Same-year correction does not prevent section 409A income inclusion

Plain-English summary

A corporation promised an executive a retention bonus but reserved discretion to accelerate its payment, causing the arrangement to violate section 409A. The corporation removed that discretion before the bonus vested, but the correction occurred during the same taxable year in which the executive's substantial risk of forfeiture lapsed. Chief Counsel concluded that section 409A applies when a plan fails at any time during the taxable year. Because the bonus was vested at the end of that year, the entire deferred amount was includible in the executive's income for that year. No amount was includible for the two earlier years because the bonus remained subject to a substantial risk of forfeiture at the end of each year.

Ruling snapshot

• Question: Does correcting a section 409A plan failure before compensation vests avoid income inclusion when vesting occurs later in the same taxable year?
• Outcome: Advice given.
• Key authorities: IRC § 409A; Treas. Reg. §§ 1.409A-1, 1.409A-2, and 1.409A-3; Prop. Treas. Reg. § 1.409A-4.

Full text (IRS public release)

      Office of Chief Counsel
      Internal Revenue Service
      Memorandum
      Number: 201518013
      Release Date: 5/1/2015
      CC:TEGE:EB:EC
      POSTS-143306-14

UILC: 409A.00-00, 409A.01-00

date: April 14, 2015

to:   Mark L. Hulse
      Area Counsel
      CC:TEGEDC:NE

from: John B. Richards,
Senior Technician Reviewer
CC:TEGE:EB:EC

subject: Tax Matter
This Chief Counsel Advice responds to your request for assistance. This advice may not be used
or cited as precedent.

  ISSUE

          Does the correction of a failure to comply with section 409A(a) of the Internal
  Revenue Code (Code) applicable only to compensation subject to a substantial risk of
  forfeiture avoid income inclusion under section 409A if the correction is made before the
  compensation vests but during the service provider’s taxable year in which it vests?

  CONCLUSION

          No. Section 409A(a)(1)(A)(i) provides that, if a nonqualified deferred compensation
  plan fails to comply, or fails to be operated in accordance, with section 409A(a)(2), (3) and
  (4) “at any time during a taxable year,” compensation deferred under the plan that is not
  subject to a substantial risk of forfeiture and that has not previously been included in
  income is includible in the service provider’s gross income for the taxable year. Deferred
  compensation that is subject to a substantial risk of forfeiture is subject to the requirements
  of section 409A(a)(2), (3), and (4) at all times during a taxable year, though a deferred
  amount is not includible in income under section 409A if it is subject to a substantial risk of
  forfeiture at all times during the taxable year. In contrast, if the amount is not subject to a
  substantial risk of forfeiture at all times during the taxable year (generally meaning the
  amount is vested as of the end of the taxable year), the amount is includible in income.

POSTS-143306-14 2

   The correction of a failure to comply with section 409A(a) during a taxable year
   indicates that a failure existed during the taxable year in which the correction is
   made. In accordance with section 409A(a)(1)(A)(i), a failure applicable to
   deferred compensation subject to a substantial risk of forfeiture that lapses
   during the taxable year results in income inclusion of the deferred amount under
   section 409A, regardless of whether the failure is corrected during the same
   taxable year but before the substantial risk of forfeiture lapses.

FACTS

Executive is an executive officer of Xco, a corporation organized under state law.
  On October 1 of Year 1, Xco entered into a retention agreement with Executive.

The retention agreement provided that, if Executive remained continuously employed
until the third anniversary of the execution date of the retention agreement (the “vesting
date”), Executive would receive a retention bonus.
The retention agreement provided for payment of the retention bonus in equal
installments on the first two anniversaries of the vesting date. However, the agreement
also provided that Xco, in its sole discretion, could pay the retention bonus as a lump
sum payment on the first anniversary of the vesting date.
Xco determined that the retention agreement failed to meet the time and form of
payment requirements of section 409A(a) because it permitted Xco to accelerate
payment of the retention bonus. To correct the failure, Xco amended the retention
agreement on June 6 of Year 3 to remove Xco’s discretion to accelerate payment of the
retention bonus. Executive continued providing services through October 1 of Year 3,
and the substantial risk of forfeiture lapsed. Xco paid Executive the retention bonus in
equal installments on October 1 of Year 4 and Year 5.
Xco asserts that the retention bonus should not be includible in the Executive’s
income under section 409A for any taxable year because the retention agreement was
amended before the vesting date to provide for payment terms that complied with the
time and form of payment requirements of section 409A(a), even though the amounts
were no longer subject to a substantial risk of forfeiture as of the end of Year 3.

LAW AND ANALYSIS

A. Background

   Section 409A(d) defines a nonqualified deferred compensation plan subject to

section 409A as any agreement or arrangement covering one person that provides for
the deferral of compensation (other than certain enumerated exceptions). Section
1.409A-1(b)(1) provides that a plan provides for the deferral of compensation if a
service provider has a legally binding right during a taxable year to compensation that,
under the terms of the plan, is or may be payable to (or on behalf of) the service
POSTS-143306-14 3

provider in a later taxable year. Section 1.409A-1(b)(1) further provides that a service
provider does not have a legally binding right to compensation to the extent that the
compensation may be reduced unilaterally or eliminated by the service recipient or other
person after the services creating the right to the compensation have been performed.
However, compensation is not considered subject to unilateral reduction or elimination
merely because it may be reduced or eliminated by operation of the objective terms of
the plan, such as application of a nondiscretionary, objective provision creating a
substantial risk of forfeiture. Therefore, a legally binding right to an amount that is
subject to a substantial risk of forfeiture generally provides for the deferral of
compensation from the time that the legally binding right arises. Stated differently,
compensation that meets the general definition of deferred compensation and does not
qualify for an exception, even if subject to a substantial risk of forfeiture (nonvested
deferred compensation), is subject to the requirements of section 409A(a) regardless of
the fact that it may never become vested and may never be paid.

   Section 409A(d)(4) provides that the rights of a person to compensation are

subject to a substantial risk of forfeiture if such person’s rights to the compensation are
conditioned upon the future performance of substantial services by any person. Section
1.409A-1(d)(1) provides that compensation is subject to a substantial risk of forfeiture if
entitlement to the compensation is conditioned on the performance of substantial future
services by any person or the occurrence of a condition related to a purpose of the
compensation, and the possibility of forfeiture is substantial.

    Section 409A(a)(2), (3), and (4) provides that certain form requirements apply to

a nonqualified deferred compensation plan. Section 409A(a)(2) provides rules for when
a plan may make a distribution to a service provider. Section 409A(a)(3) provides that a
plan may not permit the acceleration of the time or schedule of any payment to the
service provider, except as provided under the section 409A regulations. Section
409A(a)(4) provides rules for determining when a plan may permit a service provider to
elect to defer compensation.

   The requirements of section 409A(a) generally are applicable from the time that

the legally binding right to deferred compensation arises, regardless of whether the
compensation is nonvested. For example, section 409A(a)(2)(A) provides that a plan
must provide that deferred compensation may not be paid earlier than upon certain
permitted payment events, including “a specified time (or pursuant to a fixed schedule)
specified under the plan at the date of the deferral of such compensation.” Section
1.409A-2(a)(1) provides that the initial deferral election, made upon the deferral of an
amount (generally at the time the legally binding right to the amount arises), must
irrevocably designate the time and form of payment of the amount. Under section
409A(a)(4)(B)(iii), the initial deferral election for performance-based compensation
based on services performed over a period of at least 12 months must be made no later
than 6 months before the end of the period. Therefore, the decision to defer
compensation subject to a performance or a vesting condition, including designation of
POSTS-143306-14 4

the time and form of payment, must be irrevocably made with respect to a nonvested
amount even though it is uncertain whether the amount will become payable or vested.

   Section 409A(a)(1)(A)(i) provides:

   “If at any time during a taxable year a nonqualified deferred compensation plan
   (I) fails to meet the requirements of section 409A(2), (3) and (4) or, (II) is not
   operated in accordance with such requirements [(section 409A failure)], all
   compensation deferred under the plan for the taxable year and all preceding
   taxable years shall be includible in the service provider’s gross income for the
   taxable year to the extent not subject to a substantial risk of forfeiture and not
   previously included in gross income.” (emphasis added).

   Section 409A(a)(1)(A)(i) explicitly fails to distinguish between amounts deferred

during a taxable year before or after a failure to comply with section 409A(a), or before
or after a substantial risk of forfeiture applicable to a deferred amount lapses. Rather,
deferred compensation that is subject to a substantial risk of forfeiture is subject to the
requirements of section 409A(a)(2), (3), and (4) at all times during a taxable year,
though a deferred amount is not includible in income under section 409A if it is subject
to a substantial risk of forfeiture at all times during the taxable year. In contrast, if the
amount is not subject to a substantial risk of forfeiture at all times during the taxable
year (generally meaning the amount is vested as of the end of the taxable year), the
amount is includible in income. The correction of a failure to comply with section
409A(a) during a taxable year indicates that a failure existed during the taxable year in
which the correction is made. In accordance with section 409A(a)(1)(A)(i), a failure
applicable to deferred compensation subject to a substantial risk of forfeiture that lapses
during the taxable year results in income inclusion of the deferred amount under section
409A, regardless of whether the failure is corrected during the same taxable year but
before the substantial risk of forfeiture lapses.

B. Proposed Regulations

   This conclusion is consistent with the proposed section 409A income inclusion

regulations at Prop. §1.409A-4 (73 FR 74380 (December 8, 2008), 2008-51 IRB 1325)
(proposed regulations). Accordingly, even though taxpayers may rely upon the
proposed regulations, they do not support the taxpayer’s position. Prop. §1.409A-
4(a)(1)(ii) provides, consistent with the requirement of the first clause of section
409A(a)(1)(A)(i), that “an amount is includible in income under section 409A(a) for a
taxable year only if the plan fails to meet the requirements of section 409A during such
taxable year.” Therefore, the proposed regulations provide that deferred compensation
is subject to income inclusion under section 409A for any taxable year during which a
section 409A failure arises or continues to occur under the plan at any time during the
taxable year.
POSTS-143306-14 5

   Following the second clause of section 409A(a)(1)(A)(i), Prop. §1.409A-4(a)(1)(i)

provides that the amount includible in income under section 409A as the result of a
section 409A failure is the excess (if any) of the total amount deferred under the plan for
the taxable year, including the amount of any payments of amounts deferred under the
plan during the taxable year, over the portion of such amount (if any) that is subject to a
substantial risk of forfeiture or has been previously included in income. Prop. §1.409A-
4(a)(2)(i) provides the following:

   “The portion of the total deferred amount under a plan for a taxable year that is
   subject to a substantial risk of forfeiture (as defined in §1.409A-1(d)) is
   determined as of the last day of the service provider’s taxable year. Accordingly,
   an amount may be includible in income under section 409A(a) for a taxable year
   even if such amount is subject to a substantial risk of forfeiture during the taxable
   year if the substantial risk of forfeiture lapses during such taxable year, including
   if the substantial risk of forfeiture lapses after the date the nonqualified deferred
   compensation plan under which the amount is deferred first fails to meet the
   requirements of section 409A.”

   This provision is followed by an example demonstrating that whether or not an

operational failure occurs on or after the date a substantial risk of forfeiture lapses has
no consequence to the amount includible in income. See Prop. §1.409A-4(a)(2)(ii).
Although these provisions do not explicitly address a situation in which the failure was
“corrected” during the taxable year, there is nothing in these provisions to support that
such a “correction” would result in different consequences. Rather, the statute and the
regulations repeatedly provide that if a failure occurred at any time during the taxable
year (regardless of whether “corrected” and regardless of whether operational or as part
of the written plan terms), there is an amount includible in income that is determined
based on the amounts deferred at the end of the taxable year, reduced by the amounts
subject to a substantial risk of forfeiture at the end of the taxable year and the amounts
previously included in income for a year before that taxable year.

C. Application of Law to Facts

   Executive acquired a legally binding right to the retention bonus on the date that

Xco and Executive executed the retention agreement during Year 1. To receive the
retention bonus, Executive was required to remain continuously employed by Xco until
the vesting date, which was the third anniversary of the execution date of the retention
agreement. Executive’s legally binding right to the retention bonus was subject to a
substantial risk of forfeiture because Executive’s right to receive the retention bonus
was conditioned on Executive’s performance of substantial future services.

   The retention bonus arrangement did not meet the requirements of any exception

from treatment as deferred compensation under section 409A(a). The retention bonus
did not meet the requirements of the short-term deferral exception under §1.409A-
1(b)(4)(i) because the retention agreement specified that the retention bonus would be
POSTS-143306-14 6

paid after the end of the applicable 2-1/2 month period following the vesting date.
Accordingly, the retention bonus is deferred compensation, and the retention agreement
is a nonqualified deferred compensation plan subject to the requirements of section
409A(a), beginning on the execution date of the retention agreement.

   The retention agreement failed to meet the requirements of section 409A(a)(2),

(3), and (4). Section 409A(a)(2)(A)(iv) requires that a plan designate a specified time
for payment of a deferred amount. Section 1.409A-3(a)(4) provides that the
requirements of section 409A(a)(2)(A)(iv) are met if a plan designates that deferred
amounts may be paid only at a time or pursuant to a fixed schedule specified under the
plan. Section 1.409A-3(b) provides that such a fixed schedule may be based on a
payment event permitted under §1.409A-3(a), and §1.409A-3(i)(1)(i) provides that such
a payment event may include the lapse of a substantial risk of forfeiture. Therefore, the
retention agreement’s provision for payment of the retention bonus in equal installments
on the first two anniversaries of the vesting date would have complied with section
409A(a)(2)(A)(iv), §1.409A-3(a)(4), and §1.409A-3(i)(1)(i), except that the retention
agreement also provided that Xco, in its sole discretion, could pay the retention bonus in
lump sum on the first anniversary of the vesting date.

    The retention agreement’s provision for Xco’s right to accelerate payment of the

retention bonus also failed to meet the requirements of section 409A(a)(3), which
provide that a plan may not permit the acceleration of the time or schedule of any
payment, except as provided under regulations by the Secretary. None of the
regulatory exceptions provided under §1.409A-3(j) apply to Xco’s right to accelerate the
second installment payment. Moreover, the retention agreement’s provision for Xco’s
right to accelerate payment of the retention bonus also failed to meet the requirements
of section 409A(a)(4)(C), which provide that a plan may permit a subsequent change in
the time of a payment specified to be made at a time or pursuant to a fixed schedule
(other than an acceleration permitted under section 409A(a)(3)) only if the change is
made no less than 12 months before the scheduled payment date and results in an
additional deferral of no less than five years.

   On June 6 of Year 3, Xco amended the retention agreement to remove Xco’s

discretion to pay the retention bonus in lump sum on the first anniversary of the vesting
date. The amendment resulted in payment terms that meet the requirements of section
409A(a). However, the failure to meet the form requirements of section 409A(a) began
on the execution date of the retention agreement and continued through Year 1, Year 2,
and through June 6 of Year 3.

    The amount includible in income under section 409A for Year 1 and Year 2 is

reduced to zero because the entire deferred amount was subject to a substantial risk of
forfeiture at the end of Year 1 and Year 2. However, the entire deferred amount was
vested (no longer subject to a substantial risk of forfeiture) at the end of Year 3.
Therefore, the amount includible in income under section 409A for Year 3 is not
POSTS-143306-14 7

reduced by any nonvested amount, and the entire deferred amount is includible in
Executive’s income under section 409A for Year 3.

   This writing may contain privileged information. Any unauthorized disclosure of

this writing may undermine our ability to protect the privileged information. If disclosure
is determined to be necessary, please contact this office for our views.

   Please call -------------------- if you have any further questions.


                                 By: _____________________________
                                     John B. Richards
                                     Senior Technician Reviewer
                                     Executive Compensation Branch
                                     (Employee Benefits)
                                     Tax Exempt and Government Entities