Executive Compensation-IRS Provides Guidance On Correction of Section 409A Failures

In an IRS Memorandum, the IRS dealt with the following issue: Does the correction of a failure to comply with section 409A(a) of the Internal Revenue Code, which correction applies only to compensation subject to a substantial risk of forfeiture, avoid income inclusion under section 409A if the correction is made before the compensation vests but during the service provider’s taxable year in which it vests? And the IRS concluded that income inclusion is NOT avoided. Why?

The IRS said in the Memorandum that section 409A(a)(1)(A)(i) provides that, if a nonqualified deferred compensation plan fails to comply, or fails to be operated in accordance, with section 409A(a)(2), (3) and (4) “at any time during a taxable year,” compensation deferred under the plan that is not subject to a substantial risk of forfeiture and that has not previously been included in income is includible in the service provider’s gross income for the taxable year. Deferred compensation, which is subject to a substantial risk of forfeiture, is subject to the requirements of section 409A(a)(2), (3), and (4) at all times during a taxable year, though a deferred amount is not includible in income under section 409A if it is subject to a substantial risk of forfeiture at all times during the taxable year.

In contrast, if the amount is not subject to a substantial risk of forfeiture at all times during the taxable year (generally meaning the amount is vested as of the end of the taxable year), the amount is includible in income. The correction of a failure to comply with section 409A(a) during a taxable year indicates that a failure existed during the taxable year in which the correction is made. In accordance with section 409A(a)(1)(A)(i), a failure applicable to deferred compensation subject to a substantial risk of forfeiture 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.