By Joe Wallin | Updated September 14, 2026 — wage liability, compensation choices, and Section 409A correction rules.
A startup is short of cash, so its founders agree to wait for salary until the next financing, an exit, or profitability. The agreement may be verbal or recorded in an informal IOU. Either way, the company needs to distinguish future compensation from wages it already owes.
Deferring salary does not make an earned wage obligation disappear. It can create personal liability for those responsible for withholding wages and a separate tax problem for the recipient. Start with three questions: are wages legally owed, does Section 409A apply, and what remedy is available on the actual facts?
The Real Trap: You Are Personally Liable for the Wages
Under RCW 49.52.050 and RCW 49.52.070, an employer's officers, vice principals, and agents are personally liable for the willful failure to pay earned wages — for twice the amount of the wages withheld (exemplary damages), plus the employee's costs and reasonable attorney fees. This is not corporate liability that stops at the company. It reaches the individuals who controlled the decision not to pay.
Financial inability alone is not a defense. The Washington Supreme Court rejected it in Schilling v. Radio Holdings, Inc., 136 Wn.2d 152 (1998), and again in Morgan v. Kingen, 166 Wn.2d 526 (2009), which held corporate officers personally liable for unpaid wages despite the conversion of the company’s Chapter 11 case to Chapter 7 liquidation. Choosing to spend available funds on other obligations can support a finding of willful nonpayment.
A bona fide dispute about whether wages are owed can defeat willfulness. RCW 49.52.070 also contains an exception for an employee who knowingly submitted to the violation. Its application is fact-specific; agreeing to wait for payment is not a general waiver of minimum-wage protections. RCW 49.52.050 also provides potential misdemeanor exposure.
A founder who promises payment after a financing can expose both the company and the individuals responsible for withholding earned wages to a claim. Personal statutory liability is different from signing a personal guarantee, and liability depends on the statutory elements and defenses. Investors therefore ask about unpaid and deferred wages during diligence.
The Minimum-Wage Problem (Even Among Co-Founders)
The minimum-wage and overtime analysis depends on coverage and exemptions. Both federal law and Washington law recognize a qualifying owner-manager exemption. Under WAC 296-128-510(2), an employee with a bona fide equity interest of at least 20% who is actively engaged in management qualifies for the executive exemption without the ordinary salary requirement. Compare 29 C.F.R. §541.101. The ordinary executive exemption under WAC 296-128-510(1) instead requires the specified duties and salary. An officer title alone does not establish either exemption. Check applicable state and local requirements, and separately identify any wages the company has already promised.
Two ways this goes wrong:
- The minority co-founder who is let go. A 10% owner does not meet the 20% ownership test. If that person is a covered employee and no other exemption applies, equity compensation does not replace required cash wages or overtime. Termination can bring those unpaid obligations into dispute.
- The service provider with disputed compensation and IP. Equity-only arrangements require both proper worker classification and enforceable compensation and IP-assignment terms. Nonpayment can create contract claims; whether IP was transferred depends on the actual agreement and applicable law, not a universal rule that unpaid work automatically belongs to the worker.
Worker classification depends on the applicable legal test and the actual relationship. Changing a title or calling someone a contractor does not establish independent-contractor status. Determine employee coverage, exemptions, agreed compensation, and the individuals responsible for payment separately.
The owner-manager exemption does not erase salary already promised under an agreement. Outside investment can dilute an owner below the 20% threshold, so reassess ownership and duties when the facts change. A covered worker’s informal assurance that “I won’t sue” does not waive required minimum wages.
The Second Trap: Section 409A
Even setting the wage statutes aside, deferring already-earned salary into a later year can trigger Section 409A of the tax code — and the penalty falls on the recipient, the person you were trying to help.
Under Section 409A(a)(1), a plan failure can require income inclusion in the year of failure for affected compensation deferred in that year and earlier years, to the extent vested and not previously included. The recipient may also owe a 20% additional federal tax and premium interest. The year of vesting and the year of failure are not necessarily the same.
The Penalty Math
Assume a founder has a vested, legally binding right to $100,000 in Year 1, the arrangement is subject to Section 409A, and a failure in Year 1 requires inclusion of the entire amount. No exemption or correction relief applies. The company pays in Year 3 after a Series A. The illustrative tax consequences are:
- Year 1: If all $100,000 falls in the 37% federal bracket, ordinary federal income tax plus the 20% additional tax totals $57,000 before premium interest and other taxes. This assumes other income already places the entire inclusion in that bracket; $100,000 alone does not establish a 37% rate. Separately analyze payroll-tax timing, reporting and withholding.
- Year 3: Track the amount previously included so the same compensation is not simply taxed twice as income. Employer deduction timing and FICA treatment require separate analysis; do not assume both follow the cash-payment date. FICA nonduplication depends on the amount having been properly taken into account under the applicable rules.
- Interest: Section 409A’s premium-interest calculation looks back to the year first deferred or, if later, the first year the amount was no longer subject to a substantial risk of forfeiture. It is separate from the 20% additional tax.
The practical risk is tax before cash: under these assumptions, the recipient has a $57,000 federal tax cost before receiving the salary. If the company never pays, review the applicable loss and correction rules rather than assuming the original inclusion automatically disappears.
When Is a Deferred Compensation Arrangement Compliant?
Compliance is complex and arrangement-specific, but the basics are:
1. Written terms and timely elections. A covered arrangement must satisfy applicable documentation and election rules. Identify the amount or formula, permissible payment timing, and conditions. A later written agreement does not automatically cure an earlier failure. An exempt short-term deferral is a separate analysis.
2. Specified payment events. Payment must occur on one of: separation from service, disability or death, a specified date, a change in control (subject to rules), or an unforeseeable emergency (narrowly defined).
3. Payment changes are restricted. Accelerations are generally prohibited except as permitted by regulation. Subsequent deferral elections also have timing and additional-deferral requirements. Review those rules before changing a payment date.
4. Follow the terms in operation. A fixed payment date on paper is not enough if actual payment violates the applicable rules. Evaluate permitted delay, acceleration and correction provisions on their conditions rather than assuming any early payment or later amendment is harmless.
The short-term deferral exception. Under Treas. Reg. §1.409A-1(b)(4), both the arrangement’s terms and actual payment matter. The applicable period generally ends on the later of the 15th day of the third month after the end of the service provider’s or service recipient’s taxable year in which the right ceases to be subject to a substantial risk of forfeiture. For calendar-year parties, that is generally March 15 of the following year. A plan providing for deferred payment beyond that period does not become exempt merely because it pays early; the regulation’s Examples 5 and 6 expressly illustrate that limit. Narrow exceptions for certain delayed payments require separate analysis.
A Washington Income Tax Wrinkle
Washington’s enacted income tax begins in 2028 and starts with federal adjusted gross income, subject to state modifications, deductions, residency and sourcing rules. Compliant deferred compensation paid and included federally in a later year can bunch income into that year. A Section 409A failure may instead cause earlier federal inclusion; do not assume every arrangement is taxed only when cash is paid. The $1 million standard deduction is shared by spouses and registered domestic partners, and part-year and nonresident rules require separate modeling. See Deferred Compensation and Washington’s New 9.9% Income Tax and the Initiative 645 status tracker.
1. If you are setting future compensation
Agree on compensation before the work is performed. Check worker classification, applicable wage requirements and exemptions, then document the cash pay, equity and payment terms. Use an offer letter or contractor agreement appropriate to the relationship, with confidentiality and IP-assignment provisions. Run employee wages through payroll, including timely withholding deposits and employment tax returns.
Lower salary plus equity. A prospective arrangement must still satisfy applicable wage requirements. An actual transfer of restricted stock subject to Section 83 generally does not create deferred compensation merely because the stock is unvested. A promise to transfer stock in a later year requires separate analysis under Treas. Reg. §1.409A-1(b)(6).
For nonstatutory options and stock appreciation rights, the stock-right exemption requires, among other conditions, a grant-date exercise price at least equal to fair market value, qualifying service recipient stock, and no added deferral feature. Vesting alone does not exempt a discounted nonstatutory option. Statutory options have a separate exclusion. An RSU providing for payment beyond the short-term deferral period generally requires Section 409A compliance. See founder vesting schedules.
Fund payroll separately. A founder may advance new cash under a properly documented loan or convertible note, enabling the company to pay wages through payroll. The company still owes the founder under the financing instrument. Exchanging unpaid salary for a note is a different transaction and does not automatically cure wage or Section 409A problems.
Design future bonuses prospectively. Set the amount or formula and payment terms in time to satisfy the applicable documentation and election rules. Determine whether the bonus is an exempt short-term deferral or a compliant covered arrangement. The federal short-term deferral period does not extend state wage-payment deadlines.
2. If salary is already unpaid
Reconstruct the original promise, when compensation was earned and legally payable, vesting, actual payments, and who controlled payment decisions. Address the wage obligation promptly while evaluating the tax consequences. Not every late wage payment is a Section 409A failure, and an immediate payment is not a universal federal tax cure.
- “We’ll pay when we have cash” or “when we are profitable.” A binding right to earned salary may provide for deferred compensation without a permissible payment date. Profitability generally is not a permissible Section 409A payment event. If no exemption applies, the arrangement can fail.
- “Half now, half in Q4.” Determine when the second portion was legally payable, whether the original terms provided for deferral, and whether actual payment qualifies for an exception. A later operational failure does not automatically make the original agreement noncompliant from inception.
- “We’ll replace the salary with a note or equity.” Relabeling the obligation does not erase the wage claim or automatically cure a deferral failure. Review the consequences before changing the form or timing of payment.
- “The loan will be forgiven.” If the company advances cash to a founder, determine whether it is bona fide debt or compensation from the outset. A real loan has its own repayment, interest and tax consequences; prearranged forgiveness can change the analysis. Account for any prior income inclusion rather than automatically taxing the same principal both when advanced and when forgiven.
3. If you identify a Section 409A failure
Identify whether the failure is in the written terms, operation, or both. Before accelerating, delaying, repaying or restructuring compensation, check the correction procedure that fits the facts:
- Notice 2008-113 addresses specified operational failures.
- Notice 2010-6 addresses specified document failures.
- Notice 2010-80 modifies those procedures.
Relief has detailed eligibility, timing, reporting and other conditions; being outside an IRS examination alone does not establish eligibility. Preserve the original documents and record the true amendment date. A retroactive rewrite does not, by itself, cure the original arrangement.
For a material or complex failure, evaluate available administrative procedures and current IRS ruling restrictions with counsel. Do not assume a private letter ruling is available to resolve a Section 409A compliance question.
Start the review as soon as a payment problem arises, while correction options may still be available. For the broader equity rules, see the complete guide to equity compensation.
This post is for informational purposes only and does not constitute legal or tax advice. Consult a qualified professional regarding your specific circumstances.
