409A Correction for Unvested Amounts Clarified
Finding a 409A violation generally prompts a sometimes frantic search for a means of correction under various IRS pronouncements. One previously helpful — but now slightly limited — such item was included in the proposed income inclusion regulations, which were issued in December 2008. Those regulations, which have not been finalized but which may be relied upon, state that a 409A violation results in income inclusion under section 409A (including the additional 20% tax) if the violation occurs in a year in which the deferred compensation is vested. The result: If a violation is corrected before the deferred compensation vests, no adverse tax consequences occur under section 409A. A recently released chief counsel advice memorandum clarifies this mechanism for correction. The memorandum indicates that this means of correction is effective only if completed before the taxable year in which the compensation vests, and not merely before the date on which the compensation vests.
In the memorandum, the IRS addresses a retention bonus that was granted in Year 1, vested in October of Year 3, and then would be paid in two installments, one in Year 4 and one in Year 5. However, the terms of bonus also permitted the employer, in its discretion, to pay the bonus in full in Year 4. The discretion to accelerate payment would violate the anti-acceleration rule under section 409A. In June of Year 3 (that is, before the October vesting date later that same year), the employer corrected the violation by eliminating its right to accelerate payment. The IRS concluded that, although the correction was made at a time when the bonus was not vested, the entire amount of the bonus would be included in income under section 409A in Year 3 (and therefore subject to the 20% additional tax).
The memorandum explains that, during at least a portion of Year 3, the bonus terms did not comply and, by the end of that year, the bonus had vested. The amount included in income and subject to the 20% additional tax is based on the amount that has vested by the last day of the year, but the determination of whether a violation has occurred is based on whether there is a violation at any point in the year. The IRS memorandum implicitly recognizes that a 409A violation could be corrected without adverse tax consequences if no portion of the deferred compensation is vested at the end of the year of the correction.