Correction of 409A Failure in Year of Vesting Does Not Work: Time to Consider IRS Correction Programs
On April 14, 2015, the Internal Revenue Service's Office of the Chief Counsel issued a memorandum clarifying the IRS' position on the correction of Internal Revenue Code Section 409A failures in the year in which nonqualified deferred compensation vests but prior to the vesting date. By way of background, "nonqualified deferred compensation" under Section 409A refers to compensation for services performed by an employee or an independent contractor that is or may be payable in a later year. Typical examples include bonuses payable in the year after the services are performed, severance payments upon termination of employment, certain grants of stock options, restricted stock units and phantom stock, change in control payments and tax gross-up payments.
Under certain circumstances, compensation otherwise qualifying as "deferred compensation" can be structured so as to be exempt from Section 409A. For example, a bonus based on calendar year performance that vests on December 31st and is paid by the immediately following March 15th is exempt from Section 409A, as is compensation payable to an independent contractor, who, in addition to satisfying other requirements, provides "significant services" to businesses unrelated to the employer providing the compensation.
If, however, deferred compensation is not exempt from Section 409A, it must be structured and paid in a manner that complies with the myriad rules under this statute relating to deferral elections, distributions and acceleration of payments. A violation of any of these rules, either in form or operation, exposes the employee or independent contractor to adverse tax consequences, including a 20% penalty tax, immediate income inclusion for the year of vesting (even if payment occurs in one or more subsequent years) and IRS premium interest on the amount deferred. A violation in form occurs when the applicable “plan document” contains impermissible provisions or fails to contain required provisions. A violation in operation occurs when an actual deferral election, distribution or acceleration of payments violates Section 409A.
Under proposed Section 409A income inclusion regulations issued in 2008, if a nonqualified deferred compensation plan violates any requirement of Section 409A, the adverse tax consequences generally are determined as of December 31st of the year in which such compensation vests, based upon the accumulated amount of deferred compensation as of such date. Stated differently, until the year of vesting, there is no Section 409A exposure.
Soon after the issuance of these regulations, a debate emerged among practitioners as to whether a Section 409A failure, if corrected during the year of vesting but prior to the vesting date, would be considered by the IRS as having been fixed "on time" - that is, fixed so as to avoid any adverse Section 409A tax consequences. Many practitioners, relying on the December 31st "valuation" date in the regulations, began taking and have continued to take the position that such approach works. The contrary view, held by more conservative practitioners, has been that a Section 409A failure must be corrected prior to the beginning of the year in which the deferred compensation vests.
This debate has come to an end. In particular, the IRS memo, relying on the text of the statute itself and the absence of explicit language permitting the "same year of vesting" approach in the regulations, specifically holds that "a failure applicable to deferred compensation subject to a substantial risk of forfeiture [i.e., vesting requirements] 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." (Emphasis added.)
Business and Employee/Independent Contractor Next Steps:
- 2015 Presents an Immediate Need for Action. If deferred compensation that violates Section 409A vests in 2015 but the vesting date has not occurred (e.g., severance payable upon termination of employment), the IRS correction program immediately should be considered - otherwise, there is a substantial risk that the IRS would consider the "fix" to be invalid. Immediate action is particularly important for severance payments scheduled to be made pursuant to the terms of an existing employment agreement, where the terms of such agreement violate Section 409A. Frequently, when the severance provisions of an employment agreement violate Section 409A, other provisions of the agreement also violate Section 409A and need to be corrected.
- 2016 Presents an Immediate Planning Opportunity. For 2016, reviewing documents (e.g., employment, severance and change in control agreements, equity compensation plans, bonus plans and even "plain vanilla" nonqualified deferred compensation plans) now for Section 409A compliance is imperative - it may be possible to correct certain Section 409A violations in 2015, without going through the applicable IRS correction program, and avoid the adverse tax consequences altogether.
- Prior Years. For years prior to 2015 in which the "same year of vesting" approach was relied upon, the issue largely could be one of whether the applicable statute of limitations for the assessment of taxes has expired.
In any event, Section 409A is extremely complicated, so it would be prudent for the company and/or the affected employee/independent contractor to retain qualified legal counsel to provide appropriate advice.
If you would like more information, please contact your Chiesa Shahinian & Giantomasi PC attorney or the author listed below.
Adam B. Cantor
Chair, Employee Benefits & Executive Compensation Group | firstname.lastname@example.org | (973) 530-2020