Many times I have seen the following happen: a company is running out of money. In order to keep going, the team is going to have to take pay cuts. The Founder & CEO tells the team, ”We’ll have to ‘defer’ your salary. As soon as we raise our next round (or as soon as we sell), we’ll pay you what you have deferred.”

This is a mistake, and sometimes a costly one. The word “defer” is a dirty word in the law. Sort of like the word “backdating” (ok, maybe not that bad, but it is still not a good word). Why is “defer” a dirty word? Because when you “defer” you give rise to a number of potential adverse legal complications that you should, and can, avoid.

What are the problems with deferring salary?

  • Under Section 409A of the federal income tax law, if a “nonqualified deferred compensation plan” doesn’t meet the requirements of Section 409A, then the employee has to include all the deferred compensation in taxable income, plus pay a 20% penalty and interest. In other words, simply “deferring salary” without working through the complex requirements of Section 409A is not a good approach.
  • Are you reflecting the deferred amounts on the company’s balance sheet? If not, then you are probably running afoul of GAAP in some way. And, your balance sheets won’t be in a format suitable to present to potential investors.
  • Are you aware that some states impose personal liability on directors and officers for failure to pay wages? You could be subjecting yourself to these claims.

 

How can you avoid these problems? Don’t “defer.”

Instead of deferring:

  • Reduce folks’ salaries to whatever you need to.  This can be tricky because you do not want to breach any written or verbal employment contracts, so document a consensual written agreement.
  • Offer incentive bonus payments, which only vest upon the triggering event (i.e., completion of the next round of financing, sale of the company, etc.).  It is best to make it clear this money is at risk—if the company does not hit the target, then there is no obligation to pay.
  • Usually, a salary reduction/bonus agreement will achieve the business goals. When you craft this bonus plan, you do need to be careful to comply with Section 409A. However, drafting a bonus plan to comply with Section 409A is quite a bit easier than navigating through the “deferral” rules for deferred salary amounts.

 

What are the benefits of this type of agreement rather than deferring salary amounts?

If you don’t raise your next round, or sell, you don’t have potential personal liability, including double damages and attorneys’ fees, for the deferred amounts.

In conclusion, be careful.

Guest blogger Joe Wallin is a leading startup lawyer in the Pacific Northwest and the founder of the Law of Startups. He represents companies from inception to exit, as well as investors, executives, and founders. His practice focuses on startups and emerging companies, angel and venture financing, and M&A transactions. Follow him on Twitter @joewallin

This blog was adapted from Joe’s posts “Deferred Salary: A Tax Trap” and “Don’t ‘Defer Compensation” on The Startup Law Blog. For more of Joe’s writing on deferring compensation, see: