In general, proposed rulemaking issued in December 2008 with respect to income inclusion under Section 409A of the Internal Revenue Code of 1986, as amended (available here) provides that if there is a Section 409A violation in a taxable year, all compensation deferred under the applicable nonqualified deferred compensation arrangement for that taxable year and all preceding years is includible in the service provider’s gross income to the extent not subject to a substantial risk of forfeiture (i.e., vested) and not previously included in gross income in a prior taxable year. Although the proposed income inclusion regulations appear to permit the correction of certain plan provisions that do not comply with Section 409A without penalty as long as the underlying amounts are unvested, they include certain anti-abuse provisions intended to prevent impermissible changes in the time or form of payment.

By their terms, these anti-abuse rules would preclude the correction, without penalty, of a nonqualified deferred compensation failure in a taxable year prior to the taxable year in which the compensation vests, to the extent that the Internal Revenue Service (IRS) finds that a service recipient has a pattern or practice of permitting impermissible changes in the time and form of payment of unvested deferred compensation. In addition, May 2015 IRS guidance made clear that Section 409A requires income inclusion if there is a compliance failure at any time during the taxable year in which the applicable substantial risk of forfeiture lapses, even if the noncompliant provisions are corrected prior to the lapse of the substantial risk of forfeiture (confirming the unavailability of a “same-year” correction of deferred compensation that vests at any time during that tax year, even if the correction is made in advance of vesting).[1]

The proposed regulations under Section 409A (available here) recently issued by the IRS would clarify and modify the Proposed Income Inclusion Regulations by:

  • clarifying that a correction that changes the time and form of payment will not be permitted under Section 409A absent a reasonable, good faith basis to conclude that the original provision failed to comply with Section 409A and the correction is necessary for Section 409A compliance;
  • providing examples of a pattern or practice of permitting impermissible changes in the time or form of payment of unvested nonqualified deferred compensation; and
  • prescribing the use of the specific correction methods pursuant to applicable Section 409A guidance and the consistent application of those correction methods for all substantially similar failures affecting unvested nonqualified deferred compensation.

[1] See our May 2015 post on our ERISA Practice Center Blog, “IRS Chief Counsel Memorandum Clarifies that Correction of Section 409A Failures in Year of Vesting Will Not Shield Income Inclusion Under 409A,” available here.