Dangers of Deferring Salary for Troubled Companies: Risks of Section 409A

At a glance

• The main takeaway: Deferring wages can be a beneficial way for companies to save cash during times of financial distress, but companies and employees must carefully plan these arrangements to align with the rules of Section 409A, or else the employees may face detrimental tax penalties.
• The impact on your business: Violating the strict rules of section 409A carries considerable risks, and companies should consult knowledgeable accounting and legal advisors to prepare the appropriate documentation.
• Next steps: Aprio’s Transaction Advisory team can help you plan for deferred compensation arrangements as well as provide guidance on other cash-saving strategies.

The full story:

Any company can be susceptible to cashflow shortages, leading to drastic measures to keep the doors open. This is especially common with early-stage businesses and startups. A common approach to mitigate these cashflow shortages involves deferring compensation, especially for officers and senior executives. This strategy is often deployed under the impression that the deferred wages will eventually be paid once the company returns to good financial standing. However, if the deferred compensation arrangement is not planned and documented properly, those individuals who defer compensation could face extreme tax penalties under the rules of section 409A.

What is section 409A?

IRC section 409A regulates non-qualified deferred compensation (NQDC) by providing strict rules around the timing and payment of deferred compensation. Section 409A was introduced in 2005 to reduce unclear arrangement terms and abuse that often penalized employees, especially in the event of company bankruptcy. Unlike qualified deferred compensation arrangements, such as pension plans, section 409A rules only apply to arrangements in which employees defer a portion of their compensation to be paid out later, outside of a qualified retirement plan. While the IRS does not have a cap on the amount permitted to be deferred in NQDC arrangements, companies typically only offer this solution to key executives—though any employee may agree to such an arrangement.

The rules

Deferred compensation can provide a cashflow “quick fix” for companies facing fiscal challenges, but violations of section 409A rules have significant repercussions, particularly for employees. Compliance often requires extensive planning far in advance, and failure to do so can lead to significant repercussions.

To plan accordingly, consider the following rules regarding section 409A:

1. The company and employees must prepare a plan document or employee deferral election that specifies the time and form of payment for the deferred wages. This documentation should specify what amount the employees are legally entitled to and whether the deferral amount is from their current salary or a bonus amount.
2. An employee’s election to defer compensation must be made no later than December 31 of the calendar year or the end of the employer’s tax year preceding the year in which the wages will be deferred.
3. Employees can only receive payment of the deferred wages at the time specified in the documentation, which is typically a fixed date or time, or at the time of a specific event, such as separation from service, disability, death, change in control, or an unforeseeable emergency.
4. If the employee’s deferred salary is not repaid timely, the employee will be taxed on the deferred income in the year the violation occurred and will also be subject to a 20% penalty on top regular taxes.

If these rules are violated, the penalty largely falls on the employee, who is essentially double punished by paying a punitive tax penalty on a salary or income they were not paid. The employer can also expect to face tax reporting and potentially withholding tax obligations.

Exception cases

To navigate the tax law and ensure compliance, it is arguably just as important to be aware of exceptions where section 409A does not apply:

• Legally binding rights – If the employee is not legally entitled to receive the compensation that is deferred, the employee has no contractual right to the compensation and is thus excluded from section 409A.
• Short–term deferrals – Payments made within 2 ½ months after the end of the year in which the compensation was deferred are excluded from section 409A rules. For example, if employees agreed during 2018 to defer a portion of their compensation in 2019 and the company pays their compensation by March 15, 2020, the section 409A rules do not apply.
• Forfeited compensation – Employees may choose to accept a reduced compensation or forfeit it altogether without guarantee of reimbursement. Although this exception is rare, some companies attempt to repay employees with other forms of reimbursement, such as by granting a similar value of company equity. While arguably not subject to section 409A, the value of the equity will be taxed as income and payroll wages, which can further jeopardize the financial outcomes for both company and employee.
• Going Concern Exception – In cases where the company documented an intent to deploy the short-term deferral exception but was unable to make the payments due to the continued distress of the company, the going concern exception allows payments to be further delayed until the business once again achieves financial stability.
• Unforeseeable Emergency Distributions – Employees who agreed to deferred compensation may pursue earlier repayment in the form of an unforeseeable emergency distribution to avoid penalties. This exception is allowed in emergency cases, such as illness, property loss, or other extraordinary circumstances.

Alternative tactics

Although there are ways to delay or accelerate deferred compensation payments without experiencing penalties, such as those described above, it may be best to pursue alternative measures. Time- and finances-permitting, you may consider a number of other approaches, including:

• Establishing an agreement to pay a bonus equal to the unpaid salary upon a new round of financing or change of control – however, if the stipulated occurrence never takes place, the employee will not be paid
• Reducing employee salaries and immediately instituting an arrangement to pay a bonus in the future for the desired level of compensation
• Funding and insuring deferred compensation plans through rabbi trusts, which are funds set aside in a trust to pay employees’ deferred compensation obligations without immediate taxation to employees

Prepare a defendable arrangement

There are many ways to manage compensation deferrals and save cash without penalizing your employees as long as appropriate planning and documentation are arranged. Given the severity of section 409A penalties, it is best to consider compensation deferrals far in advance and under the guidance of legal and financial professionals.

If your organization is considering a deferred payment arrangement or searching for solutions to save cash, schedule a consultation with Aprio’s Transaction Advisory Services.

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