Deferred Salary: A Trap
By Joe Wallin | April 2026
Founders and early-stage startup employees often face cash constraints. The company cannot afford to pay market-rate salaries, so compensation is deferred — either verbally, through handshake agreements, or via informal IOUs.
This feels reasonable in the moment. The employee understands the company's cash situation. Everyone agrees that they will settle up once the company has more cash, or after a fundraising round, or at exit. It is how many startups operate.
But deferred salary creates a serious federal tax trap. Informal deferrals are often treated as "deferred compensation" under Section 409A of the tax code. And if your deferred compensation arrangement violates Section 409A, the recipient faces a catastrophic tax penalty: 20% federal excise tax on top of ordinary income tax, plus interest and potential penalties from state revenue authorities.
This post explains the trap, how to avoid it, and what to do if you have already created a violation.
What Is Deferred Compensation?
Deferred compensation is any arrangement where an employer agrees to pay an employee for services rendered in one year, but the payment is made in a different year.
This is broader than you might think. Examples include:
- Verbal promises of future payment. "I owe you $50,000 in back salary once we raise our next round." This is deferred compensation.
- Informal IOUs. A founder signs a note saying "I owe Employee $100,000 payable when the company has cash." This is deferred compensation.
- Back pay agreements. "We are short on cash this quarter, so let's pay you 50% of your salary now and 50% in Q4." This is deferred compensation (the Q4 portion).
- Convertible notes issued by the company to founders or employees. A note saying "The company owes you $200,000, which will convert to equity if we don't pay by [date]." This may be deferred compensation, depending on the terms.
- Equity acceleration tied to non-compete or consulting agreements. "Your unvested stock will accelerate if you stay for another year and sign a non-compete." This is often treated as deferred compensation.
- Severance arrangements. "If you are terminated without cause, we will pay you six months of additional salary." This is deferred compensation.
The common thread: the employer has incurred an obligation to pay, but the payment is deferred to a future year.
The Section 409A Problem
Congress enacted Section 409A of the tax code in 2004 to prevent wealthy executives and employees from deferring income into lower-tax years. The statute is complex, but the key rule is simple: if a deferred compensation arrangement does not comply with Section 409A, the participant is taxed on the deferred amount immediately (when the deferral is made), plus a 20% federal excise tax, plus interest.
Let me give you an example of how devastating this can be.
The Penalty Math: A Real Example
Imagine a founder receives a verbal promise from the company: "You are owed $100,000 in back salary that we will pay once we raise our Series A."
The company raises a Series A two years later. The back pay obligation is now due.
But here is the tax impact:
- Year 1 (when the promise was made): Even though no money was paid, the employee has $100,000 in taxable income from the deferred compensation arrangement. The employee owes ordinary income tax on $100,000 (37% federal + state taxes = ~45% combined), plus a 20% federal excise tax. Total tax on $0 of cash received: $65,000. The employee has no cash to pay this tax.
- Year 3 (when the money is actually paid): The company pays the $100,000 (which is now deductible as a business expense). The employee receives $100,000 in cash but has already been taxed on it in Year 1, so technically there is no additional income tax. However, the $100,000 is still subject to payroll taxes (Social Security and Medicare withholding).
- Interest and penalties: If the IRS challenges the arrangement, there are additional penalties for failing to comply with 409A. Penalties can range from 20% to 40% depending on the circumstances.
The bottom line: the employee triggered a $65,000 tax liability in Year 1 when zero cash was received. If the company later runs out of cash and never pays the back salary, the employee is stuck with the tax bill and no compensation.
When Is a Deferred Compensation Arrangement Compliant?
Section 409A compliance is complex and depends on the specific arrangement. However, the basic requirements are:
1. Written plan. The arrangement must be documented in writing. Verbal promises are never compliant with 409A. The written plan must specify:
- The amount (or the formula for calculating the amount).
- The timing of payment (e.g., "paid on separation from service," "paid on the occurrence of a specific event," "paid on a specified date").
- The conditions under which payment will be made.
2. Specified payment events. The plan must provide that payment will occur upon one of the following events:
- Separation from service (termination of employment).
- Disability or death.
- A specified time or date (e.g., "December 31, 2025").
- A change in control of the company (subject to specific rules).
- An unforeseeable emergency (very narrow definition).
3. No acceleration. The plan must not include provisions that allow the employee to accelerate or change the timing of payment. In other words, once the payment date is set, it is locked in.
4. No discounting. If payment is deferred, the arrangement must not involve any implicit or explicit discount. For example, you cannot say "We owe you $100,000, but we will only pay $80,000 when you leave." (That discount could be interpreted as deferred compensation with a penalty.)
For startups, the cleanest approach is to avoid deferred compensation altogether. If you cannot pay salary immediately, use one of the alternatives described below.
The Washington Income Tax Angle
Even if a deferred compensation arrangement is 409A-compliant for federal purposes, Washington residents face an additional tax complication.
Washington's 9.9% income tax takes effect on January 1, 2028, for income exceeding $1 million. Deferred compensation is included in your "income" for purposes of Washington's income tax, and it is taxed when paid, not when earned.
This creates a potential timing issue. If you defer salary for three years and then receive it all in a single year (2028 or later), you may trigger a large Washington income tax bill in that single year, even though the underlying services were performed (and the income was earned) over three years.
Washington does not currently have any relief provisions for bunched income or averaging mechanisms. So a deferred compensation payment made in 2029 or later is taxable in full in the year of payment, regardless of when the services were rendered.
This is another reason to avoid deferred compensation: it can create a Washington tax spike years after the services were provided.
Alternatives to Deferred Salary
If your startup cannot afford full market-rate salary, consider these compliant alternatives:
1. Lower salary + equity. Pay a reduced salary (enough to cover basic living expenses) and grant additional equity (stock options or RSUs) to make up the difference. The equity vests over time (typically 4 years), and it is not subject to 409A because the vesting schedule is set at the time of grant. This is how most startups compensate founders and early employees.
2. Formal loan arrangements. If you want to formally loan money to a founder or employee, you can execute a proper promissory note with stated terms: interest rate, maturity date, repayment schedule. For this to be a loan (not deferred compensation), it must have the attributes of a genuine loan: interest, repayment obligation, and evidence of indebtedness. If the loan is forgiven later (e.g., if the company fails), that forgiveness is taxable income, but at least the timing is clear and there is no 409A violation.
3. Convertible notes from founders to the company. Instead of the company owing the founder, the founder can purchase convertible notes from the company. The notes have a stated maturity date and interest rate. If the company later raises equity financing, the notes convert into stock. If the company does not raise financing, the founder is repaid. This creates a cleaner legal structure than an informal IOU and can avoid 409A issues if structured properly.
4. Formal bonus plans with specified payment dates. If the company wants to defer bonus payments, it can adopt a written bonus plan that specifies the bonus amount, the performance metrics or conditions, and the payment date (e.g., "bonuses are paid in March of the following year"). The plan must be adopted before the year in which the bonus is earned, and the payment date must be fixed and not subject to employee discretion. This can be 409A-compliant if structured correctly.
5. Back pay that is paid within a specified window. If the company falls short on cash and is unable to pay salary for a period, it can commit to paying back wages within a defined timeframe (e.g., "by December 31 of the same year" or "within 90 days"). The sooner the back pay is made, the safer from a 409A perspective. Paying back wages within the same calendar year is generally safer than deferring into a future year.
Common Scenarios and How They Go Wrong
Scenario 1: The verbal promise. A founder tells an employee, "Once we have more cash, I will make sure you get the back salary you are owed." Six months later, the company has cash and pays the back salary. Even though the back salary was eventually paid, the initial verbal promise is a 409A violation because it was not in writing and did not specify a fixed payment date. The employee is taxed on the deferred amount when the promise was made, not when the payment occurred. Penalty: 20% federal excise tax plus ordinary income tax.
Scenario 2: The informal IOU. A founder signs a handwritten note: "I owe you $50,000. I will pay you when the company is profitable." Years pass, the company becomes profitable, and the founder pays. But the IOU did not specify a payment date — it was contingent on profitability, which is not a compliant 409A "specified event." The employee is in violation from the moment the note was signed. Penalty: 20% excise tax when the violation is discovered, retroactively.
Scenario 3: The founder loan that gets forgiven. A founder takes a personal loan from the company with the understanding that the loan will be forgiven if the company exits. When the company is acquired, the founder's loan is forgiven as part of the transaction. The forgiveness of the loan is taxable income (the company gets a deduction, the founder gets income). But if the arrangement was structured as a disguised deferralpayment, with the "forgiveness on exit" condition built in from the start, it may also be a 409A violation. The founder is taxed on the loan amount in the year it was made, plus again when it is forgiven, plus penalties. Penalty: significant.
Scenario 4: The split salary (half now, half later). An employee agrees to work for 50% of their promised salary immediately and receive the other 50% in Q4 of that year. If the company fails to pay the Q4 portion by December 31, the deferred salary carries into the next year. The deferral into the next year is problematic unless a written plan specifies December 31 as the payment date and the payment actually occurs. If the Q4 payment is vague — "paid when we have cash" — it is a 409A violation from the moment the deferral agreement was made. Penalty: 20% excise tax plus ordinary income tax on the deferred amount in the year the deferral was made.
How to Fix a 409A Violation
If you have already created a 409A violation (e.g., you have deferred salary owed to founders or employees), you have options:
1. Pay immediately. The fastest way to resolve a violation is to pay the deferred amount as soon as possible. Once the money is paid, the immediate taxation and excise tax penalties may be avoided (though this depends on when the IRS discovers the violation). This is not a legal fix, but it mitigates the damage.
2. IRS correction programs. The IRS has published guidance on correcting 409A violations. There is a "Correction Window" (if the violation is discovered before an IRS audit) where certain violations can be corrected by paying a small user fee and amending tax returns. The correction program is described in IRS Notice 2010-80. If your violation falls within the correction window, you may be able to cure it with minimal penalties.
3. Restructure the arrangement. In some cases, you can restructure deferred compensation retroactively to make it 409A-compliant. For example, if you have a verbal promise of back pay, you can retroactively adopt a written plan that specifies the payment date and treats the arrangement as payment of a specified bonus. The IRS has some flexibility here, but there are limits — the earlier in the process you restructure, the better.
4. Seek IRS guidance. If the violation is complex or the amount is large, you can request a private letter ruling from the IRS asking for relief. This is expensive (several thousand dollars in professional fees) and slow (4-6 months), but it can resolve uncertainty if the violation is significant.
The key point: the sooner you address a 409A violation, the better. Do not wait for an audit.
Key Takeaways
Deferred salary is a tax trap. Informal deferrals are often treated as deferred compensation under Section 409A, and violations trigger a 20% federal excise tax plus ordinary income tax, even if the money is eventually paid. Washington's income tax complicates the picture further — deferred compensation paid in 2028 or later will be taxed at 9.9% in the year of payment, potentially creating a large tax spike years after the underlying services were rendered.
The solution is simple: avoid informal deferrals. If you cannot pay full salary immediately, use equity, formal loans, or properly documented bonus plans instead.
If you have already created deferred compensation (verbal promises, handwritten IOUs, informal back-pay agreements), address it now. Pay the balance, restructure the arrangement retroactively with a written plan, or seek IRS guidance. The earlier you resolve it, the better.
This post is for informational purposes only and does not constitute legal or tax advice. Consult with a qualified tax professional regarding your specific circumstances.
