The Internal Revenue Service (IRS) recently issued Notice 2008-62 which will eliminate most deferred compensation issues for school teachers and other employees who spread their compensation over a 12-month period even though they earn such compensation over a 9- or 10-month basis.
Section 409A of the Internal Revenue Code treats compensation earned in one year but paid in a subsequent year as deferred compensation. Under a common arrangement, teachers are paid over 12 months for services performed over a 9- or 10-month period, which would result in some of the compensation the teacher earns for working during one calendar year being paid in the next calendar year at or after the end of the school year. This type of arrangement is called “recurring part-year compensation”. Prior to Notice 2008-62, it appeared that recurring part-year compensation would be considered deferred compensation subject to Code Section 409A. As deferred compensation, employees could be subject to negative tax consequences if certain requirements are not met, namely, the school was required to develop a written policy on the time and method of paying salaries and any election to be paid over a 12-month period must be irrevocable and made prior to the first day of the 2008-2009 school year.
Under the Notice, recurring part-year compensation will NOT be treated as deferred compensation (and not subject to Code Sections 409A and 457(f)) if the following requirements are met:
- The arrangement does not defer payment of any of the compensation beyond the last day of the 13th month following the beginning of the service period; and
- The total amount of compensation earned in the first calendar year but paid in the second year does not exceed the annual Code Section 402(g) limits for elective deferrals ($15,500 in 2008).
For example, assume an employee works during a school year beginning on September 1, 2008 and ending on June 30, 2009 (a 10-month school year) but is paid over the 12-month period beginning September 1, 2008. This arrangement will not provide for deferred compensation unless the employee earns more than $232,500 for the school year. In this case, an employee whose salary for the school year is $232,500 earns $93,000 in 2008 and $139,500 in 2009, but under a 12-month payment schedule, the employee is paid $77,500 in 2008 (for the four months beginning September 1, 2008) and $155,000 in 2009 (for the remaining 8 months in the 12-month period). The amount earned in 2008 but deferred to 2009 would be $15,500 ($93,000 - $77,500). As such, this arrangement would not be considered deferred compensation because the amount earned in 2008 but paid in 2009 does not exceed $15,500 (the 2008 402(g) limit).
Whether the arrangement provides for deferred compensation will depend on the number of months in the work-year and when the work-year begins. In the above example, if the 10-month work-year begins in August rather than September, salary in excess of $186,000 and paid over 12-months would provide for deferred compensation. Likewise, if the work-year was 9 months, beginning in September, salary in excess of $139,500 and paid over 12 months would provide for deferred compensation.
While this Notice will exempt many arrangements with faculty from being treated as deferred compensation, academic institutions are encouraged to review all of their salary payment schedules and compensation-spreading arrangements to ensure compliance with the IRS position.