax free basis. By combining these loans with pre-specified trust distributions at the death of the hedge fund manager, income and estate tax of deferred compensation plan assets may be minimized.