In a Chief Counsel Memorandum (AM 2016-003), the IRS addressed a change in accounting method by taxpayers with grandfathered deferred compensation that must be included in income in the last tax year before 2018 under the statutory provision that enacted Sec. 457A. The IRS clarifies in AM 2016-003 that a taxpayer may not delay the income inclusion of the grandfathered deferred compensation amounts beyond 2017 by requesting a change in method of accounting from cash to accrual and then using an adjustment under the Sec. 481(a) administrative guidance to spread the income recognition to later years.
The Tax Extenders and Alternative Minimum Tax Relief Act, P.L. 110-343 (the 2008 Act), added Sec. 457A to the Internal Revenue Code. Sec. 457A applies to service providers (individuals or entities) who perform services for tax-indifferent parties (i.e., generally tax-exempt), regardless of whether the service provider uses the cash method or accrual method of accounting. Under Sec. 457A, taxpayers that provide services to a tax-indifferent party must include fees and other compensation in gross income in the later of the year when the services are performed or when the compensation is no longer subject to a substantial risk of forfeiture. If, at the time the compensation should otherwise be included in income, those amounts are not determinable (e.g., amounts due are subject to a financial performance hurdle not yet met), the compensation must be included in income when it becomes determinable, and the tax on the compensation is increased by an interest charge and an amount equal to 20% of the compensation amount.
Under Sec. 801(a) of the 2008 Act, Sec. 457A applies only to amounts deferred for services performed in 2009 or later. Section 801(d)(2) of the 2008 Act provides a transition rule for deferred amounts that are exempt from Sec. 457A solely because they are attributable to services performed before Jan. 1, 2009. (This provision commonly is known as the Sec. 457A "grandfathering" rule.) Sec. 801(d)(2) of the 2008 Act requires grandfathered amounts to be included in income in the later of (1) the last tax year beginning before 2018, or (2) the tax year in which there is no substantial risk of forfeiture of the rights to the compensation.
Service providers who are cash-method taxpayers may continue to be subject to Sec. 409A (which governs deferred compensation generally) on grandfathered amounts. Following the 2008 Act, the IRS issued Notice 2009-8, allowing taxpayers to modify the payment dates listed in deferred compensation arrangements to comply with Section 801(d)(2) of the 2008 Act without violating Sec. 409A, which generally limits the ability to change the timing of payments.
Change in Accounting Method
Questions arose as to whether a grandfathered amount could be included in a tax year after 2017 if the service provider changed its method of accounting from cash to accrual and then used the four-year spread in income inclusion provided under IRS procedures. In particular, they have been raised by some U.S. asset managers that are cash-method taxpayers and receive management fees from investment funds sited in low-tax or no-tax jurisdictions. This is the fact pattern addressed in AM 2016-003.
When a taxpayer changes its method of accounting from the cash-basis method to the accrual-basis method, the taxpayer is treated as having used the accrual-basis method of accounting for all prior tax years dating back to 1954. Sec. 481(a)(2) requires taxpayers to take into account "those adjustments which are determined to be necessary solely by reason of the change."
Under Rev. Proc. 2015-13, however, taxpayers are provided a four-year spread for those adjustments. In the case of grandfathered amounts under Sec. 457A, taxpayers questioned whether they could take the position that the application of the four-year spread could result in income inclusion beyond the 2017 inclusion date set forth in the 2008 Act. For example, under this view, if the change in accounting method became effective in 2017, the taxpayer might have taken the position that only 25% of the deferred grandfathered amount would be included in income in the 2017 tax year, and the remaining 75% would be spread ratably over the next three tax years.
In the memorandum, the IRS stated that grandfathered deferred amounts must be included in the service provider's income by the last tax year beginning before 2018, regardless of whether the service provider changes its method of accounting.
The memorandum states that allowing a taxpayer to apply the Sec. 481(a) administrative guidance to spread a positive adjustment to include grandfathered amounts in income over a four-year period beyond 2017 would directly conflict with Section 801(d)(2) of the 2008 Act, which provides a specific deadline for when the grandfathered amount must be included in income. Because precedence is given to the terms of a statute with specific application over the terms of a general statute in cases in which both statutes address the same issue, the IRS concludes that the 2008 Act's income inclusion deadline governs.
Accordingly, the memorandum states that taxpayers switching their accounting method from the cash-basis method to the accrual-basis method may not take advantage of the four-year adjustment period under Rev. Proc. 2015-13 to defer income inclusion of grandfathered deferred amounts arising from services performed before 2009 beyond the inclusion date under Section 801(d)(2) of the 2008 Act. Therefore, taxpayers must include these amounts in income no later than the service provider's last tax year beginning before 2018.
Taxpayers who have grandfathered deferred compensation amounts and who plan to change or have changed their method of accounting from the cash-basis method to the accrual-basis method should be aware that they cannot ratably include those payments in income over a four-year period that extends beyond Jan. 1, 2018. Rather, these taxpayers will be required to include all deferred compensation payments in income by their last tax year beginning before 2018 (i.e., the 2017 tax year).
Michael Dell is a partner at Ernst & Young LLP in Washington.
For additional information about these items, contact Mr. Dell at 202-327-8788 or firstname.lastname@example.org.
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