Paying Professors Over 12 Months for 9 Months Work: Current IRS Position
Many colleges and universities have what are known as "annualized pay" arrangements - that is, they require their professors to only work during the academic year (usually 9 or 10 months) but pay them over a full 12-month period. In some cases, the professors can elect whether to receive annualized pay, while in others the school requires payment on a 12-month basis.
Whether elective or required, the annualized pay arrangement raises issues under the deferred compensation rules of sections 409A and 457, each of which prohibit the payment of deferred compensation unless certain conditions are met. In addition, under section 409A, the IRS can impose a 20% tax on the amount of attempted deferral.
Why Annualized Pay Results in a Deferral of Compensation
To understand why annualized pay arrangements result in deferred compensation, consider the situation where a professor is required to work for a nine-month period from September 1, 2008 - May 31, 2009. Her salary is $72,000 for the entire nine-month period that she is required to work. If she is paid on a nine-month basis, she will receive $8,000 a month, or $32,000 in 2008 and $40,000 in 2009. But if she is paid over the 12-month period running from September 1, 2008 - August 31, 2009, she will receive $6,000 a month, which means she will receive only $24,000 in 2008 and $48,000 in 2009. Thus, by extending her $72,000
salary over 12 months, the school has deferred $8,000 in salary to 2009.
If sections 457 and 409A are violated by this arrangement, the professor will be required to report the $8,000 deferral in 2008 and will be subject to an additional tax of $1,600 under section 409A ($8,000 deferral x 20%).
Avoiding the Deferred Compensation Requirements
Sections 457 and 409A apply to "deferred compensation," and these annualized pay situations would normally be treated as deferred compensation for the reasons illustrated by the above example. In Notice 2008-62, however, the IRS has set forth a safe harbor rule that, if met, will cause the deferral created by the annualized pay arrangement not to be treated as "deferred compensation" for purposes of both statutory provisions. In order to meet this safe harbor test:
- The arrangement must not defer payment of any of the part-year compensation beyond the 13th month following the beginning of the service period; and
- The arrangement must not defer from one taxable year to another taxable year an amount in excess of the amount set forth in section 402(g)(1)(B) (the maximum amount that can be excluded as an elective deferral, currently $15,500).
The IRS has informally advised, however, that if the deferral exceeds the $15,500 cap, the full amount of the deferral, not just the amount in excess of $15,500, will be treated as deferred compensation for purposes of both sections 457 and 409A.
Applying these safe harbor rules to the above example, the school's annualized pay arrangement would not be treated as a payment of "deferred compensation" (and therefore would not run afoul of sections 457 or 409A) because (1) all wage payments will be made before the 13th month following the beginning of service on September 1, 2008, and (2) the amount that is deferred from 2008 to 2009 ($8,000) is less than the permitted $15,500 maximum deferral.
The IRS says it expects to issue regulations saying that any annualized pay arrangement that meets these two conditions will not be treated as deferred compensation for both sections 457 and 409A beginning with the first taxable year that includes July 1, 2008, and that taxpayers may continue to rely on these rules until regulations are issued. You can read Notice 2008-62 at
http://www.irs.gov/pub/irs-drop/n-08-62.pdf.
What Happens if the Safe Harbor Rules Are Not Met?
There may be situations where the salary payment made to the professor or other employee is so high that the deferral will exceed the $15,500 cap. The IRS has calculated, for example, that a professor who works for ten months from August 1, 2008, to May 31, 2009, but is paid over 12 months, will exceed the $15,500 deferral cap if he receives more than $186,000 in annual salary. Thus, there may be situations where a school cannot fall within the Notice 2008-62 safe harbor for some employees. In these cases, the amount of the deferral will be treated as "deferred compensation" for both sections 457 and 409A.
Section 409A
In order to comply with section 409A, the deferred compensation plan must meet three requirements - (1) a "distribution requirement" that relates to when distributions of the deferred compensation can be made; (2) an "acceleration of benefits requirement" that provides that the time or schedule of the payment of the deferred compensation cannot be accelerated; and (3) an "election requirement" that sets forth rules regarding how deferral and other types of elections must be made.
The first two requirements will generally be met in annualized pay situations because (1) the only "distribution" of the deferred salary is in accordance with the 12-month payment schedule, and (2) annualized pay arrangements do not contain any acceleration provisions. But note that section 409A requires that the deferred compensation plan must specifically "provide" that the distribution and acceleration of benefits requirements are met. Therefore, schools are advised to include language covering both of these two section 409A requirements either in individual employment contracts with the professors or as part of the school's overall
annualized pay policies and procedures.
With respect to the election requirement of section 409A, the IRS has said that where the school does not give the professor an option to elect annualized pay, but rather requires payment over 12 months, the section 409A election rules do not apply. Therefore, in those cases where the Notice 2008-62 safe harbor is not met but the employee does not have an election to receive annualized pay, if the other section 409A requirements are met, section 409A is satisfied and the 20% additional tax will not be imposed.
In those situations where the school gives its professors the choice to receive annualized pay, the IRS has said that the election rules of section 409A will be met if the professor makes the 12-month pay election no later than the end of the year before the year in which the deferral occurred or the start of the academic year. In the above example where $8,000 was deferred from 2008 to 2009, the section 409A election requirement would be met if the professor made her election to receive annualized pay no later than the start of the academic year.
These section 409A election provisions, as well as additional details regarding the election requirement as it applies to annualized pay situations, can be found on the IRS Web site.
Section 457
Section 457 says that any attempt to defer the payment of compensation will be ignored and the compensation will be taxed in the year of the deferral, unless the plan conforms to the requirements of section 457(b) and other provisions in the statute. Without going into detail, suffice it to say that the typical annualized payment plan (whether elective or nonelective) does not meet the requirements of section 457. Accordingly, in those situations where the safe harbor rules of Notice 2008-62 are not met, section 457 will require that the amount of the annualized pay deferral be treated as taxable wages in the earlier year. In the
above example, this means that the $8,000 deferred to 2009 will be treated as 2008 income.
In order to avoid this result, some schools are considering modifying their annualized pay procedures by shifting the 12-month pay period. For example, a school with a September - August pay period would shift to a July - June pay period. This means that a portion of the professor's annual salary would be paid before the beginning of the academic year, thereby increasing the wage payments in that year. To illustrate: assume that the school in the above example paid the professor over the 12-month period running from July 1, 2008 - June 30, 2009. The professor would receive $36,000 in 2008 and $36,000 in 2009 with no deferral
from 2008 to 2009. While this would slightly increase the amount of her 2008 income, it would avoid any adverse impact of section 457.
While this may be a solution for some schools, public schools should make sure that state law does not prevent the payment of wages before services are performed (e.g. ghost employment or anticipatory wage laws), as well as public policy or political concerns, particularly in the event of an employee's early termination before all wages have been earned. Additionally, schools should carefully consider the implications of such a shift on employment practices and employee benefit programs. |
