Starting on January 1, 2008, regulations issued by the IRS in April, 2007 will impact teachers and other school district employees who work only part of the year and are given the option to annualize their compensation, or spread their compensation out over a twelve month period. School districts will want to review their compensation plans and alert employees to the requirements before January 1, 2008.
An employee who works only part of the year but elects to have his or her compensation spread out over the entire year is deferring compensation from one year to the next. The IRS website gives the following example to illustrate why such an arrangement gives rise to deferred compensation:
Assume a school year starts Aug. 1, 2007, and ends May 31, 2008 (10 months), and that a teacher earns $5,400 per month ($54,000 per year). If the teacher were paid over 10 months, the teacher would receive $27,000 in 2007 for the five months of August through December, and would receive $27,000 in 2008 for the five months of January through May. If instead, the teacher were paid over 12 months, the teacher would receive $4,500 per month. The teacher would receive only $22,500 in 2007 for the five months of August through December and would receive $31,500 in 2008 for the seven months of January through July. In this example, $4,500 that the teacher earned in 2007 is paid in 2008. In other words, the $4,500 of 2007 pay is deferred until 2008.
This is important because generally, unless a deferred compensation arrangement complies with certain requirements, any income that is deferred from one year to a later year is subject to a 20% penalty, in addition to the income tax already payable on the income. The penalty would apply to the income of school district employees who work only part of the year but choose to spread their compensation out over the entire year. The IRS has offered relief for such employees, however. The income of these employees will not be subject to the 20% penalty, as long as the deferral arrangement complies with the following requirements:
- The election to spread the compensation out over a longer period of time must be made before the service period begins. This means that an employee must elect to have annualized compensation before the start of the school year in which they are making such an election. If an employee starts work after the school year has begun, they must make the election before their first day of work.
- The period over which the compensation is spread out cannot extend for more than 13 monthsbeyond the first day of the service period. For example, if a teacher starts teaching on the first day of school on September 1, 2007, they cannot extend their compensation beyond September 31, 2008.
- The election made by the employee must comply with several requirements:
- The election must be made in writing, and must be made by each employee individually.
- The election must be irrevocable, so that it cannot 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, spread out over the 12 months with the beginning of the school year).
- Note that the election does not need to be in any particular form – it simply needs to comply with the above requirements.
These requirements only apply if employees are given the option to choose annualized compensation. If a school district only offers one compensation plan, i.e. employees can only be paid over a twelve month period, without an alternative plan, then the employees do not need to comply with the above requirements.
If a part-year employee fails to make an election, or fails to do so before the deadline, the employee must be paid in the same manner as other employees who did not make an election (i.e. whatever the school district’s default manner of paying its part-year employees).
Employees do not need to make the election every year. An employee can indicate that they would like the compensation arrangement they have chosen to remain in place until they indicate otherwise to the school district. An employee can only change their compensation arrangement before the first day of a new school year. An employee cannot change their compensation arrangement in the middle of a school year.
The Regulations do not take effect until January 1, 2008. By December 31, 2007, Districts will need to set forth in writing how they will compensate annualized compensation employees for the remainder of the 2007-2008 school year.
If your district offers a choice of annualized compensation, it should ensure that employees comply with the above-noted requirements starting with the 2008-2009 school year. Technically, each individual employee is responsible for complying with the IRS requirements. School districts that offer annualized compensation arrangements can help their employees comply with the requirements by creating forms that comply with the IRS requirements, and having their employees sign the forms before the first working day of the 2008-2009 school year.
For more information on this topic visit the IRS website at www.irs.gov.