United States: The Importance Of Fixing Section 409A Compliance Failures Sooner Rather Than Later

A recent Memorandum issued by the Office of Chief Counsel within the Internal Revenue Service demonstrates yet again the perils of failing to comply with Section 409A of the Internal Revenue Code.1 The Memorandum takes the position that Section 409A penalties may apply even when a non-complying provision in a deferred compensation arrangement is corrected before the amounts subject to deferral become substantially vested.

Background

A company entered into a retention agreement with one of its executives. The agreement provided for the executive to vest in his right to a retention bonus if he remained continuously employed until the third anniversary of the execution date of the agreement. The bonus was to be paid in two equal installments on the first and second anniversaries of the vesting date.

As the Office of Chief Counsel acknowledged, if the agreement had stopped there, there would have been no Section 409A violation. Unfortunately for the company and the executive, the agreement also afforded the company discretion to pay the entire retention bonus in a lump sum on the first anniversary of the vesting date. Such discretion violated Section 409A's general prohibition on accelerating payment of deferred amounts.

During the third year following execution of the retention agreement, but before the vesting date, the company amended the agreement to remove its discretion to accelerate payment of the retention bonus. The Office of Chief Counsel was asked to advise whether, notwithstanding the amendment, the executive would be required to include the amount of the retention bonus as income under Section 409A during the year the amendment was made. The Chief Counsel advised that he would.

Analysis and Implications

The retention agreement at issue provided for a deferral of compensation subject to Section 409A, since the executive acquired a legally binding right to the retention bonus in one year (when the retention agreement was signed) but would not receive the bonus until a subsequent year, and the arrangement did not meet the requirements of any exception from treatment as deferred compensation under Section 409A. Nevertheless, an agreement that provides for a fixed payment schedule triggered by vesting of the right to the deferred amount generally will satisfy Section 409A's rules relating to time and form of payment. The agreement in question provided for an appropriate fixed payment schedule, but included, in violation of Section 409A, discretion for the company to accelerate payment. An amendment to the agreement to remove the discretion was intended to correct this formal Section 409A failure.

The Chief Counsel's view was that the correction was not made soon enough. Based on a narrow reading of the statute and proposed regulations relating to income inclusion under Section 409A2, the Chief Counsel concluded that if a Section 409A failure exists at any time during a taxable year, the taxpayer (here, the executive) is required to recognize income under Section 409A in the amount that remains deferred at the end of the taxable year, reduced by any amounts that remain subject to forfeiture at the end of the taxable year. Applying this principle, the Chief Counsel expressed the view that the full amount of the retention bonus would be included in the executive's income under Section 409A – and presumably would be subject not just to standard income tax but to the 20% additional tax imposed under Section 409A – during the third year following execution of the retention agreement.3

The result advocated by the Office of Chief Counsel seems harsh. The "failure" under consideration was purely formal. It had no effect on how the retention bonus was actually paid. The offending provision, moreover, was removed at a time when the executive's right remained subject to substantial risk of forfeiture, and more than a year before the first installment of the retention bonus was scheduled to be paid. While the Chief Counsel's position finds some support in the statutory and regulatory texts analyzed in the Memorandum, the Chief Counsel acknowledged that the situation under consideration was not explicitly addressed. It is difficult to perceive a convincing tax policy justification for subjecting the executive to early income recognition and a 20% penalty under these circumstances.

We note that if the failure had been corrected during the second year following execution of the agreement – that is, during the year before vesting – then the executive would have escaped adverse consequences Section 409A. While there would have been a Section 409A failure during the year, under the proposed regulations no amount would have been taken into income for that year, as the entire amount remained subject to forfeiture at the end of the year.

Correction Procedure

On January 5, 2010, the IRS issued Notice 2010-6, which enables taxpayers to correct certain failures of nonqualified deferred compensation plans in order to comply with the document requirements of Section 409A. Notice 2010-6 allows a plan sponsor to remove impermissible discretion to accelerate payment events from a plan, provided that the amendment is made before discretion to accelerate has been irrevocably exercised and before any payment has been made under the plan. Both conditions appear to have been satisfied in the situation considered in the Office of Chief Counsel Memorandum. Notice 2010-6 imposes additional general conditions for relief – including that the plan sponsor identify and correct any other nonqualified deferred compensation plan documents that contain a similar failure, that it attach a statement to its tax return for the year of correction and that it provide the service provider with a statement to be attached to its tax return for that year – but these conditions generally can be met without significant cost or burden to either the plan sponsor or the affected employees.

Interestingly, the Memorandum from the Office of Chief Counsel makes no reference to Notice 2010-6. One is left to speculate whether the company and the executive who entered into the retention agreement might have mooted the issue considered by the Office of Chief Counsel by following the correction procedure of Notice 2010-6. One can also question whether the potential availability of a correction procedure might have made the Office of Chief Counsel less willing than it otherwise might have been to issue a taxpayer favorable interpretation.

Conclusion

Memoranda from the Office of Chief Counsel may not be used or cited as precedent, and it remains to be seen how zealously individual IRS agents will pursue formal Section 409A violations that are corrected while deferred amounts remain unvested. The Memorandum nevertheless serves as a reminder that the documentation for arrangements that provide for a deferral of compensation subject to Section 409A need to be drafted with care, and that when mistakes are made, it is important to catch them, and correct them, as early as possible.

Footnotes

1 Internal Revenue Service Office of Chief Counsel Memorandum No. 201518013 (April 14, 2015).

2 Proposed Treas. Reg. 1.409A-4 (published in the Federal Register on December 8, 2008).

3 Amounts included in income under Section 409A are not required to be included in income at any other time. Under the position advocated by the Office of Chief Counsel in the Memorandum, this rule would effectively allow the company to accelerate payment of the retention bonus to the third year following execution of the agreement, as the bonus will already be includible in income for that year and subject both to income tax at the executive's marginal rate and to the 20% additional tax imposed under Section 409A.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Topics
 
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions