On June 23, 2017, the IRS Office of Chief Counsel released an advice memorandum addressing the application of Section 409A to a back-to-back arrangement. The back-to-back arrangement involved a foreign investment fund, the ultimate service recipient (USR), and its investment manager, the intermediate service recipient (ISR). The fund and its manager were parties to a deferred compensation arrangement (the USR plan) under which the manager deferred some of its management and performance fees. The manager sponsored a deferred compensation arrangement for its employees (the ISR plan). Under the plans, the deferral elections and payment events triggering payments from the fund to the manager were coordinated with the deferral elections and payment events triggering payments from the manager to its employees. The IRS concluded that the USR plan did not meet the requirements of Section 409A.

Under Section 409A and its related regulations, amounts deferred under a nonqualified deferred compensation plan may only be paid on the occurrence of the following payment events:

(26 U.S.C. § 409A(a)(2); Treas. Reg. § 1.409A-3(a).)

A payment to a service provider generally cannot be triggered by the separation from service of another service provider. However, an exception exists in the regulations for back-to-back arrangements that meet the requirements of Treas. Reg. § 1.409A-3(i)(6). Under the exception, a USR plan may provide for a payment to the ISR on the occurrence of a permissible payment event under the ISR plan if:

(26 U.S.C. § 409A(a)). For more information on Section 409A, see Practice Note, Section 409A: Deferred Compensation Tax Rules: Overview.

The IRS found that the USR plan failed to meet the requirements that apply to back-to-back arrangements under Section 409A. The USR plan provided for the payment of deferred amounts to the manager when an employee forfeited unvested amounts under the ISR plan because the employee's separation from service occurred before the vesting date. As a result, payments to the manager under the USR plan would be made in connection with the employee's separation from service, but there would be no corresponding payment from the manager to the employee. Because payments to the manager could exceed the payments made to the employee under the ISR plan, this provision resulted in an impermissible payment event under Section 409A.

The IRS also found that the USR plan was not operated in accordance with Section 409A's requirement that payments under a plan be made:

(26 U.S.C. § 409A(a)(2)(A); Treas. Reg. § 1.409A-3(a).)

Although the manager elected to be paid deferred compensation on certain dates and in certain amounts, payments actually made to the manager were less than the amounts called for under the USR plan in some tax years, and more than the amounts called for under the USR plan in other tax years. Consequently, the plan was not operated in accordance with Section 409A's requirements.

The IRS also found that the USR plan was not operated in accordance with the requirements of Section 409A because the USR plan did not pay the manager an amount equal to the amount the manager paid to an employee as required under the terms of the ISR plan.

Under the ISR plan, the manager had discretion to accelerate vesting of an employee's deferred amounts in connection with the employee's separation from service and distribute amounts on the last day of the thirteenth month following the employee's separation date. When an employee separated from service, the manager accelerated vesting of the employee's unvested deferred amounts and paid the employee in accordance with the terms of the ISR plan. The fund, however, failed to pay the manager an amount equal to the amount paid to the employee, which was required under the terms of the USR plan.

The IRS concluded that a Section 409A violation occurred in connection with each of the issues raised in the memorandum. Failure to comply with Section 409A's requirements results in adverse tax consequences, including the following:

Administering a deferred compensation plan and ensuring compliance with Section 409A's requirements is complicated under any circumstances. Back-to-back arrangements add another layer of complexity and distributions under each plan must be carefully coordinated. This IRS memorandum highlights the significant adverse tax consequences that can result from failing to apply the Section 409A rules correctly.