Key points covered in this article:

  • Why owner-only deferred compensation plans in government contracting must comply with IRS Section 409A and FAR 31.205-6(k), requiring formal documentation, pre-established terms, and reasonable compensation aligned with GAAP.

  • How plans may be exempt from ERISA rules as Top Hat Plans, a one-time Department of Labor filing is still required to mitigate audit risks.

  • Why business owners must be prepared for scrutiny from auditors like the DCAA and ensure proper disclosure, documentation, and justification of deferred compensation in financial and rate submissions.

Government contractor business owners often wear multiple hats, whether it is as CEO, business developer, or sometimes CFO. If you have ever thought about “paying yourself later,” you are not alone. However, structuring an owner-only deferred compensation plan is not just a smart tax move; it can be a compliance issue. If your company has cost-reimbursable contracts, performs work under CAS-covered awards, or submits indirect rate proposals, you should understand the full scope of regulations that apply.
Here is what you should consider.

What Counts as Deferred Compensation?

Deferred compensation is any arrangement where payment for services is made in a future tax year, unless it qualifies for a short-term deferral exception (which generally means paid within 2.5 months of year-end).

Some common examples of owner-only plans include:

  • Annual bonuses that are paid months or years after they are earned
  • Phantom equity or stock appreciation rights
  • Severance pay arrangements greater than the 2.5-month threshold

In smaller businesses, these are often in the form of informal promises. If the Plan creates an expectation of a future payment, it most likely will fall under IRC Section 409A.

409A Compliance for Owner-Only Plans

Section 409A applies regardless of whether you are the sole owner or employee. These are not exempt simply because they are for an individual or are internal.

To comply:

    • Establish a formal written plan before the services are performed
    • Clearly define the payment timing and triggering events (e.g., termination, retirement, or specific date)
    • Avoid any acceleration of payment except as allowed by regulation
    • Keep the plan unfunded and unsecured (subject to creditor risk)

FAR 31.205-6(k): What Makes It Allowable?

If you want to include deferred compensation costs in your indirect rates or bill the government, FAR compliance matters. Allowability requires:

  • Compensation must be reasonable (support with internal analysis, benchmarking surveys, or industry comparable)
  • The agreement must be pre-established (before work is performed), i.e., it was planned and expected
  • Payments must be allocated to the periods in which services were earned, as per GAAP
  • Avoid contingent or performance-based criteria that make the cost questionable

Such costs can be subject to scrutiny by the Defense Contract Audit Agency (DCAA), especially if the compensation increases net income significantly in a future period.

Is ERISA a Concern? Probably Not, But File Anyway

Most owner-only NQDC plans qualify as Top Hat Plans, which are exempt from ERISA’s funding and fiduciary requirements. However:

  • You must still file a one-time notice with the Department of Labor (DOL Reg. 2520.104-23)
  • Keep plan documents on file in case of a DOL or IRS inquiry

This filing can help reduce audit risk.

Disclosure and Audit Considerations

If you’re audited (financially or by DCAA), be prepared to:

  • Provide the plan agreement and board resolutions
  • Justify the compensation as reasonable
  • Show that accruals align with GAAP and the timing of services
  • Disclose in footnotes as a related party transaction (ASC 850)

Owners’ only deferred compensation plans can help align executive compensation with long-term strategic objectives. Document clearly and ensure compliance with regulations. Most importantly, surround yourself with advisors who understand how these frameworks intersect in the government contracting world.

 

Sources

FAR 31.205-6

Internal Revenue Code 409A

Top Hat Plan Statements Search