Most practitioners agree that a document failure can be corrected without resulting in tax and penalties under Code Section 409A, and without utilizing the IRS correction program found in Notice 2010-6, if the deferred compensation is nonvested throughout the service provider’s entire taxable year in which correction is made. This fix-before-vest technique arises from language in the proposed regulations regarding Section 409A income inclusion. Practitioners have disagreed, however, as to whether the language in the proposed regulations can be interpreted to permit correction at any time before vesting, even if vesting occurs later during the same taxable year as correction. Some practitioners have interpreted the language broadly as permitting correction as long as it occurs before the vesting date even at the last minute. The IRS has now set the record straight; last minute corrections are not permitted!
In a Chief Counsel Advice memorandum (CCA) 201518013 issued on May 1, 2015, the IRS ruled that a purported correction of a Section 409A document violation that was made before vesting occurred, but in the year of vesting, was ineffective. Consequently, the employee was required to recognize income under Section 409A (plus the 20% penalty tax) even though the plan document was corrected before the payments vested and in a tax year before the payments were required to be made.
In the arrangement discussed in the CCA an employee was granted a retention bonus that would fully vest if the employee continued to work for three years. If vested, the retention bonus was to be paid in two equal installments on the first two anniversaries of the vesting date. Unfortunately for the employee, the arrangement gave the company the discretion to pay the retention bonus in a single lump sum on the first anniversary of the vesting date. The discretion to accelerate payment of the retention bonus violated Section 409A. The company, presumably after learning of the Section 409A violation, amended the agreement to eliminate its discretion in year three before the retention bonus became fully vested. The company took the position that no Section 409A penalty should apply because the correction occurred before the retention bonus was vested. The IRS disagreed because the bonus vested later in the same taxable year as correction.
Importance of Memorandum
This guidance is important for a number of reasons. First, there has been very little guidance issued by the IRS beyond the Section 409A regulations. The CCA may be a sign that the IRS is going to be more active when it comes to Section 409A compliance, especially given its recent launch of a 409A audit program intended to determine the general level of compliance with Section 409A. Second, the CCA highlights the importance of careful drafting! All arrangements that could potentially be considered deferred compensation subject to Section 409A should be reviewed by legal counsel with an in-depth understanding of the restrictions of Section 409A. If caught soon enough, mistakes can be corrected.