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Guest Article

(From the August 25, 2008 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

IRS Carves out from Code Sections 457(f) & 409A Certain Arrangements by Public School and Other Employees to Have Salary Paid over 12 Months

Under a common arrangement, public school and other employees who provide services during only a portion of the year can elect to be paid ratably over 12 months. This "election to defer" payment can trigger the unwanted application of IRC § 457(f) which governs certain deferred compensation plans of tax-exempt entities and state and local governments, and IRC § 409A which otherwise governs amounts deferred under nonqualified deferred compensation plans. IRS recently issued guidance to preclude the unwanted application of IRC §§ 457(f) & 409A to these and other similar arrangements. IRS Notice 2008-62.

The Problem: Taxation before the Compensation Is Paid

Internal Revenue Code § 457 governs deferred compensation plans of state and local governments and tax-exempt organizations. If such a sponsor sets up a plan that satisfies the requirements of IRC § 457 (i.e., deferrals are limited to the applicable dollar amount, the distribution requirements are met, etc.) the plan is an "eligible" IRC § 457 plan and the amounts deferred are not taxable until they are paid or otherwise made available to the participant. However, if the sponsor's plan does not meet the requirements of IRC § 457, the plan is an "ineligible" plan under IRC § 457(f) and the amounts deferred are taxable in the first taxable year in which they are not subject to a substantial risk of forfeiture.

Separately, IRC § 409A governs when amounts deferred under a nonqualified deferred compensation plan are included in gross income. Like IRC § 457(f), it provides that if the requirements of IRC § 409A are not satisfied (i.e., timing of elections, restrictions on distributions, etc.) for any taxable year, the amounts deferred under the plan are taxable that year to the extent they are not subject to a substantial risk of forfeiture.

As a result, public school or other employees who work a 10-month year commencing August 1, 2008 -- but who elect to be paid ratably over 12 months -- could be considered to be participating in an "ineligible" IRC § 457 plan or a non-compliant IRC § 409A plan and, thereby, subject to income tax in 2008 on the portion of their salary that is earned in 2008 but paid in 2009.

The Solution: Special Rule Will Apply

In Notice 2008-62, IRS acknowledged the desire to accommodate such arrangements and not subject them unnecessarily to the strictures of IRC §§ 457(f) or 409A. It advised that regulations under IRC § 457(f) will be issued -- and changes to the regulations under IRC § 409A will be proposed -- to provide that an arrangement in which an employee or independent contractor receives "recurrent part-year compensation" will not be treated as providing deferred compensation as long as it does not:

defer payment beyond the last day of the 13th month following the start of the service period, or
defer to the next taxable year more than the applicable dollar amount under IRC § 402(g)(1)(B) for the calendar year in which the service period started (i.e., $15,500 for 2008).

The term "recurrent part-year compensation" is defined under the IRC § 409A as: "compensation paid for services rendered in a position that the service recipient and service provider reasonably anticipate will continue on similar terms and conditions in subsequent years, and will require services to be provided during successive service periods each of which comprises less than 12 months (for example, a teacher providing services during a school year comprised of 10 consecutive months), and each of which periods begins in one taxable year of the service provider and ends in the next such taxable year."

Notice 2008-62 provides the following examples, which serve to illustrate that the special rule will be available except where the employee is very highly paid.

Example 1:
[A]ssume a school district employee works during a school year that begins on August 1, 2008 and ends on May 31, 2009 (a 10-month school year). Assume further that the employee is paid over the 12-month period beginning August 1, 2008 (either because the school system pays over a 12-month period or because the employee may elect to be paid over the 12-month period and has made such an election). Under these facts and circumstances, the arrangement would not provide for deferred compensation for purposes of IRC § 457(f) unless the employee earns more than $186,000 for the school year. Since five months of the school year are in 2008 and five months are in 2009, an employee whose salary for the school year is $186,000 earns $93,000 in 2008 and $93,000 in 2009. Under the 12-month payment schedule, the employee receives $77,500 in 2008 and $108,500 in 2009. Because the amount the employee earns during 2008 that is paid in 2009 ($93,000 - $77,500, or $15,500) does not exceed the applicable dollar amount under IRC § 402(g)(1)(B) for 2008 ($15,500), the arrangement would not provide for deferred compensation for purposes of IRC § 457(f).
Example 2:
Similarly, a school district employee working during a school year that begins on September 1, 2008 and ends on June 30, 2009 (a 10-month school year), that paid the employee over the 12 month period beginning September 1, 2008, would not provide for deferred compensation for purposes of IRC § 457(f) if the employee earns less than $232,500 for the school year. Since four months of the school year are in 2008 and six months are in 2009, an employee whose salary for the school year is $232,500 earns $93,000 in 2008 and $139,500 in 2009. Under the 12-month payment schedule, the employee receives $77,500 in 2008 and $155,000 in 2009. Because the amount the employee earns during 2008 that is paid in 2009 ($93,000 - $77,500, or $15,500) does not exceed the applicable dollar amount under IRC § 402(g)(1)(B) for 2008 ($15,500), the arrangement would not provide for deferred compensation for purposes of IRC § 457(f).

The information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations.

If you have any questions or need additional information about articles appearing in this or previous versions of Washington Bulletin, please contact: Robert Davis 202.879.3094, Elizabeth Drigotas 202.879.4985, Mary Jones 202.378.5067, Stephen LaGarde 202.879-5608, Erinn Madden 202.572.7677, Bart Massey 202.220.2104, Mark Neilio 202.378.5046, Tom Pevarnik 202.879.5314, Sandra Rolitsky 202.220.2025, Tom Veal 312.946.2595, Deborah Walker 202.879.4955.

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