School Districts Must Review How Teachers are Paid

July 1, 2008 | Roger McEowen

 

A provision in the 2004 Jobs Bill created a new section of the Internal Revenue Code (I.R.C. §409A) that dramatically changed the taxation of non-qualified deferred compensation arrangements – arrangements under which compensation is earned in one year, but is paid in a later year.  As a result, school districts will have to examine how their teachers are paid, and ensure compliance with the new rules by the end of 2007.

Under the new provision, income from deferred compensation arrangements may no longer be deferred past the year in which the compensation is earned, with some exceptions.  In general, the effective date of the new rule was January 1, 2005, but IRS only recently got around to writing regulations for the new law.  If a non-qualified plan does not meet the requirements of I.R.C. §409A, the compensation is subject to additional taxes, including a 20 percent additional income tax (but, there is no effect on FICA, Social Security and Medicare tax). 

So, what is the application to school teachers?  When teachers (and other taxpayers with similar part-year work periods) are given an annualization election – a choice between being paid only during the school year and being paid over a 12-month period – and they choose the 12-month period, they are deferring part of their income from one year to the next.

Example:
A school district’s school year begins on September 1, 2007 and ends
on May 31, 2008 (9 months).  Assume that a teacher earns $5,000 per
month ($45,000 per year).  If the teacher were paid over 9 months, the
teacher would receive $20,000 for 2007 (for the months of September
through December), and would receive $25,000 in 2008 (for the months
of January through May).  If the teacher were instead paid over 12 months,
the teacher would receive $3,750 per month.  In that event, the teacher would
receive only $15,000 in 2007 and $30,000 in 2008.  Thus, $5,000 that the
teacher earned in 2007 is paid in 2008 (i.e., $5,000 is deferred until 2008),
and the arrangement would be considered deferred compensation that is
subject to I.R.C. §409A.

The new rules do not require that an employee be provided an election regarding how the employee is paid.  So, a school district may provide all teachers will have their pay spread over 12 months, without providing any election to the teachers.  The I.R.C. §409A rules don’t apply in that situation and no additional taxes are triggered.  But, if a school district provides employees a choice as to how their income is to be paid, the district must follow the election deadlines established in the new law.  In general, those rules require that a deferral election must be made not later than the end of the prior year (i.e., for salary earned in 2007 to be deferred to 2008, the election must have been made by the end of 2006).  But, IRS regulations that were issued in April don’t become effective until January 1, 2008.  So, that’s the date by which the new rules must be followed.  By then, school districts must have set forth in writing how the teachers are to be paid for the compensation earned for the rest of the scheduled work period (for example, for the remainder of the school year).  In addition, for a school year starting after 2007, employers and employees will need to meet the new rules for any elections to annualize compensation (such as for the 2008-2009 school year). 

Here are the new election rules that must be followed beginning in 2008:

  • The teacher must give a written (or electronic) election to the school district that notifies the district that the teacher wants to spread out the compensation over 12 months.
  • The election must be made before the beginning of the work period (the first day of the school year for which the teacher is paid).
  • The election must be irrevocable, so that it can’t be changed after the work period begins.
  • The election must state how the compensation is going to be paid if the election is made (for example, ratably over 12 months starting with the beginning of the school year).

No particular form is necessary for the election, and the election need not be filed with the IRS.  But, if an election is not submitted, or is submitted late, the teacher must be paid in the same way as other teachers who do not make the election (paid during the school year only).  In addition, the election need not be made each year.  An arrangement may provide that a pre-existing election will remain in place until the teacher changes the election (but, the change must be made before the beginning of the school year to with the change applies).

The bottom line is that all school districts will have to review how their teachers are paid, and some districts that offer annualization elections may have to make some changes in their procedures.  School districts that have not been offering teachers annualization elections do not have to start. 

But remember, IRS has announced in IR 2007-142 (Aug. 7, 2007) that the new rules will not be applied to annualization elections for school years beginning before January 1, 2008.  So, there is time for school districts to review compensation arrangements this fall and come into compliance by year end, if necessary.  

Update:  On September 10, 2007, IRS published a Notice giving taxpayers with non- qualified plans until December 21, 2008, to comply with the new rules. But, taxpayers must still determine, by the end of this year, whether to continue or terminate their plans to avoid the 20 percent penalty tax on employee deferred amounts. So, while the appropriate documents need not be filed by the end of 2007, plans can be amended in 2008 if the amendments are retroactive to the beginning of 2008. IRS Notice 2007-78.    

Further Update:  On July 1, 2008, IRS issued a Notice that largely eliminates the 20 percent penalty tax on employee deferred amounts.  The Notice provides an example of a school district employing a teacher from August 1, 2008 through May 31, 2009.  But, the teacher is paid over the 12-month period beginning August 1, 2008 (either because that’s the way the school district contracts are established or the employee has elected to be paid over the 12-month period beginning on the commencement of employment).  IRS states in the Notice that the compensation arrangement would not provide for deferred compensation for purposes of I.R.C. §457(f) unless the teacher earns more than $186,000 for the school year.  That’s because, under the contract, the teacher would receive $77,500 in 2008 and $108,500 in 2009.  As a result, the amount the employee earns during 2008 that is paid in 2009 ($15,500 [$93,000 - $77,500]) does not exceed the applicable dollar amount under I.R.C. §402(g)(1)(B) for 2008 ($15,500), the arrangement would not provide for deferred compensation for purposes of I.R.C. §457(f).  IRS Notice 2008-62, 2008 IRB LEXIS 503 (Jul. 1, 2008).