The Office of Chief Counsel of the Internal Revenue Service (the “IRS”) recently confirmed that violations of Section 409A of the Internal Revenue Code (the “Code”) could be corrected without penalty in any taxable year before the taxable year in which an arrangement became vested. However, the IRS went on to clarify that the Code would require immediate recognition of taxable income of the amounts deferred and the assessment of an additional 20% tax if taxpayers waited until the taxable year of vesting to correct an error.
In Chief Counsel Advice 201518013 (the “CCA”),the IRS clarified what some perceived to be an ambiguity under previously issued proposed regulations describing Code Section 409A income inclusion issues. The proposed regulations explained that an employer generally could correct a Code Section 409A error before the arrangement vests without immediate income tax and additional taxes being imposed on the participant. Most practitioners agreed that an arrangement could be corrected without the risk of penalty so long as the compensation under the arrangement became vested no earlier than the taxable year after the taxable year of correction, and the IRS has confirmed that view in the CCA. What was less clear was whether a correction could be made without the risk of penalty if compensation became vested after the date of correction but still within the same taxable year in which the correction was made. In the CCA, the IRS explained that the correction technique works only when the compensation remains unvested throughout the entire taxable year in which the correction is made and vests no earlier than the taxable year after the taxable year of that correction.
The facts discussed in the CCA help illustrate this point. At issue was a retention bonus granted on October 1 of Year 1 that would vest if the employee remained continuously employed through October 1 of Year 3. The bonus was to be paid in two annual installments in October of Years 4 and 5. This payment schedule subjected the bonus to Code Section 409A because it was not payable quickly enough after vesting to qualify for an exemption. The arrangement also provided the company with discretion to combine the two installments into a single lump sum paid in October of Year 4. This discretion clearly violates Code Section 409A’s requirement that an arrangement specify the exact time and form of payment. The employer presumably realized this error and amended the agreement in June of Year 3 to remove the impermissible discretion provision. The employer argued that no Code Section 409A penalty should apply because the correction occurred before the date on which the arrangement became vested. The IRS disagreed because the correction took place in the same taxable year (in this case, Year 3 of the arrangement) in which the compensation differed under the arrangement became vested (on October 1 of Year 3 of the arrangement).
This guidance highlights the broad scope of Code Section 409A and the importance of careful drafting of executive compensation plans. Although Code Section 409A applies generally to nonqualified deferred compensation plans (“NQDC plans”), its scope goes beyond traditional NQDC plans to cover the type of retention bonus arrangements at issue under the CCA. Further, the CCA confirms that an employer that discovers a Code Section 409A problem early still may have the opportunity to fix the issue without penalty. It should be noted that while CCAs are not binding precedent on taxpayers or the IRS, they do inform us about the opinions and reasoning of the IRS on tax issues and thus are instructive. Due to budget constraints, the IRS has issued fewer formal regulations and increasingly has relied upon these types of non-binding opinions to provide guidance to practitioners. Thus, while a CCA may not carry the same weight as a formal regulation, practitioners would be wise to show it a similar level of deference.