No Good Deed Goes Unpunished – Reducing Compensation in an Economic Downturn 

When a company faces an economic downturn, its board of directors and executives may agree to reduce or defer the executives’ compensation to preserve cash. While this approach makes good business sense, it can trigger harsh tax penalties for the executive if not managed properly. The risk is the unintended violation of the deferred compensation rules under Section 409A of the Internal Revenue Code of 1986, as amended (“Section 409A”).  

What Section 409A Governs. Section 409A broadly regulates any arrangement under which a service provider has a legally binding right to compensation in one taxable year that is payable in a later taxable year. The statute imposes strict requirements on both the timing of deferral elections and the events that may trigger payment. The permitted payment events are limited to: (1) a specified date or fixed schedule, (2) separation from service, (3) a change in control event (as defined in the regulations), (4) disability (as defined in the regulations), (5) death, and (6) an unforeseeable emergency. No other payment trigger is permitted. Tax penalties fall entirely on the executive—not the company—and include immediate income inclusion of all deferred amounts, a 20% additional tax on the amount included in income, and a premium interest charge calculated at the underpayment rate plus one percentage point, accruing from the earlier of the original deferral date or the date the amounts vested.  

The Dilemma. When a cash-strapped company asks its executives to accept a reduction in compensation in exchange for a promise to repay later, the arrangement creates a new legally binding right to deferred compensation subject to Section 409A. The problem is twofold. First, a deferral election under Section 409A must generally be made no later than the close of the taxable year preceding the taxable year in which the compensation is earned—a deadline that usually lapsed by the time a cash crunch hits. Second, Section 409A requires that the arrangement be documented in a written plan specifying the time and form of payment in advance, tied to one or more of the permissible payment events listed above. An informal promise to “make the executive whole later” does not satisfy this requirement.  

Where Violations Arise. The most common Section 409A violation in this context arises when the company fails to pay the deferred amounts by the short-term deferral deadline—March 15 of the calendar year following the year in which the compensation was earned—and no timely deferral election was made before the start of that year. The short-term deferral exception under Treasury Regulation Section 1.409A-1(b)(4) is the primary safe harbor that keeps these amounts outside the scope of Section 409A and missing that deadline triggers a violation. Similarly, an informal or implied understanding that the company will repay the deferred amounts “when it can afford to” does not qualify as a permissible payment event under Section 409A and will result in a violation. The IRS has indicated that it is unlikely to grant relief for Section 409A failures arising from financial downturns. Congress designed Section 409A partly to limit executive access to nonqualified deferred compensation during periods of company financial distress—precisely the situation at issue. 

Practical Alternatives. Cash-strapped companies have several Section 409A-compliant strategies available, though each involves tradeoffs.  

Permanent Compensation Reduction. A true, permanent compensation reduction—with no promise, understanding, or expectation of future repayment—eliminates the deferred compensation issue entirely because there is no legally binding right to future payment. Executives may oppose what amounts to a forfeiture of earned compensation, so companies should clearly document that the reduction is irrevocable and unconditional.  

Repayment Within the Short-Term Deferral Window. If the company can repay the amounts within the short-term deferral period, it may pay the previously reduced amounts by March 15 of the calendar year following the year in which the amounts vested, satisfying the short-term deferral exception and avoiding Section 409A.  

Prospective Deferral Arrangement. With advance planning, companies can reduce future compensation and simultaneously establish a new Section 409A-compliant deferred compensation arrangement—with a proper initial deferral election made before the start of the applicable year and payment tied to one or more permissible payment events, such as a specified date, a change in control event, or separation from service—to give executives an opportunity to recover the forgone compensation in the future.  

The Bottom Line. The time to plan for a downturn-related compensation adjustment is before it becomes necessary. Once a crisis hits and compensation has already been earned, the alternatives narrow considerably—and the consequences of getting it wrong fall squarely on the executives. Companies that foresee financial headwinds should engage executive compensation counsel early to structure compensation adjustments that protects both the company’s cash position and its executives from avoidable tax exposure. 

If you have questions about structuring executive compensation reductions to comply with Section 409A, please contact a member of our Executive Compensation and Employee Benefits practice.