Managing cash-flow problems
For many small companies, a typical method of managing cash-flow problems has been for corporate-insider employees to voluntarily defer their salaries until the next big check arrives in the company coffers. Sometimes, that happens in a few weeks, allowing all employees to get back on their regular payroll cycle. Too often, though, the dry spells last longer than anticipated, and the corporation ends up booking a substantial back-pay obligation to its executives. Most executives in this situation would consider their salary deferrals to be generous and noble acts, with the insiders sacrificing their own financial well-being to help their company in a time of need.
Risk for penalties
Imagine the surprise and indignation, then, when the self-sacrificing employees learn that their salary deferrals might have exposed them to penalty taxes. Section 409A of the Internal Revenue Code was enacted in 2004 to prevent corporate executives from cavalierly deferring compensation they’d earned, in an effort to postpone the taxation of that compensation to a more favorable future tax year. But the 409A legislation as drafted and interpreted by regulations vastly overshoots its target. Section 409A can now impose a penalty tax of 25 percent (20 percent federal and 5 percent California) on “nonqualified deferred compensation” that does not comply with the rigid 409A timing rules. The statute generally provides that all compensation, once earned, must be paid either as of the date the employee’s rights to the compensation are vested or at one of five sanctioned 409A trigger events: (i) a designated and specific future date, (ii) a separation from service, (iii) the employee’s disability, (iv) the employee’s death, or (v) a change in corporate control. If nonqualified deferred compensation does not satisfy the 409A rules, the compensation is taxable on the vesting date (whether or not paid to the employee at that time), the 25-percentage-point supplemental tax applies (and is to be enforced by employer withholding), and certain penalty interest amounts can be applied to the employee’s tax liability.
What to do in these circumstances?
There are a few possible workarounds, none of which is completely satisfactory. Under the short-term deferral rule, compensation is normally deemed paid on time if it is paid no later than the 15th day of the third month following the close of the year in which the compensation was due. Under the going-concern rule, an employer does not need to make a compensation payment when due if doing so would “jeopardize the ability of the [employer] to continue as a going concern” (but the catch-up payment then must occur no later than the date on which making the payment would no longer have that effect). And under general principles of compensation taxation, an employer could pay the compensation on time, subject to regular wage withholding as appropriate, and then have the employee loan back the after-tax amount to the employer – this approach, of course, would alleviate some of the cash-flow problems of the employer, but it would deplete corporate cash reserves by the amount of tax withheld.
The IRS is only now starting to pay significant attention to 409A problems on audit. Most practitioners hope that the focus of tax authorities will be on situations that prompted the original legislation, involving clearly earned and payable compensation that is being improperly postponed with intent merely to defer the employee’s tax hit. But the statutory and regulatory language is expansive – there is a fear that nothing can catch her, nothing can touch that 409 – here’s hoping there will be a legislative fix to this overreaching set of rules.
This article originally appeared in the August 2015 edition of the ACBA Business Section Newsletter. Read the full newsletter on the ACBA Business Law Section’s webpage.