Earlier this month, the Office of Chief Counsel of the Internal Revenue Service released a Memorandum clarifying the impact of a correction of a Code Section 409A operational failure before the date of vesting of nonqualified deferred compensation but during the year of vesting.  In the Chief Counsel Memorandum, the IRS clarified that such a correction, under such circumstances, would not avoid income inclusion under Code Section 409A. 

In general, the 2008 proposed rules on income inclusion under Section 409A (available here) provide that if there is a Section 409A violation in a taxable year, all compensation deferred under the applicable nonqualified deferred compensation arrangement for that taxable year and all preceding years is includible in the service provider’s gross income to the extent not subject to a substantial risk of forfeiture (i.e., vested) and not previously included in the service provider’s gross income in a prior taxable year.  Whether or not deferred compensation must be included in income under Section 409A is determined as of the last day of the taxable year.

Consistent with the proposed rules, the IRS guidance clarifies that Section 409A requires income inclusion if there is a compliance failure at any time during the taxable year in which the applicable substantial risk of forfeiture lapses, even if the noncompliant provisions are corrected prior to the lapse of the substantial risk of forfeiture.  Accordingly, a “same-year” correction of an operational failure under Section 409A is not effective in fixing noncompliant deferred compensation in time to escape the corresponding adverse tax consequences to the extent that the deferred compensation becomes vested at any time during that tax year.

Perhaps more interesting, however, is that the Chief Counsel Memorandum guidance does not preclude correction of noncompliant nonqualified deferred compensation in a taxable year prior to the taxable year in which the compensation vests.  Under the 2008 proposed income inclusion rules, Section 409A income inclusion does not appear to be required for the year that nonqualified deferred compensation ceases to be subject to a substantial risk of forfeiture (or any later years) to the extent that the applicable plan is amended to comply with Section 409A prior to the taxable year in which the compensation vests.  By not providing any indications to the contrary with regards to such a “prior year” correction, it appears the IRS has tacitly blessed the correction of unvested amounts in years prior to the year of vesting.  Of course, the IRS retains the authority under the Proposed Rules to nonetheless disregard such a correction as part of the general “anti-abuse” provisions under Section 409A to the extent it finds a “pattern or practice” of permitting impermissible changes in the time and form of payment of unvested deferred compensation.