2015-Issue 20 — In the years since Section 409A of the Internal Revenue Code was first implemented, most practitioners have become comfortable with the idea that a document failure may be remedied outside the formal IRS correction programs without resulting in Section 409A tax penalties if the correction is made before the deferred compensation amount vests. However, practitioners have disagreed on whether a Section 409A document failure may be corrected before vesting if such deferred compensation amounts vest later in the same taxable year. These issues often come up with mergers and acquisitions. The IRS has weighed in on this issue in Chief Counsel Advice Memorandum 201518013 (the “CCA”) and has clarified that an attempt to correct a document failure prior to vesting, but in the year of vesting, is not an effective correction method.
Overview of Section 409A
Section 409A applies to nonqualified deferred compensation plans, which are defined as any plan that provides for the deferral of compensation other than a qualified employer plan or any bona fide vacation leave, sick leave, compensatory time, disability pay or death benefit plan. This definition is broad and can be complex to apply in practice. Arrangements potentially subject to Section 409A include everything from severance plans to equity arrangements to reimbursement programs, just to name a few. A plan must provide for compensation deferred to be paid only upon one (or the earlier/later of several) of the following events:
- A fixed date;
- Separation from service;
- A change in ownership or control;
- Death; or
- An unforeseeable emergency.
Non-compliant deferrals will become immediately taxable once vested and will be subject to an additional tax of 20 percent plus interest. Accordingly, it is important for companies to correct deferred compensation plans with document or operational failures to avoid having their employees face these harsh consequences.
409A Correction Methods
The IRS has issued the following formal correction programs, which companies can use in certain circumstances within limited time periods after the error is made:
- IRS Notices 2010-6 and 2010-80 are aimed at correcting errors regarding document or “form” failures, such as impermissible provisions in deferred compensation agreements. These correction programs are not available if the service provider’s tax return is under IRS examination or the company is under IRS examination with written notification citing nonqualified deferred compensation as an issue.
- IRS Notice 2008-113 is directed towards correcting errors regarding “operational” failures (i.e., not doing what the plan documents say to do in certain circumstances). This correction program is not available if the service provider’s tax return is under IRS examination.
The programs offer varying degrees of administrative complexity and relief from tax penalties. However, not all errors can be corrected under these programs. In certain circumstances, it is possible to correct errors outside of the correction programs.
One such correction method stems from the proposed regulations regarding the timing of income inclusion for Section 409A violations. Specifically, under Proposed Regulation Section 1.409A-4, a documentary violation of Section 409A may be corrected with regard to unvested deferred compensation amounts that vest in later years (i.e., document failures may be corrected before the substantial risk of forfeiture lapses on deferred amounts). It was argued, however, that the proposed regulations are not clear with regard to whether a correction of such unvested amounts is permissible where vesting occurs later in the same tax year.
Chief Counsel Advice Memorandum 201518013
The IRS sheds light on the above issue in the recently released CCA. In the CCA, the IRS addressed the specific question of whether a correction of a document failure avoids income inclusion under Section 409A if the correction is made before the deferred compensation vests albeit during the same taxable year in which it vests.
The company in question entered into an executive retention agreement providing for a retention payment that would vest after three years of continuous employment with the company (the “vesting date”) and would be paid in equal installments on the first two anniversaries of the vesting date. Unfortunately, the agreement also provided the company with the sole discretion to accelerate payment of the retention bonus in lump sum to the first anniversary of the vesting date (a document failure). Once the company discovered that the discretionary acceleration provision was problematic under Section 409A, it amended the agreement to comply with Section 409A prior to the vesting date (but in the same year as the vesting date). In doing so, the company asserted that the retention bonus should not be included in income under Section 409A for any tax year and should not subject to Section 409A tax penalties because the retention agreement had been amended before the vesting date. The IRS disagreed and concluded that because the retention bonus vested later in the same taxable year as the correction, the bonus would still be subject to Section 409A tax penalties.
The IRS confirmed that if an amount is subject to a substantial risk of forfeiture at all times during the year, no amount is includible in income as a result of the Section 409A failure during such year. However, if an amount is not subject to a substantial risk of forfeiture at the end of the year, the amount is includible income as a result of a Section 409A failure during such year. Hence, contrary to the position some practitioners have taken, a correction made before a deferred compensation amount vests, but in the same year as vesting, would not be an effective correction.
Alvarez & Marsal Taxand Says:
When the proposed regulations are finalized, we expect that the IRS will incorporate the position that it took in the CCA. Meaning, a document failure that is corrected in the same taxable year of vesting will not be an effective method of avoiding Section 409A tax penalties. This restriction of the informal correction method highlights the importance of ensuring that plans and arrangements satisfy Section 409A requirements from the beginning. It also underscores the importance of catching and correcting any document failures early.
Companies should be mindful of documentary compliance with Section 409A when implementing any new plans or arrangements. Moreover, to the extent not completed already, companies should perform a self-assessment of their deferred compensation arrangements to identify any compliance issues, evaluate eligibility for correction and, if necessary, start taking steps to correct any failures.