Deferred salary or deferring salaries is an alluring trap in startup land. A company’s runway gets shorter. The company wants to extend its runway. It can be tempting for the founders to start “deferring” salary. Maybe some non-founder employees start deferring salary too.
Deferred Salary: The problems?
What are the problems with simply 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 of 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.
So, what to do?
Don’t defer salaries. Reduce salaries. Get folks to agree in writing that their salary has been reduced. Then, if you want, you can agree to pay a “bonus” upon the occurrence of a well-defined milestone that includes a substantial risk of forfeiture. 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.
Bottom line: Reduce salaries. Don’t defer unless you really want to take the time to do it right.
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