Key points covered in this article:

  • Deferred compensation in government contracting must follow strict IRS Section 409A rules and FAR 31.205-6 requirements to avoid tax penalties and disallowed costs.

  • A written, pre-established deferred compensation plan is essential, detailing payment timing, events, and compliance to ensure allowability and audit defense.

  • Planning deferred compensation before services are performed is crucial to maintain compliance and avoid costly IRS and government contract issues.

It can start innocently enough: you are a government contractor, cash flow is tight, and you tell yourself you will defer your compensation until next quarter. After all, you are the owner—can’t you decide when to pay yourself?

The answer is: Maybe.

Deferred compensation is one of the most misunderstood areas in owner-run government contracting businesses. Even if the plan only covers one person (the owner), it may trigger a landmine of compliance requirements under IRS Section 409A, FAR 31.205-6, and ERISA. Here is what you need to know.

What Is Deferred Compensation?

Deferred compensation refers to an arrangement where payment for services is earned in one year but paid in a future year. Deferred compensation typically involves a formal or informal plan to push earnings into future tax years.

Often these are contemplated to manage cash flows or defer taxes. However, when you do this without structure, that can lead to potential compliance issues.

Does 409A apply?

Section 409A of the Internal Revenue Code applies to any arrangement where compensation is earned in one year but paid in a future year and applies to nonqualified deferred compensation plans. It will be applicable even if you are an owner of a business or if you are the only person covered by the plan.

Under Section 409A, a compliant plan must:

  • Be in writing before services are performed
  • Specify the timing and form of payment
  • Limit payments to specific events (e.g., separation from service, death, fixed date)
  • Prohibit the acceleration of payment

Failure to comply can mean that all deferred amounts become immediately taxable, plus a 20% additional tax penalty and interest (IRC §409A(a)(1)(B)). Even if the arrangement is not funded, constructive receipt rules could apply if you have access or control over those assets and this could be another trigger for early taxation.

FAR 31.205-6(k): The Government Cares Too

If your company performs on cost-reimbursable contracts or submits incurred cost proposals, allowability becomes a key factor. We look to the Federal Acquisition Regulation (FAR) which governs what is allowable.

FAR 31.205-6(k) states that deferred compensation is allowable if:

  • It is based on an agreement made before the services are performed
  • It is reasonable for the services rendered
  • It is appropriately accrued in accordance with GAAP
  • It complies with IRC requirements (including 409A)

If there is no documentation around the arrangement, then there is a possibility of no allowability, as the DCAA may question allowability.

You Still Need a Plan Document

Even if it is just for yourself, you need a written deferred compensation plan. Verbal intentions or after-the-fact journal entries are not a substitute. A valid plan includes:

  • An election to defer compensation made before the start of the performance period
  • A defined vesting schedule (if applicable)
  • Stated payment terms and permissible payment events
  • Consistent application (and preferably board or owner resolution)

Having the plan adopted via a board or owner resolution gives it formality and a defense for reasonableness of the arrangement.

Bottom Line: Compliance First, Then Compensation

Formalizing how and when you pay yourself is not just about preference; it is about compliance. Without structure, you can risk IRS penalties, disallowed contract costs, and audit findings. The best time to plan a deferred compensation arrangement is prior to services being performed and not after the year end close or in response to a DCAA request.

For more information on deferred compensation and compliance requirements under IRS Section 409A, FAR 31.205-6, and ERISA, contact PBMares Government Contracting Partner Neena Shukla.