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IRS Rethinks its Deferred Compensation Rules

July 18, 2008

Authors: Richard I. Cohen

This month, the IRS announced that it is revising its approach to regulating deferred compensation. Now, the new deferred compensation rules (that were scheduled to go into effect in the coming school year) will not apply when ten month employees take their salaries over twelve months except in limited circumstances. This change by the IRS relieves school districts and other employers from the burden of obtaining written elections from teachers and other ten month employees who take their salary over twelve months.

Where we were a year ago.

On August 7, 2007, the IRS released a Press Release in which it explained that the annualizing of recurring part-year compensation created deferred compensation that was subject to the statutory and regulatory requirements of Section 409A of the Internal Revenue Code, and failure to comply could lead to harsh tax consequences for the employee, including a 20% penalty tax over and above the income tax that was otherwise due. The following example illustrates the deferred compensation issue that had caught the IRS’s attention:

Example: A Teacher earns $80,000 per contract year (10 months from September 1 to June 30) commencing September 1, 2008, payable as $8,000 per month for 10 months or if elected by the Employee, $6,666.67 per month for 12 months If a Teacher elects payment over 12 months, then by doing so, the teacher shifts $5333.32 of pay from tax year 2008 to 2009. As explained in the Press Release and the IRS Regulations issued in 2007, the IRS considers this $5333.32 to be deferred compensation because it is earned in 2008 but not paid and taxed until 2009.

NOTE: Although teachers are the most common type of employee affected by this issue, it technically applies to any employee who has the right to get paid over a 12 month period even though their pay each year is for a work period that is shorter than 12 months.

In its 2007 Press Release, the IRS announced that beginning with the 2008 contract year, the following steps were required for annualizing pay elections to comply with 409A:

1. the electing employee must do so in writing (which includes an email).

2. the election will have to be made BEFORE the beginning of the work year (e.g., school year) for which the employee is being paid (which in the case of teachers might be earlier than the first day of classes for the students), and

3. the election must be irrevocable and also must state the longer payment period (e.g., twelve months) resulting from the election.

Although the IRS explained in the 2007 Press Release that the applicable 409A rules would not apply until the start of the 2008 contract year, and the 2007 issue date of the IRS Press Release provided employers with ample lead time to come into compliance with their election forms and procedures, many employers in the public sector (where 10-month employees is more prevalent) still continued to wonder why the IRS would interpret 409A in a way that seemed well beyond the law’s purpose of stamping out the types of deferred compensation abuses involving executive compensation payable by private companies.

What a difference a year makes.

On July 2, 2008, the IRS released Notice 2008-62 in which it adopted a more sensible approach by re-defining “deferred compensation” so that it will not include these types of routine annualizing pay elections. To qualify for this new rule, the following two requirements must be met:

1. the annualizing election does not defer payment of the part-year compensation beyond the last day of the 13th month after the beginning of the service period.

Example: A teacher starts his or her service period on the first day of school, which is September 1, 2008. All of the pay owed to the teacher for said services must be paid to the teacher no later than September 30, 2009. [NOTE: Since the annualizing elections typically spread the pay over 12 months (instead of the 10 months actually worked), all of the pay would be paid by August 31, 2009, which will comply with this 13-month requirement.]

2. the maximum amount that is deferred from year one to year two by virtue of the annualizing election is no more than $15,500 for the 2008 service period (or the COLA adjusted amount set forth in IRC 402(g)(1)(B) for years after 2008)

Example: A teacher earns $80,000 per contract year commencing September 1, 2008, payable as $8,000 per month for 10 months or if elected by the Employee, $6,666.67 per month for 12 months. If a teacher elects payment over 12 months, the amount of the deferred payment totals $5333.32, which is less than $15,500, so this requirement is met.

NOTE: The IRS notice explains that for employees electing to be paid over 12 months whose compensation for the 2008 school year is less than $186,000 and whose contract year begins August 1, this second requirement will always be met. Similarly, for employees whose contract year begins September 1, the second requirement is automatically met if the employee earns less than $232,500 for the school year.

Bottom Line:

In light of the IRS’s new position in Notice 2008-62, the three previously required IRS steps to comply with 409A (listed earlier in this Alert) no longer are required. This is welcome news for all employers who allow their employees to annualize their part-year pay, and should help alleviate some of the pressure they are under at the end of the summer when they are typically very busy getting ready for the start of a new school year (or other type of new contract year).

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If you have any further questions regarding this Alert, please contact Richard Cohen or any other member of the Employee Benefits Practice Group.

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