A question is bouncing around the market regarding what type of substantial risk of forfeiture is necessary before compensation will be subject to a substantial risk of forfeiture. This particular question boils down to the question of whether there needs to be a substantial risk that a service provider will voluntarily separate or be terminated in order for that SP to be considered unvested. If the SP is considered unvested, and if the compensation in question is paid while the service requirement continues in place, or immediately after it expires, then the compensation may be a S-TD and Section 457A will, as to that compensation, be much ado about nada.
To address this question, let's start by considering certain seminal principles. Any effort to do so, in matters relating to identifying substantial risks of forfeiture, must begin with a look to Section 83.
A person is considered unvested in compensation under 83 if the person is required to perform substantial services in order to be entitled to the compensation, and the risk of forfeiture is substantial if the condition is not satisfied. See Treas. Reg. § 1.83-3(c)(1)(second sentence). There is little if any doubt under 83 that this result is unaltered by protection against termination without cause. Were that not the case, there'd be a heckuva lot of unhappy CEOs with respect to the 83 treatment of their restricted stock. And, while we're at it, a whole bunch of payments that presumably are S-TDs for purposes of 409A would be deferred compensation after all.
Similarly, one does not do an inquiry under 83 regarding the likelihood the SP might quit (or be terminated, where there is no not-for-cause termination protection). It's not that we concede that the CEO might quit; rather, it's that we don't do the inquiry. Indeed, I would never want to do such an inquiry. It's sufficient that the SP has to perform substantial services in order to get the compensation - that's a substantial risk of forfeiture (regardless of whether there's a substantial risk that the SP won't be performing the requisite services). The -3 regulations under 83 are clear and express on this point.
And there should be no confusion regarding the 83 provisions requiring likelihood that the forfeiture provision will in fact be enforced. See Treas. Reg. § 1.83-3(c)(3). Those are provisions that get to whether the provisions will be enforced as written, not to whether there is a likelihood that the provisions will be activated (i.e., that a condition specified in the condition will occur).
So, if you want to make compensation subject to a substantial risk of forfeiture under 83, and you're willing to provide that services must be performed in order to get the compensation, where is the Achilles' Heal in the use of these bedrock principles to get there? Going through the principles discussed above, there will be potential manageable questions surrounding (i) the extent to which the services required to be performed as a condition to receiving the compensation are substantial, and (ii) the legitimacy of the provision itself in terms of enforcement of the forfeiture condition. The pitfalls, however, do not lie in some imagined and far less manageable notion of likelihood of forfeiture (e.g., of early separation).
Thus, there is a legitimate focus on whether services required to be performed as a condition to payment are substantial. If property remains to be liquidated at optimal times or in an optimal matter, services required in connection therewith would ordinarily be expected to be considered substantial. Ministerial administration of a shell company after all material investment activity has been completed might be a tougher case.
And there can be legitimate questions regarding whether a forfeiture condition will ever really be enforced against an SP. If that is a real concern in terms of controlled entities in the like, I suspect it will not be hard to find an investor or other counterparty who would be happy to enforce a forfeiture right if it had the power to do so.
Yet, some seem to be concerned that, in the Brave New World of 457A, a services condition, even if clearly requiring substantial services, and even if virtually certain to be enforced if tripped, is somehow insufficient to constitute a 457A SRoF if the forfeiture condition (i.e., an early separation) is not substantially likely to occur as a practical matter. Did something happen to disturb these bedrock 83 principles as applied under 457A?
I submit that, if it did, someone needed to tell us. Wouldn't you think that a change as fundamental as this would need to be (i) express or otherwise pretty clear and (ii) in this age of long-form prose preambles and similar introductory language, alluded to by Treasury or the IRS at least to some extent? Such a fundamental sea change in rules and analysis would hopefully not be effected on the basis of some vague legislative history, or feeling that something is askew in light of perceived statutory purposes. Where the game is changed under 457A is that the condition must be a services, rather than a performance, condition. But that difference doesn't poke a hole in the above analysis, which presupposes a service-based analysis. Frankly, I suspect that even the regulatory personnel involved with 457A don't think they made the fundamental change in direction that people are for some reason worried about.
So, if I've got a contract that says that my manager must continue to provide services in order to be entitled to receive previously accrued and otherwise vested fees, it would seem that an excellent case could be made in favor of the contention that my manager is not yet vested. Thus, any such amounts paid within the 457A S-TD period after that services requirement lapses would be - you guessed it - an S-TD (assuming that the payment would in all circumstances be paid within the S-TD period) and therefore outside of 457A altogether.* By the same logic, there'd be nothing wrong with viewing compensation as unvested and potentially outside of 457A if services were required to be performed to the point of (but not beyond) investor withdrawal or dissolution, either, so long as the fees in question were paid shortly after the applicable withdrawal or dissolution.
How far can this be taken? For example, how would the analysis apply in the case of an entity manager? In the context of an entity manager, the planning possibilities are admittedly broader, as, if the entity is respected, it may be possible to require ongoing services from the entity, even though its personnel might change over time. While it is possible to imagine being concerned about whether the entity might be looked through to the individual for these purposes, Treasury has thus far understandably shown a willingness and propensity to respect bona fide entities in the context of 457A. It's all pretty interesting.
Now, we all have our preconceived notions of what a statute or other rule is trying to address, but sometimes we maybe just need to get out of our own way a bit. To paraphrase Justice Frankfurter, it's not like we should be going to the statute only when the legislative history is unclear. Thus, maybe, for those managers willing to subject themselves or their entities to continuing service requirements there is - in honor of Halloween - a bit of a silver bullet here.
I recognize that we often consider structures that run against such preconceived notions as being abusive. But is there really any abuse here? Ultimately, if there is compensation that's not vested or potentially vested a year or more before it's paid, 457A doesn't reach that compensation - and in some sense shouldn't.
Having said all that, how steel-trap is all of this? I'm not sure. Technically, it does seem pretty strong. However, it's surely not consistent with what some people were thinking in terms of the way 457A works. Maybe the position is more comfortably taken in contexts that have greater intuitive appeal, such as in the case of a multi-year performance plan, as opposed to, on the other extreme, an accrued management fee which is otherwise vested. But, to me, the position may well be analytically strong across the board, as to all types of compensation, at least unless and until someone expressly changes the rules.** Will people act on this type of analysis? I'm not sure, but I wanted to throw it out there.
Maybe things aren't as messed up as feared? Scary, huh?!
Happy Halloween!!
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* Query whether the much of the whole "side pocket" fiasco could be addressed with approaches grounded in this analysis.
* If one is interested in exploring this alternative, and wants to hedge (no pun intended) one's bets, consider whether some type of periodic true-up might make sense, so that there might be the argument that the risk of being wrong is acceleration, rather than a 20% tax on compensation not susceptible of valuation.
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