Deferred Compensation Arrangement Out of Compliance with §409A Could Not Be Successfully Amended in Year of Vesting

In Chief Counsel Advice 201518013 the IRS decided that an employer’s attempt to reform a non-qualified deferred compensation plan that failed to comply with the time and form of payment requirements of IRC §409A(a), even though the plan was revised to contain compliant language prior to date in the tax year where the taxpayer no longer had a substantial risk of forfeiture. 

An executive had entered into a retention agreement with his employer that provided if the executive remained employed with the company on the third anniversary of the retention agreement, the executive would receive a bonus paid evenly on the first two anniversaries of the vesting date.

So, for example if the executive signed the agreement on September 1, 2012, his interest would vest on September 1, 2015.  Under the terms of the agreement he would receive ½ of the retention payment on September 1, 2016 and the other half on September 1, 2017.

Under IRC §409A a nonqualified deferred compensation agreement must meet various requirements.  One of those requirements imposes restrictions on what triggers a payment under the plan and when those payments will be made.  One qualifying option is if the agreement provides for payment at a specific date specified at the time the agreement is entered into.  The plan can allow for the payments to be delayed, but any such delay option must be exercised no later than 12 months before the payment date and must result in an additional deferral of at least five years.  [IRC §409A(a)(4)(C)]

With the facts to this point there is no problem—but the agreement did not stop here.  It provided that, at the employer’s discretion, the balance of the payment due could be paid at any time.  So, in our example, the employer could pay the entire amount at any time after September 1, 2015, but it had to pay at least ½ by the first anniversary and have the entire amount paid out by September 1, 2016.

Such an acceleration option is not allowed under the provisions of §409A, regardless of whether it is the employee or the employer who has the discretion to exercise the option. [IRC §409A(a)(3)]

Congress enacted these rules following some very highly publicized cases (including Enron) where executives cashed out their deferred compensation agreements under “haircut” arrangements where the executive could be paid before the date stated in the agreement by taking a reduced benefit, doing so just before the employer entered bankruptcy (where their package would have simply become that of an unsecured creditor).  Congress made the rule broad, most likely due to concerns that an executive with sufficient influence over decisions for the employer could effectively trigger an option even if held solely by the employer.

The consequences of failing to comply with the rules under §409A accelerate the inclusion in income of amounts by the employee, as well as imposing a penalty tax of 20% of the balance and interest (at a higher than normal rate) on the period of deferral of the income.  Suffice it to say the results are very poor for the employee who would face tax without necessarily having any current cash that could be used to pay the tax due.  Even worse, the law provides for mechanical rules—the fact that there was no bad intent or the fact that any “bad” clause was never actually used is not relevant to the triggering of the tax consequences to the employee.

In this case the defect was noticed during the year in which the executive would vest in the benefit, but before the actual day his benefits vested.  Prior to the vesting date, but during the year in which the benefits would vest, the plan was revised to remove the employer’s option to accelerate payments under the plan. 

So, to continue our example, the plan would be amended on June 1, 2015 providing that the employer could not accelerate payments, but instead they would be made equally on September 1, 2016 and September 1, 2017.  As well, moving into the future, the payments were actually made on September 1, 2016 and 2017.

The transaction came to the IRS’s attention, leading to this request from the field for guidance on the situation.  The employer argued that no amount would be includable in the executive’s compensation for the year the agreement was modified (in our example 2015), nor would any of the other penalty provisions of §409A apply in this case. 

The National Office, in the memo, did not agree with that view.  The memo noted that the plan was out of compliance from the day it was first signed (in our example, in 2012).  However the employee did not owe tax at that time because, the ruling held, the compensation was still subject to a substantial risk of forfeiture at the end of that year and the following two years (2013 and 2014 in our example).

But at the end of year 3 three (2015 in our example) there would no longer be a substantial risk of forfeiture since the executive’s rights had vested.  The memo points out that §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).

The plan failed to meet the requirements right up until it was corrected during the year the right vested.  The IRS, pointing out the “any time” language, finds that the law does not allow for relief in this case.   The plan had to be in compliance beginning at the stroke of midnight on January 1 and, in this case, it was not.

The ruling goes on to note that it would also not matter if amounts were deferred under the plan before or after the failure is corrected.  Since the executive no longer had the protection of a substantial risk of forfeiture to keep the amount out of his income for the year, the provisions of §409A that had previously been held in check now applied in full.

Advisers should note the following items from this memo:

  • Note that the ruling also appears to hold that if the employer had caught and fixed this problem before the year the employee vested, there would not have been a problem.   That suggests a “cold review” of significant compensation arrangements more than a year before vesting is a good protective measure.  While we don’t know for sure, it seems likely that this problem was discovered only after someone starting looking at the package anew because the executive was going to vest in the year in question.
  • Advisers who work with employers need to be well versed in these rules and, more importantly, insure those executives and owners who most often are negotiating compensation arrangements with new hires are aware of the problem—that is, anytime someone earns a right to income in one tax year but will receive it in another it is time to make sure that the plan is reviewed for compliance with §409A.
  • Similarly, advisers who may work with employees need to be just as conversant, if not more so, in this area of the law because the negative consequences will impact the employee.  While employees who are impacted may look to be compensated by their employer, it’s much better to simply avoid the problem entirely.  If the employer balks at compensating the employee for the damages, even a successful claim will likely consume time and money, neither of which your client may have enough of to carry on a successful challenge.