Chief Counsel Memorandum Clarifies IRS Position on Informal 409A Corrections

On May 1, the IRS released a Chief Counsel Memorandum that clarifies the IRS’ position with respect to the correction of deferred compensation arrangements outside of the IRS’ formal Section 409A correction programs.

In the Memorandum the IRS analyzed a retention bonus that was granted in year 1, vested in year 3, and to the extent vested, would be paid in equal installments in years 4 and 5. The retention agreement contained a provision that gave the employer the discretion to accelerate and pay the retention bonus in a single lump sum payment in year 4.  As noted by the IRS, the employer’s discretion to accelerate and pay the retention bonus early violated Section 409A’s prohibition against acceleration.  The employer discovered the 409A violation in year 3 and, before the employee’s right to receive the retention bonus vested, amended the agreement to remove the provision that violated Section 409A.

In applying Section 409A’s proposed income inclusion rules to the employer’s attempted correction, the IRS concluded that the retention agreement violated Section 409A during the year in which the retention bonus vested, even though the employer amended the agreement before the employee’s right to receive the retention bonus vested.  Accordingly, because the retention agreement violated Section 409A during at least a portion of year 3, the IRS determined that the retention bonus must be included in the employee’s income under Section 409A in year 3 meaning that the entire amount of the bonus would be subject to taxes and penalties under Section 409A.

Although not specifically addressed in the Memorandum, the IRS implicitly confirmed the ability to informally correct 409A failures during years prior to the year in which deferred compensation amounts become vested. In other words, if the employer had amended the retention agreement in year 2 (rather than year 3), the IRS may have respected the correction and determined that the retention bonus was not subject to taxes and penalties under Section 409A. Employers may wish to consider taking advantage of this ability to correct 409A failures prior to December 31, 2015 for deferred compensation amounts that will remain unvested for the balance of 2015.