Mismatched back-to-back deferred compensation arrangements violate section 409A

Plain-English summary

A foreign investment corporation deferred fees owed to a U.S. manager, which separately deferred compensation owed to investment professionals under an intended back-to-back arrangement. The upper-tier plan violated section 409A because it paid the manager when participants forfeited unvested compensation, allowing its payment to exceed the amount paid under the employee plan. The plan also was not operated according to its terms because actual payments in several years differed in timing and amount from the scheduled payments. In another instance, the manager paid an employee after accelerated vesting, but the foreign corporation failed to make the matching payment required by the upper-tier plan. Chief Counsel concluded that each defect caused a section 409A failure. Vested deferred amounts not previously included in income were includible for the applicable open years and subject to the statute's additional tax and interest consequences.

Ruling snapshot

• Question: Did excess, mistimed, mismatched, or omitted payments under the two intended back-to-back plans violate section 409A?
• Outcome: advice given
• Key authorities: IRC § 409A(a); Treas. Reg. §§ 1.409A-2(b), 1.409A-3(a), and 1.409A-3(i)(6)

Full text (IRS public release)

           Office of Chief Counsel
           Internal Revenue Service
           memorandum
           Number: 201725027
           Release Date: 6/23/2017
           CC:TEGE:EB:EC:JBRichards                              Third Party Communication: None
           POSTU-154691-12                                       Date of Communication: Not Applicable

 UILC:     409A.00-00

  date:    March 6, 2017

     to:   Division Counsel/Associate Chief Counsel
           (Tax Exempt & Government Entities)

           Milan Kim, Attorney
           Division Counsel
           (Tax Exempt & Government Entities)

  from:    John B. Richards
           Senior Technician Reviewer, Executive Compensation (Employee Benefits)
           (Tax Exempt & Government Entities)


subject:   Application of Section 409A to Back-to-Back Arrangement

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

           LEGEND

           Taxpayer = ---------------------------------

           Foreign Corporation = --------------------------------------------------------------------------------------
           -----------------

           USR Plan = ---------------------------------------------------------------------------------------------------
           ---------------------------------------------------------------------------------------------------------------------
           -------

           ISR Plan = -----------------------------------------------------------------------------------------------------
           -------------------------------------------------------------------------

           Employee A = ------------------
POSTU-154691-12                            2

ISSUE 1

       The USR Plan is a back-to-back arrangement sponsored by the ultimate service
recipient, Foreign Corporation, providing for payments to be made to Taxpayer, the
intermediate service recipient, in excess of the payments to be made to the Participants
under the ISR Plan. Does the USR Plan meet the requirements that apply to back-to-
back arrangements under Treas. Reg. §1.409A-3(i)(6)?

CONCLUSION

        No. Treas. Reg. §1.409A-3(i)(6) provides that the amount of the payment under
the ultimate service recipient plan may not exceed the amount of the payment under the
intermediate service recipient plan. Therefore, the USR Plan fails to meet the
requirements of section 409A because the USR Plan provision providing for a payment
to Taxpayer in the event of a Participant’s separation from service before vesting is an
impermissible payment event.

FACTS

      Taxpayer is a United States taxpayer that manages many investment funds, both
overseas and in the United States, including Foreign Corporation. Foreign Corporation
pays Taxpayer management and performance fees for investment advisory services,
and Taxpayer in turn employs individual investment professionals who receive salaries
and bonuses for management and investment advisory services performed.

       Foreign Corporation and Taxpayer were parties to a deferred compensation
arrangement (“USR Plan”) under which Taxpayer deferred some of its management
fees and/or performance fees. Taxpayer in turn sponsored a deferred compensation
arrangement (“ISR Plan”) for individual investment professionals (“Participants”) working
for Taxpayer. The USR Plan and the ISR Plan were intended to be “back-to-back”
arrangements. Thus, under the USR Plan and the ISR Plan, Taxpayer’s deferral
elections were coordinated with the Participant’s deferral elections, and the payment
events triggering payments from Foreign Corporation to Taxpayer under the USR Plan
were coordinated with the payment events triggering payments to the Participants under
the ISR Plan. Thus, for example if a Participant was entitled to a payment of deferred
compensation upon separation from service under the ISR Plan, then Taxpayer was
likewise entitled to a payment in the same amount under the USR Plan.

      The USR Plan provided that a payment of deferred compensation was to be
made to Taxpayer when an amount was forfeited by a Participant.

      Section ------ of the USR Plan states:
POSTU-154691-12                                                  3

       ---------------------------------------------------------------------------------------------------------------------------------
       ---------------------------------------------------------------------------------------------------------------------------------
       --------------------

       -----------------------------------------------------------------------------------------------------------

       ---------------------------------------------------------------------------------

       ----------------------------------------------------------------------

       ------------------------------------------------------

       ---------------------------------------------------------------------------------------------------------------------------------
       ---------------------------------------------------------------------------------------------------------------------------------
       ---------------------------------------------------------------------------------------------------------------------------------
       ---------------------------------------------------------------------------------------------------------------------------------
       -------------------------------------

Thus, under the terms of the USR Plan between Taxpayer and Foreign Corporation, an
amount was to be paid to Taxpayer even though the amount was forfeited by a
Participant (and thus not paid to the Participant) because the Participant separated from
service before the vesting date. During --------and -------, three Participants forfeited
unvested amounts (approximately $-- million) upon their separations from service.

LAW AND ANALYSIS

        Section 409A(a)(1)(A) provides that if certain requirements related to the timing
of elections, distributions, and funding are not met at any time during a taxable year,
amounts deferred under a nonqualified deferred compensation plan for that year and all
previous taxable years are currently includible in gross income to the extent not subject
to a substantial risk of forfeiture and not previously included in gross income. Amounts
includible in income under section 409A are also subject to two additional taxes under
section 409A(a)(1)(B). Section 409A(a)(1)(B)(i)(II) provides that if compensation is
required to be included in income under section 409A(a)(1)(A)(i) for a taxable year, the
income tax imposed is increased by an amount equal to 20 percent of the compensation
that is required to be included in income. Section 409A(a)(1)(B)(i)(I) provides that if
compensation is required to be included in income under section 409A(a)(1)(A)(i) for a
taxable year, the income tax imposed is increased by an amount equal to the amount of
interest determined under section 409A(a)(1)(B)(ii).

        Section 409A(a)(2) provides that compensation deferred under a plan may not be
distributed earlier than death, disability, separation from service, or a fixed date set forth
in the plan, or another date to the extent provided by the Secretary. Treas. Reg.
§1.409A-3(a) provides that a plan must provide that an amount of deferred
compensation may be paid only upon the occurrence of the following events:

       (1) the service provider’s separation from service;
POSTU-154691-12                                     4

      (2) the service provider becoming disabled;
      (3) the service provider’s death;
      (4) a time or fixed schedule set forth in the plan;
      (5) a change in ownership or control of a corporation;
      (6) the occurrence of an unforeseeable emergency.

      Thus, in general, a payment to a service provider cannot be triggered by the
separation from service of another service provider. For example, in the case of an
investment fund, the payment to an investment manager cannot be triggered by the
separation from service of an individual investment professional.

      However, the regulations provide an exception for a back-to-back arrangement
that meets the requirements of Treas. Reg. §1.409A-3(i)(6).

Treas. Reg. §1.409A-3(i)(6) provides:

      This paragraph (i)(6) applies where a service provider is providing services to a service
      recipient (the intermediate service recipient), who in turn is providing services to another
      service recipient (the ultimate service recipient), the services provided by the service
      provider to the intermediate service recipient are closely related to the services provided
      by the intermediate service recipient to the ultimate service recipient, there is a
      nonqualified deferred compensation plan providing for payments by the ultimate service
      recipient to the intermediate service recipient (the ultimate service recipient plan), there is
      a nonqualified deferred compensation plan or other agreement, method, program, or
      other arrangement providing for payments of compensation by the intermediate service
      recipient to the service provider (the intermediate service recipient plan), and the
      intermediate service recipient plan provides for a payment upon the occurrence of an
      event described in paragraph (a)(1), (2), (3), (5), or (6) of this section. In such a case,
      notwithstanding the generally applicable limits on payments in paragraph (a) of this
      section, the ultimate service recipient plan may provide for a payment to the intermediate
      service recipient upon the occurrence of a payment event under the intermediate service
      recipient plan described in paragraph (a)(1), (2), (3), (5), or (6) of this section if the time
      and form of payment is defined as the same time and form of payment provided under
      the intermediate service recipient plan, the amount of the payment under the ultimate
      service recipient plan does not exceed the amount of the payment under the intermediate
      service recipient plan, and the ultimate service recipient plan and the intermediate service
      recipient plan otherwise satisfy the requirements of section 409A (regardless of whether
      such plan is subject to section 409A).”

       As described above, the USR Plan provides that unvested amounts forfeited by
Participants are nevertheless to be paid to Taxpayer. Thus, under the terms of the USR
Plan, an amount paid to Taxpayer upon the separation from service of a Participant
could be in excess of the amount paid to the Participant. Therefore, the requirements
under Treas. Reg. §1.409A-3(i)(6) are not met because the amount of the payment
under the ultimate service recipient plan may exceed the amount of the payment under
the intermediate service recipient plan. See underlined language above.
Consequently, the requirements for the exception for back-to-back arrangements are
not met, and thus the USR Plan includes a payment provision that fails to meet the
POSTU-154691-12                                  5

requirements of Treas. Reg. § 1.409A-3(a). The payment event under the USR Plan
providing for payment of an unvested amount upon separation from service of a
Participant is not a permissible payment event under Treas. Reg. § 1.409A-3(a).
Therefore, the USR Plan failed to meet the requirements of section 409A.

        Section 409A(a)(1)(A)(i) provides that if at any time during a taxable year a
nonqualified deferred compensation plan (I) fails to meet the requirements of
paragraphs (2), (3), and (4) of section 409A(a), or (II) is not operated in accordance with
such requirements, all compensation deferred under the plan for the taxable year and
all preceding taxable years shall be includible in gross income for the taxable year to the
extent not subject to a substantial risk of forfeiture and not previously included in gross
income. Therefore, all vested amounts deferred under the USR Plan for the first open
year that have not been previously included in income are includable in gross income
under section 409A(a)(1)(A) and are subject to the additional taxes under section
409A(a)(1)(B). For taxable years after the earliest open year, the Taxpayer must
include under section 409A(a)(1)(A) the vested amount deferred under the USR Plan,
less amounts included for previous taxable years.

ISSUE 2

        Taxpayer elected to be paid deferred compensation on certain dates and in
certain amounts over several tax years. In some tax years, the payments actually made
were less than the amounts called for under the USR Plan and in other tax years the
payments actually made were more than the amounts called for under the USR Plan.
Section 409A(a)(2)(A) and the regulations thereunder require that a payment be made
at the time and in the amount specified in the plan. Did the USR Plan fail to meet the
requirement of section 409A(a)(1)(A) that a plan be operated in accordance with the
requirements of section 409A(a)?

CONCLUSION

      Yes. The Taxpayer failed to meet the requirements of section 409A(a)(A)
because the USR Plan was not operated in accordance with the requirements of section
409A(a)(2)(A) and the regulations thereunder because payments made under the USR
Plan were not made at the time and in the amount specified in the plan.

FACTS

       On ----------------------------, Taxpayer made “special deferral elections (---------
deferral elections)” to defer all fees earned prior to ----------------------------for services
provided to Foreign Corporation except as follows:

Percentage of Total Deferred Fees                                    Distribution Dates
to be distributed
POSTU-154691-12                                          6

--------------------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------------------------------
-----------------------------------------------------------------------------------------------------------------

On ---------------------------, Taxpayer elected to re-defer the ----------% of fees that were
scheduled to be distributed on -------------------------------------------------------------. The ------
re-deferral states ----------% of the deferred amounts credited to Taxpayer’s accounts as
of ----------------------------will be deferred and -----% of the deferred amounts credited to
the accounts as of ----------------------------and invested in ------------------------------------------
----------. will be deferred. Therefore, the remaining --------% is to be distributed by --------
---------------------------------and the rest is to be deferred until -------.

    1. --------Tax Year

There were to be two distribution events on tax year -------.

        Records show total distributions for the --------tax year per Taxpayer’s records for
         the two distribution events were $--------------------. The total distributions in the ---
         --------tax year were supposed to be $----------------.

       --------deferral elections show --------% of the deferrals were to be distributed on ---
        ---------. Foreign Corporation’s Audited Financials show a total deferral balance of
        $------------------as of ---------.

            o --------% x ------------------=-----------------is what should have been distributed
              on ----------per the ------- deferral election. Foreign Corporation’s Audited
              Financials show $---------------------was transferred from Foreign Corporation
              to Taxpayer in -------------------.

        --------deferral election shows ------% of the deferrals were to be distributed by ----
         ------------. Foreign Corporation’s Audited Financials show a total deferral balance
         of $------------------as of --------------[$------------------(total deferral balance as of ------
         ------------) - -----------------(less total distributions made on ----------per the Foreign
         Corporation’s Audited Financials) -------------------(plus earnings/appreciation as
         of ------------)= $------------------.

                      o ------% x $------------------=-----------------is what should have been
                        distributed per the deferral election. Records show $-------------------
                        was transferred from Foreign Corporation to Taxpayer in -------.

    2. --------Tax Year

        The --------deferral election states --------% of the deferral balance should be
POSTU-154691-12                                        7

          distributed during tax year -------. The ------- Foreign Corporation Audited
          Financials shows a total deferral balance of $-------------------as of ---------------($---
          ---------------------total deferral balance as of ----------+ $----------------appreciation as
          of ---------------------).

                      o --------% x ------------------= $-----------------is the total that should have
                        been distributed in ------- per the ------- special deferral election.

         The total distributions for the ------- tax year per Taxpayer’s records were $---------
          -----------------.[1] The total distributions in the --------tax year were supposed to be
          $----------------.

         --------Tax Year

         The --------deferral election states a --------% of the deferral balance was to be
          distributed by ------------. The Foreign Corporation Audited Financials shows the
          total deferral balance as of --------------is $------------------($------------------total
          deferral balance as of ----------+ $-----------------appreciation as of ------------).

         --------% x ------------------= $----------------, this is the total that should have been
          distributed in ------- per the ------- deferral election. Records show the $-------------
          ------------------was actually transferred from Foreign Corporation to Taxpayer in ---
          -------[2]

The total distributions for the --------tax year per Taxpayer’s records were $------------------
-----------------. The total distribution that was supposed to be distributed in the ------- tax
year was supposed to be $----------------.

      3. ------- Tax Year

         The --------deferral election required ----------% of the remaining deferred fees to
          be distributed by ----------------. On ------------, Taxpayer opted to re-defer -----------
          ---------% of the deferred fees (the balance determined as of ------------) until -------
          ------------. Therefore --------% of the deferrals were required to be distributed by -
          ------------. The ------- Foreign Corporation Audited Financial Statements shows a
          total deferral balance of $------------------as of --------------($------------------as of ------
          ---------+$-----------------appreciation as of ------------).


[1]
    Records used to verify that this information the amount transferred from Foreign Corporation to
Taxpayer are bank statements from both entities, Taxpayer’s ------- Form 1120S, the ------------------
Repatriated Deferred Fees, and the ------- Foreign Corporation Audited Financial Statements.
[2]
    Records used to verify that this was the amount transferred from Foreign Corporation to Taxpayer are
bank statements from both entities, Taxpayer’s ------- Form 1120S, an excel called “----------------------------
---------------------------------------------------------” which is supposed to show deferred fees coming into
Taxpayer’s accounts,” and the ---------Foreign Corporation Audited Financial Statements
POSTU-154691-12                                  8

$------------------x --------%=$ ----------------, this is the total that should have been
distributed in ------- per the ------- re-deferral. Records show $-----------------was
distributed in -------.

LAW AND ANALYSIS

       Section 409A(a)(1)(a) provides that a plan must meet the requirements of
paragraphs (a)(2), (a)(3), and (a)(4) and the plan must be operating in accordance with
such requirements. Section 409A(a)(2)(A) provides that compensation deferred under a
plan may not be distributed earlier than the death, disability, or a date set forth in the
plan. Deferred compensation subject to section 409A may be paid only upon the
occurrence of certain events (e.g., death, disability, separation from service) or on a
fixed date set forth in the plan. Treas. Reg. §1.409A-3(a). Thus, deferred
compensation amounts must be paid on the dates set forth in the plan, and accelerated
payments and delayed payments are generally not permissible. Section 1.409A-3(j)(1)
provides that the acceleration of payments provided under a plan is not permitted.
Section 1.409A-2(b)(1) provides a plan may not delay a payment unless an election is
made to delay the payment at least 12 months before the payment is scheduled to be
made and the payment is delayed at least five years beyond the date the payment was
originally scheduled to be made. Under §1.409A-3(d), if a plan sets forth fixed payment
dates, an actual payment may be made 30 days before or the specified date or until the
end of the service provider’s taxable year in which the specified date or event occurs. If
the service provider’s taxable year ends less than 2 ½ months following the specified
payment date, the payment can be made by the 15th day of the third month after the
specified date. Here, payments were not made at the time set forth in the USR Plan.
Therefore, the USR Plan was not operated in accordance with the requirements of
section 409A(a). Accordingly, all compensation deferred under the plan for the taxable
year and all preceding taxable years is includible in gross income for the taxable year to
the extent not subject to a substantial risk of forfeiture and not previously included in
gross income.

ISSUE 3

       Employee A separated from service on or about ---------------------------, and
Taxpayer accelerated vesting of the amount owed to A under the ISR Plan. Taxpayer
paid the amount to Employee A pursuant to the terms of the ISR Plan, but Foreign
Corporation did not pay an amount equal to the amount paid to A to Taxpayer as
required under the USR Plan and Taxpayer did not include this amount in income. Did
the USR Plan fail to meet the requirement of section 409A(a)(1)(A) that a plan be
operated in accordance with the requirements of section 409A(a)(2)?

CONCLUSION

       Yes. The USR Plan was not operated in accordance with the requirements of
section 409A(a)(2) because the USR Plan did not pay Taxpayer an amount equal to the
POSTU-154691-12                              9

amount paid to Employee A, as required under the terms of the USR Plan. Therefore,
the USR Plan failed to meet the requirements of section 409A(a).

FACTS

       Employee A was a service provider who performed service for Taxpayer and who
separated from service on or about ---------------------------. Under the ISR Plan, Taxpayer
had the discretion to deem unvested amounts as vested upon a separation from service
of a participant. The ISR Plan states that if the Taxpayer exercises this discretion,
Taxpayer will distribute such amounts to a former employee on the last day of the
thirteenth month following the employee’s separation of service. Taxpayer chose to
accelerate vesting for Employee A upon A’s separation from service. Taxpayer and
Employee A executed a separation agreement memorializing this
understanding. Payroll records show Taxpayer paid Employee A $-----------------in --------
on or about the last day of the thirteenth month following the separation from
service. However, Foreign Corporation did not pay $-----------------to Taxpayer in ---------
and Taxpayer did not include this amount in income.

LAW AND ANALYSIS

        As discussed above, a plan must meet the requirements of paragraphs (a)(2),
(a)(3), and (a)(4) of section 409A, and the plan must be operated in accordance with
these requirements. Amounts must be paid on the dates set forth in the plan, and thus
accelerated payments and delayed payments are generally not permissible. Section
409A(a)(2)(A) provides that compensation deferred under a plan may not be distributed
earlier than the death, disability, or a date set forth in the plan. Treas. Reg. § 1.409A-
3(a) provides that a payment from a plan may be made only upon the occurrence of
certain events, one if which is a separation of service of a participant. Under Treas.
Reg. §1.409A-3(i)(6), payments under an ultimate service recipient plan to the
intermediate service provider must match the payments made under the intermediate
service recipient plan to the ultimate service provider. Here, the terms of the USR Plan
were not followed and Foreign Corporation did not pay an amount equal to the amount
paid to Employee A. Therefore, in --------the USR Plan was not operated in accordance
with the requirements of section 409A(a). Accordingly, all compensation deferred under
the plan for the taxable year and all preceding taxable years is includible in gross
income for the taxable year to the extent not subject to a substantial risk of forfeiture
and not previously included in gross income.

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.
POSTU-154691-12                           10

Please call (202) 622-6030 if you have any further questions.


                                       _____________________________
                                       John B. Richards
                                       Senior Technician Reviewer, Executive
                                       Compensation (Employee Benefits)
                                       (Tax Exempt & Government Entities)