Section 409A and the Deferred Compensation Trap for Startups and Early-Stage Growth Companies

Frequently during the financial crisis, the COVID pandemic, and now in a rising interest rate environment, we see startup and early-stage growth companies that, in the effort to conserve cash, reduce or eliminate the pay of the founders and senior executives for some period of time.  While this step is logical and critical to the company achieving long-term success, it is fraught with potential adverse consequences under Internal Revenue Code section 409A (“section 409A”).  

This article is intended to be a general overview of the issues that arise and the proactive and mitigating strategies that may be applied to avoid the harsh tax consequences to the employee when violations of section 409A occur.

Background

Section 409A is drafted very broadly and essentially applies to any arrangement that can result in compensation being deferred from an earlier tax year into a future tax year unless the arrangement is specifically exempt under the law or meets one of the exceptions under the related tax regulations.  Failure to comply with the requirements of section 409A result in the employee being taxed on the deferred income in the year in which the violation occurred, plus an additional 20% penalty tax on the gross amount of the income deferred and penalty interest.  In this context, the punitive tax result is exacerbated by the fact that the employee did not receive any cash.

Further, section 409A requires a plan document, and the plan document or an employee deferral election must specify the time and form of payment.  If the documentation does not exist, section 409A has been violated.  Obviously, when founders and executives of early-stage companies are focused on the success and/or survival of their company, they are not necessarily focused on or even aware of the consequences of not paying themselves.  Thus, any form of documentation is typically missing in these situations.

Application of Section 409A

Knowing when section 409A applies and when it does not can assist in avoiding the tax trap before a company steps into it.  Below is a general discussion of when 409A applies, when it does not apply, and potential mitigation strategies.

When Section 409A Does Apply

Assuming the employee has a legally binding right to the compensation (see discussion below), deferred compensation under section 409A potentially includes any arrangement under which an employee has a right to receive compensation earned in one tax year and paid in a subsequent tax year.  Consider the situation in which the company needs to use its cash for purposes of keeping the business going and executives (or any employees) agree to not be paid current salary or bonuses in exchange for payment at a later time.  Unless the unpaid salary is paid by March 15 (see discussion of short-term deferral exception below) of the year following the year in which the agreement was made to forego the salary, section 409A will apply and the arrangement will not comply with the deferral election requirements of 409A.  The result is the harsh tax consequences for the executive/employee as outlined above. Since employees are the ones who have to pay, this causes concerns about participants suing employers for 409A failures.

When Section 409A Does Not Apply

No legally binding right - Section 409A will not apply if the employee has no legally binding right to the compensation.  This means that the company can unilaterally decide not to pay the compensation and the employee has no legal recourse to recover the unpaid compensation.  This would be a highly unusual situation as payment of compensation is for virtually all employees subject to state wage laws or an employment agreement.

Short-term deferral exception – Under this exception, section 409A will not apply if the compensation is paid within two and one-half months (by March 15 for calendar year entities) after the year in which the compensation was deferred.  For example, if executives of a company agree to forego being paid in February of Year 1 and the company pays the foregone compensation by March 15 of Year 2, no violation of section 409A will occur. Such an arrangement should be documented and something as simple as a letter agreement is sufficient.

Forfeiture - Executives can agree to reduce or forfeit pay with no promise from the company to repay the compensation in the future. The rules under this scenario are very strict and most executives or employees are not willing to completely forfeit compensation they have earned without some promise of future payment.  Some companies try to grant equity with a similar value to the foregone compensation; however, if they do, the value of the equity will be taxed as wages and the employee and the company will likely not have the cash to pay the income and payroll taxes.

Mitigation Opportunities

The best way to mitigate potential problems under section 409A is to be aware that there is a potentially harsh tax result and to determine what the best approach is to avoid such a result, based on the company’s current situation. Below is a general discussion of approaches that can be taken when a company faces a cash crunch.

1. One mechanism to delay payment, preferably in conjunction with having documented the honest intent to pay the foregone compensation within two and one-half months after the end of the year, is based on the ‘going concern’ exception under section 409A.  Under this rule, the payment may be delayed until the risk to the company as a going concern has passed.  As noted, this rule is intended to assist with payments that are subject to the short-term deferral exception.  In some instances, the position has been taken that regular compensation payments that have not been paid may utilize this exception as well; however, it is not clear that the IRS would agree.
2. The company and employee/executive can enter into an agreement to pay a bonus equal to the foregone salary that vests and is paid only upon a new round of financing or a change of control.  If the specified event does not occur, no bonus is paid.
3. With some foresight and a little planning when the potential for a cash crunch surfaces, the executives and company can agree to reduce salaries immediately and then put in a section 409A compliant arrangement to pay a bonus in the future to get the executive to the desired level of compensation.
4. The company should review its compensation arrangements annually for springing section 409A obligations, regardless of cash flow.

Conclusion

As they love to say in the sports world, the best offense is a good defense.  Startup companies can defend themselves against running into problems with section 409A by structuring pay to increase as the company hits certain milestones rather than promising more than it can afford in the earliest stages.  Even key hires should be on board, if they are serious about making the company a success, with bonuses and pay increases tied to the company’s success.  And as everyone knows, it is better to address the issue up front than to have to fix it later, which is always much more expensive either in fees or the loss of key employees.