In a Chief Counsel Memorandum issued last month, the IRS concluded that an executive retention arrangement violated Section 409A despite the employer’s efforts to correct the arrangement before the retention bonus vested.

The arrangement in question provided for a retention bonus that vested after 3 years of employment and was then payable over the two years after vesting. However, under the terms of the arrangement, the employer had the discretion to accelerate the payments and pay them in a lump sum on the first anniversary of the vesting date. The employer, recognizing that the arrangement failed to comply with Section 409A’s anti-acceleration rule, attempted to correct the arrangement by amending it to remove the employer’s ability to accelerate the payments. The amendment was made in the same taxable year in which the retention bonus vested, but before the actual vesting date.

The IRS ruled that the correction was ineffective because it occurred in the same year in which the retention bonus vested. The ruling is consistent with the IRS’s proposed Section 409A income inclusion regulations, which provide limited relief for corrections of Section 409A errors that occur before the year in which the deferred compensation vests, provided the correction is not part of pattern or practice to avoid Section 409A. Interestingly, the employer in question may have been able to correct the error in this case under the more formal correction procedure for 409A document failures set forth in Notice 2010-6.

The memorandum is a reminder that the options for correcting Section 409A problems after arrangements have been put in place are limited and few, and therefore retention agreements, long-term incentive agreements, employment agreements, severance agreements, change in control agreements and the like, all of which may be subject to Section 409A, should be reviewed for Section 409A compliance issues prior to adoption.