IRS Rules That Retention Bonus Violates Code Section 409A

Miller & Martin PLLC Alerts | May 14, 2015

by Clay Walts

In a memorandum released earlier this month, the IRS Office of Chief Counsel ruled that a retention bonus payable to an executive violated Section 409A of the Internal Revenue Code ("409A"). The IRS further ruled that the correction of the payment schedule for the bonus prior to the time the bonus became vested did not relieve the executive from the tax implications of such violation. Payments which violate 409A generally are includible in income and subject to an additional 20% penalty tax in the year they become vested.

Facts of the Memorandum

The memorandum involved a retention bonus agreement entered into between a company and an executive pursuant to which the executive was entitled to a bonus if he remained employed with the company through the third anniversary of the date of the bonus agreement (i.e., the vesting date). The agreement provided that, once vested, the bonus would be paid out in equal installments in each of the two years following the vesting date. The agreement further provided that the company could elect to pay the entire amount in the first year following the vesting date, in its discretion. Upon realizing that retaining the discretion to accelerate the payment of the bonus violated 409A, however, the company amended the agreement prior to the date the bonus became vested to remove this discretion.

In reviewing this situation, the IRS concluded that a 409A failure with respect to deferred compensation that vests during a taxable year causes the deferred compensation to be includible in income in that year, regardless of whether the failure is corrected in that year but prior to the time the compensation becomes vested. On the other hand, the memorandum also infers that 409A violations may be able to be corrected prior to the taxable year the deferred compensation becomes vested.

Action Items

As the memorandum reminds us, the failure to comply with 409A can result in significant adverse tax consequences to employees and other service providers. Accordingly, to ensure compliance with 409A, it is advisable to periodically review employment agreements, severance plans, SERPs, nonqualified deferral arrangements, stock option plans, long-term incentive plans, change in control agreements, consulting agreements, bonus programs, offer letters and any other formal or informal plans, agreements or arrangements that provide for a deferral of compensation. Importantly, it should also be noted that correction procedures have been established pursuant to which certain 409A violations may be corrected even with respect to deferred compensation that is already vested, with no or reduced penalties.

As always, should you have any questions regarding this development, please contact Clay Walts or any other member of our Labor & Employment Practice Group.

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