Feb 152012

It’s a common scenario: a startup is short on cash and doesn’t have enough money to pay its officers. The officers are willing to go without pay for a while, but do want to get paid back when the company is able. So, the board tells the officers “Hey, your salary is $8,000 per month (or whatever), but we don’t have the cash right now, so we’ll pay you later when we get funding.” This used to be fairly common practice. But, a section of the tax code that was added after the Enron and Worldcom scandals  has turned many of these simple arrangements into costly mistakes.

I’m referring to Section 409A of the tax code, which governs how “deferred compensation” is taxed when it isn’t part of a qualified pension, profit-sharing or other sort of plan.  In tax lingo, “deferred compensation” just means compensation that may be paid out in a later tax year than the tax year you had a legal right to it. Applying this definition, a payment that’s delayed from January to December would not be “deferred compensation,” but a payment that’s delayed from December to January would be. (All assuming that the company’s tax year is the same as the calendar year.)  Our situation above qualifies —  nobody disputes that the officer has earned the money and since it may be paid out in the next tax year, it’s deferred compensation.

Here’s the problem: if the deferred compensation arrangement doesn’t meet 409A’s requirements, then the IRS treats the compensation as if it was actually paid when the officer first had the legal right to the money, and taxes it accordingly.  On top of that, there’s interest AND a 20% penalty, in addition to whatever penalties the states impose (I’ve heard, but haven’t verified, that California imposes its own 20% penalty).  All of those taxes, interest and penalties are paid by the employee. The employer, meanwhile, has its own problems — penalties for incorrect withholding, penalties for incorrect reporting, penalties for underpaying Social Security/Medicare, penalties for failing to make required deposits, and so on.  What a mess.

What’s the easiest way out of this? That’s easy: don’t do that. Instead, see your attorney about how to structure the deferred compensation so it isn’t affected by Section 409A. One easy way is usually to make the payment subject to a “substantial risk of forfeiture,” which would mean that the IRS won’t consider it to be awarded until that risk goes away. But, in typical IRS fashion, they’ve defined “substantial risk of forfeiture” in its own byzantine way:

Compensation is subject to a substantial risk of forfeiture if entitlement to the amount is conditioned on the performance of substantial future services by any person or the occurrence of a condition related to a purpose of the compensation, and the possibility of forfeiture is substantial. . . . 

So, basically, there’s only a risk of forfeiture if (i) it depends on somebody (either you or somebody else) providing substantial services in the future, or (ii) if it depends on a condition related to why you’re getting the compensation.  With that understanding, the “you’ll earn $8,000 per month, but we’ll pay you later” can be fixed by changing how and why it’s awarded: “If you are successful in obtaining external financing in excess of $200,000, we will pay you $8,000 for each month between now and the date the financing comes in.” Now, there’s a “substantial risk of forfeiture,” and the 409A problem, along with all those taxes, penalties and interest, goes away.

Two important caveats: 409A also requires the plan to be in writing, and has some specific requirements for what has to be in it, and when the plan has to be written.  But, that’s easy to deal with. And, see an attorney who knows about this stuff. 409A is just too complicated to be adequately addressed in a blog post.

[Graphic courtesy of DonkeyHotey on Flickr.]