It happens insidiously, even with the best of intentions. Imagine: A startup or growing company has limited cash, and at times may prefer to cover important expenses other than payroll. The employees, or perhaps specifically the high-level executives, are on board with not getting paid on time, and come to an agreement with the company that their earned but unpaid salaries will be paid at a later time, when the company has the cash.
Section 409A
Unfortunately, the employees and the company may have stepped into an issue raised by Section 409A of the Internal Revenue Code. Section 409A imposes a broad set of rules and restrictions with respect to deferred compensation. It was enacted, at least in part, in the context of certain practices by Enron executives with respect to their deferred compensation, and the rules (and the draconian penalties) are perhaps a reflection of the negative perception of those practices. Section 409A is written so broadly that it applies to situations that one typically may not expect, like our hypothetical above. The employees, who generously agreed to be paid later, when the company has sufficient cash, have likely entered into a deferral arrangement that is neither exempt from, nor compliant with, Section 409A.
The penalties under Section 409A are harsh, and fall mostly on the employee[1]. If applicable, Section 409A imposes a 20% additional tax penalty on the employee’s deferred income, as well as interest. The penalties are imposed at the time of deferral, so by definition the penalty is imposed before the payment to the employee.
Avoiding a Section 409A Problem
There are some techniques to address the hypothetical situation above. If the deferred salary is actually paid in the first 2.5 months of the year following the year of deferral (i.e., by March 15th), then such “short-term deferrals” are exempt from Section 409A.
What if payment in that time period is not possible? The company may be able to take the position that payment of the deferred salary “would have jeopardized the ability of the service recipient [i.e. the company] to continue as a going concern. . .” In that case, the company would need to make the payment as soon as the risk to its existence as a “going concern” was over. Unfortunately, it is not clear under the regulations and case law what facts would meet the standard of jeopardizing the company as a “going concern,” and depending on the reasons that salary is not being paid, it may be risky to rely upon such a position.
One other potential solution is to pay the salaries, but arrange for loans from employees for the same amounts back to the company. This approach comes with its own issues, including documentation and a potentially higher interest expense at the company, but nevertheless is another approach to consider.
To minimize issues going forward, as soon as the Section 409A problem is recognized, the company and its applicable employees can agree to reduce certain salaries effective immediately, and figure out how to structure compensation going forward in a way that doesn’t violate Section 409A.
Better still is to get out ahead of the issue altogether. With some advance planning, the risk of the hypothetical situation above can be reduced, or completely avoided . Companies should consider setting guaranteed salaries at levels it will realistically be able to pay. If key people require higher compensation, then such compensation should be structured in a way that is exempt from, or compliant with, Section 409A.
For example, the company and employee can agree in the employment agreement that, upon a triggering event (e.g., a certain level of profits or sales), the employee becomes entitled to additional compensation (perhaps calculated as a make-whole with respect to the salary originally desired). The event or goals should be chosen with cash liquidity in mind – it does little good to trigger higher compensation at a future time if the company will have to defer it!
With some foresight, companies can creatively structure compensation that avoids running afoul of Section 409A, better match their finances and cash flow and retain top talent. Section 409A is complex with a broad reach. Please consult a tax advisor if you have Section 409A concerns.
[1] Section 409A can also apply to independent contractors. This article will continue to use the term “employee” to reference both service providers who are employed and service providers who are contractors.
The contents of this Alert are for informational purposes only and do not constitute legal advice. If you have any questions about this Alert, please contact the Shulman Rogers attorney with whom you regularly work or contact us here.
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