In the typical independent school’s faculty payroll arrangement, faculty work for 10 months but may be paid ratably over a 12-month period—in effect deferring a small portion of salary earned during one calendar year into the following calendar year. Although this arrangement may currently constitute nonqualified deferred compensation subject to Section 409A of the Internal Revenue Code because income that is earned in one taxable year is not paid until the next taxable year, it will generally comply with the requirements under Section 409A so long as the election to be paid over 12 months is made before the service period begins.
The Treasury Department and the Internal Revenue Service (IRS) recently issued Notice 2008-62, which proposes a new rule under Section 457(f) for recurring part-year compensation. Under Notice 2008-62, stretching an employee’s compensation over a period that goes into a subsequent tax year would not constitute deferred compensation for purposes of Section 457(f) so long as the arrangement does not:
- Defer payment of any of the recurring part-year compensation beyond the last day of the 13th month following the beginning of the service period; and
- Defer from one taxable year to the next taxable year the compensation payment of more than the applicable 401(k), 403(b) and 457(f) deferral limit in effect for the calendar year in which the service period begins (i.e., $15,500 for 2008).
Such arrangement would also cease to be considered nonqualified deferred compensation for purposes of Section 409A provided that the foregoing requirements are met.
Consider the following example:
Assume a teacher works during a school year that begins on Aug. 1, 2008, and ends on May 31, 2009 (a 10-month school year). The teacher’s salary is $60,000. Since five months of the school year are in 2008 and five months are in 2009, under a 10-month school year, the teacher whose salary is $60,000 earns $30,000 in 2008 (60,000/10 months x 5 months) in 2008 and $30,000 in 2009. Under a 12-month payment schedule, the teacher actually receives only $25,000 in 2008 ($60,000/12 months x 5 months) in 2008 and the balance of $35,000 in 2009. Because $5,000 ($30,000 - $25,000) of what the employee earned during 2008 is actually paid in 2009, a deferral of income from 2008 to 2009 is created. However, this arrangement would not be considered to be deferred compensation for purposes of Sections 457(f) and 409A because the deferred amount ($5,000) is less than the applicable dollar amount for 2008 of $15,500, and payments are made to the teacher by the end of the 13th month after payments begin.
For 2008, to remain within the IRS exemption, the maximum salary for a ten-month school year beginning on Aug. 1 is $186,000; for a ten-month school year beginning Sept. 1, the maximum salary is $232,500.
Notice 2008-62 provides that, until further guidance is issued, taxpayers may rely on advice provided therein beginning with the first taxable year that includes July 1, 2008.