USA Account for Compensation Paid at a Future Date (1 or 2 years later)

[ptownbro]

We have a new start-up company with 4 founders. Each of us have agreed to forgo payment of the majority of our salaries until we raised enough funding or generated enough sales. What I'm trying to figure out is how to record this on the books as a liability without having an impact on our income so we don't have to pay taxes on it. In other words, since we didn't really receive the money/cash, we shouldn't pay taxes on it. But, we do want to reflect it on the books to show that the money is owed to each of us. What would be accounting / journal entries need to do something like that?

I believe the right thing to do is to treat it as an unfunded non-qualifying deferred compensation transaction. However, while most of it makes sense, there's some of it that's not clicking for me.

 

[kirby]

No way to record the liability without also recording the expense. If there is an agreement that a person will perform service for x pay and they do perform, then there is an expense to be recorded offset by a payment liability, whether long or short term.

 

[ptownbro]

Ok. But my question was related to how you record (and understand) the transaction. I found some examples online, but they were very simplified or not exactly related.

Assume you own a one person (you) business and earned Revenues of $300k in the first year. You decide to not pay yourself during that year, but instead pay yourself the $100k a year later. For simplicity, assume these are the only transactions (nothing else happened), your income tax rate is 40%, and employer and employee payroll tax rates are 10%.

Year 1

1. First you record and collect your revenues.

Dr Cash………….………….…………300
Cr Revenues...……..………….……..(300)

2. The amount you didn't pay yourself you want to record as a liability to keep track that it's owed to you. Therefore, I believe what you need to do is (this is where I need help) record it as Deferred Comp Expense and Liability. This allows you to record the liability, but since its classified as deferred comp (unfunded, non-qualifying) you don't have to pay the associated payroll taxes at this time. Instead, you pay the payroll taxes when the cash payment is actually made later (in year 2 below).

Dr Deferred Comp Exp………….......100
Cr Deferred Comp Liab………….......(100)

3. At this point your earnings before taxes (EBT) should be $200k and at 40% your income taxes should be $80k. Questions: I've read that the rule is you cannot deduct Deferred Comp Exp. If that's the case, shouldn't your EBT be $300k and your income taxes at 40% be $120k which would equate to the actual amount of taxes I pay? To take that further, why then is it recorded as an expense at all if you can't deduct it?

Dr Income Tax Exp…………………...80
Cr Taxes Payable……………………..(80)

4. Not only do you not record the associated payroll taxes now, you also don’t record the associated income taxes at this time either. To reflect this, you record the income tax expense (related to the deferred comp) you would have recorded, as an asset and credit the income tax expense related to what you'll deduct later when you actually pay it out. Questions: This is a part I don’t understand really. You end up with a 'credit' to income taxes and your total income tax expense is $40k afterward. Following my point in #3 above, if you can't deduct the deferred comp, then your actual tax payment is $120k, yet you only end up showing $40k of income tax expense. Is this right? Shouldn't the income tax expense be $120k to match your actual payment? That would mean a debit to the income tax exp and not a credit. Plus, you'd have to adjust your taxes payable somehow to reflect that you owe the $120k... Sooo many questions about this.

Dr Deferred Tax Asset.………….......40
Cr Income Tax Exp…………………..(40)

5. Last you settle your payments due for income taxes.Questions: Again, weird to me following #3 and #4 above. At this point, your taxes payable is $80k, but shouldn't it be $120k since you can't deduct deferred comp? My understanding of the whole point you complete #4 above is because you cannot deduct the tax expense now and need to reflect it later, but the entry to reflect that seems incorrect.

Dr Taxes Payable...........................80
Cr Cash.........................................(80)


Year 2

6. You pay yourself the amount you deferred. Note that now you reflect the amount of the associated payroll taxes for both employer and employee.

Dr Deferred Comp Liab....................100
Cr Taxes Payable...........................(10)
Cr Cash.....…………..………………..(90)

Dr Payroll Tax Exp………………….10
Cr Taxes Payable……………………(10)

7. At this point your EBT should be -$10k (negative) and at 40% you'd get a credit income tax of $4k.

Dr Taxes Payable…………………...4
Cr Income Tax Exp………………….(4)

8. You now reflect the income taxes related to the deferred compensation.

Dr Income Tax Exp…………………40
Cr Deferred Tax Asset.……………(40)

9. Last you settle your payments due for taxes (payroll taxes).

Dr Taxes Payable……………………16
Cr Cash………………..……………..(16)

 

[Samir]

This is a tricky scenario. I've run across this personally, and potential problem with creating a liability is that if you don't generate enough revenue and close your business, the written-off liability is considered income for the company. Depending on if you have a pass-through entity or a corporation, these additional 'balance sheet only' revenues will be taxed as actual income.

Here's how I'd do it. Do the first scenario as you suggest--doing all the entries for the amount you are paid.

But then I'd treat the salary not paid as a capital investment vs a liability. This helps two places. One is that you have a more accurate basis in case of losses, and the second is if you do close the company, there is no liability that the IRS can consider income--your capital simply goes kaput.

So for deferred payment:
cr captial
dr payroll expenses like normal for additional amount

when finally paying yourself:
dr capital
cr cash

The caveat to this method is that you will have to pay the payroll taxes on the deferred amount right now, as it's considered paid right now. In fact, now that I look over your idea in more detail, I don't think you could defer the payroll taxes while taking the expense deduction.

To help answer the tax questions #3, you have two different taxes with the payroll--the liability of what you withhold, and also the employer's share of the withheld taxes (treated as an expense). I think this may be why you've got the deferred tax asset, although I still don't follow it myself either.

 

[ptownbro]

Thanks for the reply. But if that works, that still would require paying payroll taxes which is what I'm trying to avoid paying until the actual payment is made. The whole point of this is that we don't have the cash to pay the salary or the taxes now. When we do have the cash we'll pay both. But it doesn't seem right to force them (any of us) to pay taxes related to income you didn't really get. We just want to record the liability to keep track of it and to show that it is due at some point. But that should not trigger a tax payment/event of any kind since we didn't really get paid yet.

Note: I changed my original example to clean it up and simplify it a bit.

 

[Samir]

The problem with what you're trying to do is expensing something that hasn't been paid yet. If you expense it, those are gross wages you'll have to report on quarterlies, and if you report them on quarterlies, you'll be liable for the tax. I'm not sure there's a good way around that.

 

[The Finance Writer]

An employee’s taxes are not affected by compensation that meets the requirements of IRC Section 409A. An election is required to defer compensation. Distributions of deferred compensation under Section 409A are only allowed under certain conditions. However, this nonqualified deferred compensation has no impact on FICA taxes.

 

[ptownbro]

Thanks. That is correct.

What I'm hoping to get however is an understanding on the accounting entries to book this.

 

[cmesh]

I think the confusion is because you are talking about two different methods of accounting. What you are describing is booking the compensation based on the accrual method for books, while booking on a cash basis for taxes. This involves two different sets of books--one for your internal use which would reflect the liability, and one for tax reporting purposes that wouldn't. Most of my clients would just record the accrual to get it on their books, but remove the expense when preparing tax returns (not removing from the books, just removing it from the returns).