A common practice for school districts is to allow nine and ten month employees the option of receiving their compensation over a twelve-month period. This practice can have tax-related implications under Internal Revenue Code Section 409A, which applies to “nonqualified deferred compensation” (i.e. income earned by a worker in one year but not paid until the following year). If employees are given this option (which is not required under Section 409A), and an employee elects to take a twelve-month pay distribution, the result is “nonqualified deferred compensation,” as defined under section 409A. Recent regulations issued by the Internal Revenue Service (IRS) clarify that such “nonqualified deferred compensation” is subject to an additional 20% excise tax if the employee does not make certain “elections” concerning the compensation.
To avoid the 20% excise tax on the salaries of school employees who choose to receive their compensation over a twelve-month period, your school district must satisfy several conditions:
For the 2007-2008 school year, each school district that offers a choice between a school-year pay period and a twelve-month pay period must, by January 1, 2008, designate in writing how employees will be paid (i.e., over a nine-month pay period or a twelve-month pay period). Thus, if your school district has not yet done so, notify affected employees in writing by December 31, 2007 of the term over which their pay is distributed for the 2007-2008 school year.
Beginning with the 2008-2009 school year, Section 409A sets forth deadlines before which employees must make their elections to defer compensation. Specifically, if school district employees choose the twelve-month option, the following requirements must be met:
- The employee must give a written or electronic election to the employer that notifies the employer that the employee wants to receive their compensation over a twelve-month period.
- The election must be irrevocable (i.e., it cannot be changed once the work period begins).
- The employee must make this election – either in writing or electronically - prior to the beginning of the school year.
Section 409A does not require a particular type of form to be used for making the election, as long as the election is in writing (or an electronic document), and the election need not be filed with the IRS.
Under Section 409A, if an employee fails to submit his or her written election, or submits the election after the beginning of the work period, the employee is to be paid on the same basis as employees who do not make an election. Therefore, if employees are typically paid only throughout the nine-month school year but are provided an election for a twelve-month pay period, an employee who fails to submit the election or submits the election late must, by default, receive payment over the nine-month school year.
Section 409A does not require that an election must be made each year. Instead, a school district can provide for an election arrangement of twelve-months that remains in effect indefinitely until the employee notifies the school district otherwise. Of course, the employee may not withdraw the election in the middle of the school year, but must do so prior to the beginning of the following school year.
Finally, it is important to note that the requirements of Section 409A apply only where a school district offers an election. If, for example a school district does not provide employees with an election, but instead spreads payment for all employees over a twelve-month period, the district is not subject to the election requirements and additional tax rules of Section 409A.
If you have any questions regarding the information contained in this Client Alert, please contact Matt Roeschley at (630) 682-0085 or
mroeschley@obkcg.com.
