Corrected retention agreement failed to avoid income inclusion for executive’s retention bonus

A correction to a nonqualified deferred compensation plan made before compensation vested, but during an executive’s tax year in which the compensation vested, failed to meet the requirements of Code Sec. 409A(a), according to an IRS Chief Counsel advice memorandum. The deferred compensation was entirely includible in the executive’s income in the year in which there was no longer a substantial risk of forfeiture.

A deferred amount under a nonqualified deferred compensation plan is not includible in income under Code Sec. 409A if it is subject to a substantial risk of forfeiture at all times during the taxable year. However, 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.

A company determined that a retention agreement with an executive failed to meet the time and form of payment requirements of Code Sec. 409A because it permitted the company to accelerate payment of the retention bonus by paying the retention bonus as a lump-sum payment on the first anniversary of the vesting date. To correct the failure, the executive’s retention agreement was amended to remove the employer’s discretion to pay the retention bonus in a lump sum before the bonus vested, but during the executive’s taxable year in which it vested. The executive continued to provide services and the substantial risk of forfeiture lapsed. The company paid the executive the retention bonus in equal installments over two years. The company asserted that the retention bonus should not be includible in the executive’s income under Code Sec. 409A for any taxable year because the retention agreement was amended before the vesting date to bring the agreement into compliance with Code Sec. 409A, even though the bonus amounts were no longer subject to a substantial risk of forfeiture at the end of the same year in which the agreement was amended.

According to the IRS, if a nonqualified deferred compensation plan fails to comply, or fails to be operated in accordance, with Code Sec. 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 (i.e., the executive’s) gross income for the taxable year. Although the amendment to the retention agreement resulted in payment terms that met the requirements of Code Sec. 409A(a), the failure to meet the requirements of that section began when the retention agreement was executed and continued until it was amended. Therefore, the entire deferred amount was vested and includible in income at the end of the taxable year.

Source: IRS Letter Ruling (Chief Counsel Advice Memorandum) 201518013, May 1, 2015.

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