Deferred (and Unpaid) Salary: A Trap for Founders

By Joe Wallin | Updated June 2026

Founders and early-stage startups routinely run short of cash. So they skip salary, or defer it — verbally, on a handshake, or with an informal IOU. The understanding is always the same: we'll settle up after the next round, or at exit, or once we're profitable.

Deferring salary does not make the obligation disappear. It converts a cash-flow shortfall into the founder's personal legal exposure — and in Washington, that exposure is severe. There is also a tax trap layered on top of it. This post covers both heads of the problem and what to do instead.

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.

The defense a cash-strapped founder reaches for — "we couldn't afford it" — does not exist. The Washington Supreme Court rejected financial inability as an excuse in Schilling v. Radio Holdings, Inc., 136 Wn.2d 152 (1998), and again in Morgan v. Kingen, 166 Wn.2d 526 (2009), where corporate officers were held personally liable for wages that went unpaid straight through the company's Chapter 11 bankruptcy. The court's reasoning is blunt: the business decisions that create the insolvency are themselves volitional, so nonpayment is willful. Running an undercapitalized company, overspending, or diverting cash to other obligations are not defenses — they are the conduct the statute reaches.

The only real off-ramp is a bona fide dispute over whether the wages are actually owed. An inability to pay wages everyone agrees are owed is not a dispute. And willful nonpayment is not just a civil problem — under RCW 49.52.050 it is a misdemeanor.

So the founder who says "work for now, I'll make you whole after the raise" has not deferred a problem. He has personally guaranteed the wages, doubled the downside, handed the other side its attorney fees, and — if the company later can't pay — put himself first in line for a lawsuit he cannot win on the merits. This is also why investors ask, in diligence, whether there are any outstanding or deferred wage obligations before they fund.

The Minimum-Wage Problem (Even Among Co-Founders)

Skipping cash compensation creates a related, federal-and-state minimum-wage exposure. A founder acting as a corporate officer is generally an employee, and it is difficult to escape minimum-wage and overtime coverage. The federal Fair Labor Standards Act exempts a bona fide executive who owns at least a 20% equity interest and is actively engaged in management — but Washington has no equivalent carve-out, and Washington and Seattle minimum-wage levels run above the federal floor. For a Seattle-area startup, the state rules control.

Two ways this goes wrong:

• The minority co-founder who is let go. A 10% co-founder who took only equity, never any cash, and is not a properly exempt salaried employee, is terminated and feels aggrieved. He sues the company and the other founders personally for failure to pay minimum wage. He may face an uphill battle, but it is a costly thorn — and one you avoid entirely by paying at least minimum wage in cash.
• The unpaid contractor who claims the IP. You classify a service provider as a contractor, pay only in vesting equity, and terminate before vesting, so the equity reverts. That person may sue for failure to compensate — and, to add insult to injury, assert that they own the IP they created, because you never paid them for it.

Worker classification is the lever here, and it is fact-specific — it turns largely on how much control the company exercises. A genuine independent contractor isn't owed minimum wage. But a co-founder who is also an officer usually cannot be classified as a contractor. If the company has to cut a minority founder loose, that person can sue the company and the dominant founders for unpaid minimum wage and, under Washington law, double damages and attorney fees.

The majority founder is a practical exception: you are unlikely to sue your own company, so in the very earliest days you can often go unpaid. That changes the moment you take outside money — investors want assurance that there is zero exposure from outstanding wage claims.

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.

Congress enacted Section 409A in 2004 to stop executives from shifting income into lower-tax years. The key rule: if a deferred compensation arrangement does not comply with Section 409A, the participant is taxed on the deferred amount when it vests — for salary already earned, the year it is earned — plus a 20% additional tax and premium interest at the IRS underpayment rate plus one percent.

The Penalty Math

Imagine a founder is told: "You're owed $100,000 in back salary; we'll pay it once we raise our Series A." The Series A closes two years later and the back pay comes due. The tax impact:

• Year 1 (the promise): Even with no cash paid, the $100,000 is taxable income from the deferred compensation arrangement. Ordinary income tax (≈45% combined federal and state) plus a 20% federal additional tax is roughly $65,000 — on $0 of cash received.
• Year 3 (payment): The company pays the $100,000 and deducts it. The employee already paid income tax in Year 1, but the payment is still subject to payroll taxes.
• Interest: Premium interest runs back to the year of deferral, and some states (California, for example) add their own penalty.

The bottom line: a $65,000 tax bill in Year 1 against zero cash. If the company never pays the back salary, the employee is left with the tax bill and nothing else.

When Is a Deferred Compensation Arrangement Compliant?

Compliance is complex and arrangement-specific, but the basics are:

1. Written plan. The arrangement must be in writing. A purely verbal promise generally can't satisfy 409A's documentation rules — unless it is simply paid within the short-term deferral window below, in which case 409A never applies. A compliant deferral specifies the amount (or formula), the timing of payment, and the conditions of payment.

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. No acceleration. Once set, the payment date is locked; the employee can't move it.

4. No discounting. No implicit or explicit haircut for early or late payment.

The short-term deferral escape hatch. If the compensation is actually paid by the 15th day of the third month after the end of the year in which it vests — March 15 of the following year for a calendar-year taxpayer — Section 409A simply doesn't apply. Salary earned and vested in one year and paid by that March 15 is exempt, however informal the arrangement was. Beyond that window, the cleanest move is to avoid deferred compensation altogether and use one of the alternatives below.

A Washington Income Tax Wrinkle

One additional timing point for Washington residents: because Washington's 9.9% tax (effective January 1, 2028, on income above $1 million) taxes deferred compensation when paid rather than when earned, a multi-year deferral that pays out in a single post-2028 year can bunch into one large taxable year with no averaging relief. The mechanics are covered in detail in Deferred Compensation and Washington's New 9.9% Income Tax.

Alternatives to Deferred Salary

If you can't afford full market salary, use a compliant structure instead:

1. Lower salary + equity. Pay a reduced cash salary that covers basic living expenses and grant equity to make up the difference. The equity vests on a schedule set at grant, so it isn't 409A deferred compensation. This is how most startups pay founders and early employees. (See founder vesting schedules.)

2. Formal loan. A genuine promissory note — stated interest, maturity, repayment obligation — is a loan, not deferred compensation. If it's later forgiven, the forgiveness is taxable income, but the timing is clear and there's no 409A violation.

3. Convertible notes from founders to the company. Rather than the company owing the founder, the founder buys convertible notes with a stated maturity and rate. They convert on a financing or are repaid if none occurs — cleaner than an informal IOU, and 409A issues can be avoided if structured properly.

4. Written bonus plan with a fixed payment date. Adopt the plan before the year the bonus is earned, fix the amount or formula and the payment date, and keep the date out of employee discretion.

5. Back pay inside a defined window. If you fall short for a period, commit to paying within a defined timeframe. Paying within the same calendar year — and certainly by the following March 15 — is far safer than deferring into a future year.

Common Scenarios and How They Go Wrong

Two clarifications first. Section 409A only bites when payment lands outside the short-term deferral window — salary earned and actually paid by the following March 15 is exempt no matter how informal the promise. And the 409A tax falls on the recipient, not the company. The scenarios below assume the deferral pushes payment past that window; the wage-liability exposure in the first half of this post applies regardless.

Scenario 1: The open-ended verbal promise. "Once we have more cash, I'll make sure you get your back salary." If the payment crosses the following March 15 without a written, fixed-date plan, the open-ended promise is a 409A violation — the employee is taxed in the year the right vested, not when paid. Penalty: 20% additional tax plus ordinary income tax. (If you pay it before that March 15, there is no 409A issue — though the wage-liability exposure still applies if you don't.)

Scenario 2: The contingent IOU. "I owe you $50,000, payable when the company is profitable." Profitability is not a compliant 409A payment event, so the arrangement is non-compliant from the moment the note is signed. Penalty: 20% additional tax, assessed when discovered.

Scenario 3: The founder loan that gets forgiven. A founder takes a company loan understood to be forgiven on exit. Forgiveness is taxable income. But if the "forgiveness on exit" condition was baked in from the start, the arrangement may be a disguised deferral payment and a 409A violation as well — taxed when made, again when forgiven, plus penalties.

Scenario 4: The split salary (half now, half later). Work for 50% now, 50% in Q4. If the Q4 portion isn't paid and slides into the next year on a vague "when we have cash" basis, it's a 409A violation from the moment of the agreement. A written plan fixing a December 31 payment date — actually honored — is the difference.

What a Startup Should Do

• Paper every relationship. Every worker, employee or contractor, signs a confidentiality and IP assignment agreement. Think of it as the lift pass — no one skis your mountain without one.
• Document the terms. Employees sign an at-will offer letter; properly classified contractors sign a well-drafted independent contractor agreement.
• Pay officers at least minimum wage in cash. If you truly can't, don't make that person an officer, treat them as a contractor while you legitimately can, and pay a small amount of cash to make the IP assignment binding. This works for someone contributing nights and weekends in the earliest days.
• Don't rely on "I won't sue." Informal assurances among friends and family evaporate when relationships sour. A worker can never waive the right to minimum wage, even in writing.
• Use a payroll service so withholding is deposited and employment tax returns are filed on time.
• Consider the salaried-exempt route. You may qualify a founder/employee as an exempt salaried executive under WAC 296-128-510. That doesn't eliminate the obligation to pay, but it can lower the required salary floor if the other requirements are met.

How to Fix a 409A Violation

If you've already created one — deferred salary owed to founders or employees — you have options:

1. Pay immediately. Paying the deferred amount as fast as possible mitigates the damage, though whether it cures the issue depends on timing relative to any IRS examination.

2. IRS correction programs. Notice 2010-80 describes a correction window for violations caught before audit, sometimes resolvable with a small user fee and amended returns.

3. Restructure. A verbal back-pay promise can sometimes be restructured retroactively into a written, fixed-date bonus arrangement. The earlier you do it, the more room you have.

4. Seek IRS guidance. For large or complex violations, a private letter ruling can resolve uncertainty — expensive and slow, but available.

The constant: the sooner you address it, the better. Do not wait for an audit.

Key Takeaways

Deferring — or simply skipping — startup salary is a two-headed trap. The bigger and more certain head is personal liability: under Washington's wage statutes, the officers and agents who decide not to pay earned wages are personally on the hook for double the wages plus attorney fees, with no "we ran out of money" defense and potential criminal exposure. The second head is tax: an informal deferral of already-earned salary can violate Section 409A and hit the recipient with a 20% additional tax on income they never received in cash.

The fix is the same for both. Don't run informal, open-ended deferrals. Pay at least minimum wage in cash to anyone who is an employee, paper every relationship, and where you can't pay full salary, use equity, a formal loan, or a properly documented bonus plan. If deferred compensation already exists, clean it up now.

This post is for informational purposes only and does not constitute legal or tax advice. Consult a qualified professional regarding your specific circumstances.