In the life of a startup, sometimes the company runs out of cash to pay its salaried and wage employees. In order to keep going, the founders may decide to “defer” wages and salaries until fortunes improve, or the company raises another round or sells.
But deferring compensation raises a couple of legal consequences that founders may not be aware of. Firstly, deferring compensation can result in employment law violations, depending on the state, and especially if the compensation is not eventually paid — such violations can lead to state fines, as well as double or treble damages and attorneys’ fees in the event of civil litigation. Second, deferring compensation may lead to additional taxes and penalties for employees under Section 409A of the Internal Revenue Code (which normally applies to stock options, but technically covers all deferred compensation plans).
A better option than deferring compensation is simply to reduce salaries and make up the difference in contingent incentive bonus payments. Salaries can be reduced to whatever level the company can handle — although be careful that the reduction doesn’t violate a prior employment agreement (oral or written), and get the employee to agree to the reduction in writing — while incentive bonus payments, which will make up the difference of the reduction, can be made contingent upon a vesting event such as a financing round or sale of the company. Again, you will want the employee to agree in writing to such an incentive bonus plan, and have it made clear that if the vesting event doesn’t occur, there is no obligation to pay the bonus. A carefully structured plan under this arrangement may be able to avoid employment law and tax liabilities for employer and employee alike.