Introduction: IRS Chief Counsel Advice 201725027 (Mar. 6, 2017). On March 6, 2017, the IRS issued Chief Counsel Advice 201725027 (“CCA”), released on June 23, 2017, advising Associate Chief Counsel that a certain nonqualified deferred compensation (“NQDC”) plan had document and operational failures and the deferrals under such plan were includible in income of the participant and subject to additional taxes under section 409A (“Section 409A”) of the Internal Revenue Code of 1986, as amended ("Code"). Generally, if an unfunded promise by a service recipient to pay compensation to a service provider in a subsequent tax year violates certain restrictions on timing or form of payment or rules for electing the deferral of pay to a later tax year, Section 409A requires inclusion in income and payment by the service provider of an additional 20 percent tax and interest on the taxable amount.
The CCA demonstrates two significant points in the ever-evolving area of executive compensation plans subject to Section 409A. First, the IRS hewed closely to the literal language of Section 409A Treasury regulations, on which very little IRS guidance exists, in applying the requirements for “back-to-back arrangements" involving an ultimate and an intermediate service recipient. Second, the IRS used some informal, internal company records, such as Excel data, in additional to audited financials and returns on IRS Form 1120S to determine whether Section 409A violations occurred.
Under the facts of the CCA, an investment fund organized as a foreign corporation maintained an NQDC plan to compensate a U.S. entity, the taxpayer in the case which apparently elected S corporation status, for investment management services (ultimate service recipient or “USR Plan”). In turn, the U.S. entity maintained an NQDC plan for the investment professionals it employed to provide the investment advice (intermediate service recipient or “ISR Plan” consistent with the language of Treas. Reg. section 1.409A-3(i)(6)(i) (2007) providing an exception to the general rule that amounts under an NQDC plan may be distributed to a participant only upon the occurrence of certain payment events described generally in Section 409A(a)(2)(A)).
Literal Construction by the IRS of the “Back-to-Back Arrangements” Exception. Consistent with the regulations, the USR Plan provided for payments to be made to the U.S. entity upon, among other events, separation from service of an employee of the U.S. entity who was a participant in the ISR Plan. The USR Plan appeared to be intended to comply with the “back-to-back arrangements” exception under the regulation to the general Section 409A payment event criteria, as follows. Under the USR Plan, the U.S. entity employing the investment advisers was the service provider and the foreign corporation was the service recipient.
Under Section 409A(a)(2)(A)(i), a payment may be made to a participant in the plan upon the service provider’s separation from service. However, under the USR Plan, consistent with the exception, the foreign corporation would make the payment to the U.S. entity, the participant under the USR Plan, upon the separation from service of its employee, who does not participate in the USR Plan but is a service provider and participant only under the ISR Plan.
Treas. Reg. section 1.409A-3(i)(6)(i) required plainly that the amount of payment under a USR plan “does not exceed the amount of the payment under the” ISR plan. Although not mentioned in the CCA, the regulation also provided in the accompanying example, “Company C’s payment to Company B of the amount due under the ultimate service recipient plan upon the separation from service of Employee A from Company B may constitute a permissible payment event for purposes of” the general rule in the regulation. Treas. Reg. section 1.409A-3(i)(6)(ii) (2007).
The IRS found, among other factors, that the USR Plan allowed for payments to the U.S. entity even if an employee of the U.S. entity participating in the ISR Plan forfeited his NQDC due to separating from service earlier than required for the employee’s compensation to vest under the ISR Plan. The IRS interpreted this USR Plan provision to violate the requirement above that the amount of payment under the USR Plan “does not exceed” the amount of the payment under the ISR Plan. Thus, in the view of the IRS, construed literally, the regulation required an actual payment, and a forfeited amount that otherwise would have been due if vested was not sufficient to amount to a required payment within the language of the regulation. Thus, because no payment actually had occurred under the ISR Plan, the service recipient could not make a corresponding payment under the USR Plan. Accordingly, the IRS interpretation of the “back-to-back arrangements” exception was a strict reading of the regulation.
The IRS said, “Therefore, the requirements under Treas. Reg. § 1.409A-3(i)(6) are not met because the amount of the payment under the ultimate service recipient plan may exceed the amount of the payment under the intermediate service recipient plan.” Thus, the IRS concluded, “The payment event under the USR Plan providing for payment of an unvested amount upon separation from service of a Participant is not a permissible payment event under Treas. Reg. § 1.409A-3(a).” Accordingly, the IRS advised that the USR Plan provision was a document failure by the plan to meet the requirements of Section 409A(a)(2). Consequently, under Section 409A(a)(1)(B), the taxpayer or any of its shareholders (to the extent the fee income was subject to pass-through taxation under Subchapter S of the Code) would have to pay income tax, additional 20 percent tax and interest for the first open year for the IRS to assess and collect tax on all vested amounts deferred under the USR Plan and not included in income by the taxpayer (or any S corporation shareholder) for prior tax years. Any amounts that vested in subsequent tax years, in which the plan failures occured, also would be includible in income and subject to additional taxes under Section 409A(a)(1)(A) and -(B).
Violation of Timing of Payment Rules Found Through Unofficial Internal Records. Also, under the facts of the CCA, the IRS found that the foreign corporation paid some deferred fees under the USR Plan to the U.S. entity inconsistent with the USR Plan provisions for timing of payment of such compensation. Thus, these untimely payments to the U.S. entity amounted to either the prohibited accelerations or subsequent deferrals of payments not made in accordance with Section 409A regulations and constituted an operational failure of the plan to comply with the requirements under Section 409A(a)(3) or 409A(a)(4), respectively.
(Conversely, as a third issue addressed in the CCA, the IRS found that failure of the foreign corporation to make a corresponding payment under the USR Plan when vesting and payment of NQDC by the U.S. entity to an employee permissibly was accelerated under the ISR Plan similarly was an operational failure of the USR Plan in violation of Section 409A(a)(2).)
In a footnote, the IRS remarked with respect to payments found to have been made in violation of Section 409A timing requirements, “Records used to verify that this was the amount transferred from Foreign Corporation to Taxpayer are bank statements from both entities, Taxpayer’s * * * Form 1120S, an excel called “* * *” which is supposed to show deferred fees coming into Taxpayer’s accounts,” and the * * * Foreign Corporation Audited Financial Statements * * *”.
Thus, among other items, the IRS relied apparently on an internal Excel file not part of bank statement transcripts or audited financials but produced to the IRS by either the taxpayer or the foreign corporation, which appeared to constitute a record of fee transfers to the U.S. entity from the foreign corporation. There may be situations, especially where the employer is both the plan sponsor and the administrator, in which such a file may not necessarily have been prepared with utmost accuracy or may have been prepared by an individual not familiar with Section 409A requirements or the employer’s Section 409A compliance efforts. Yet, from the facts of the CCA, it is apparent the IRS may use such a document to assess a taxpayer’s compliance with Section 409A.
Therefore, employers sponsoring Section 409A plans, especially in instances where a third party administrator is not involved, must treat any documents related to plan administration, with utmost care and with a view that any such document prepared by staff must be accurate and reflect operation of an NQDC plan consistent with Section 409A rules. Accordingly, it is important to instruct bookkeeping personnel or anyone handling accounting or financial records that may have even remote relevance to an NQDC plan on the need to be aware of possible Section 409A consequences.
Conclusion and Action Items for Employers Sponsoring Section 409A Plans. In sum, there are conceptions that the IRS may have an expansive view of Section 409A requirements for nonqualified plans so long as an arrangement comports with the underlying legislative and regulatory principles. But this CCA illustrates that, in the absence of significant guidance or case law in the developing Section 409A landscape, the IRS puts much stock into the language of the Treasury regulations. Also, this CCA highlights the importance of taxpayers keeping accurate and consistent internal records that reflect Section 409A compliance and instruct staff involved in preparation of such records accordingly. These precautions bear significance because, in the event of an investigation or audit, the IRS may request and use informal records produced in response to the IRS request in addition to audited financials or tax returns to reach a determination adverse to the taxpayer.
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