SunGard Relius

It's back to school season: time for buying clothes, wrapping up vacations, and engaging in advanced tax planning!

The tax planning probably wasn't what the IRS had in mind when the final Code §409A regulations listed income annualization agreements as possible 409A situations. An example will demonstrate what an annualization agreement is and why the IRS would view it as a deferral arrangement.

Carey is a public school teacher making $36,000/year. The school year is from September through May, and the school district pays her $4,000/month during those 9 months. Carey receives no pay during the summer. However, if Carey wants, the district will pay her $3,000/month for 12 months so she can have a more even cash flow. This would be annualizing her pay. If Carey doesn't annualize, she will receive $16,000 of her 2008-2009 school year compensation in the 2008 calendar year, and $20,000 in 2009. If she does annualize, she will receive only $12,000 in 2008 and $24,000 in 2009. Thus, she will be deferring $4,000 to 2009.

Under the technical definitions of deferral of compensation in the 409A final regulations, Carey would be deferring compensation if she made the annualization election. The regulations allowed her to make that election any time before the school year began, but the election would be irrevocable for that year once she made it. (In the absence of the special annualization clause in the final regulations, she would have had to make her 2008-2009 deferral election by December 31, 2007.)

When the regulations came out, school teachers and school districts were very concerned. They did not want to have a complex 409A agreement for a simple salary accommodation with fairly trivial dollar amounts at stake. The IRS responded with some FAQs in 2007 saying:

1. You don’t have to do anything before the 2007-2008 school year. (This was important because at that time the IRS had not yet issued Notice 2007-86 delaying the effective date of the final regulations, and hence the deadline for adopting written 409A plans, to January 1, 2009.)
2. It is not difficult to comply with the regulations. Just have a clear written arrangement at the district level and let each teacher who wants to elect send in a postcard with the election.

That FAQ postponed the problem for a year. During that year, someone brought up another problem: If an annualization agreement for a public school district is a deferral for 409A, wouldn’t it also be a deferral for Code §457? And since the deferral does not satisfy the distribution requirements of Code §457(b), this would be a Code §457(f) deferral. Under Code §457(f), employee deferrals of governmental entities (such as school districts) are taxed in the year that there is no longer a substantial risk of forfeiture. There certainly is no risk of forfeiture in these annualization agreements, and so the timing of employee taxation would be the same regardless of whether the employee chose to annualize. Returning to the example of Carey, suppose she agrees to annualize her pay for the 2008-2009 school year. She would nonetheless pay 2008 income tax on the full $16,000 she could have received in 2008, because there would not be a substantial risk of forfeiture.

The IRS and Treasury realize that this has gone too far. In Notice 2008-62, the IRS announced that it plans to issue regulations under which annualization agreements are not subject to Code §457(f) or to Code §409A. To qualify for this exemption, the employer must pay the entire compensation no later than the last day of the 13th month after the beginning of the work year (October 31, 2009 in Carey’s example). In addition, the total amount deferred cannot exceed the 402(g) limit (currently $15,500). Examples in the Notice demonstrate that employees would need very sizeable incomes (over $175,000/year) to have more than $15,500 deferred from one year to the next under a typical annualization agreement. Teachers and other employees with annualization agreements can rely on this rule for the 2008 taxable year.

In September, SunGard Relius Education will present a full-day Code §409A Workshop to address the final regulations and all of the transition guidance issued over the last year. We will also address what employers and employees must do before the end of the year to satisfy the new regulations. SunGard Relius Education is also presenting full day workshops on cross-tested plans and cash balance plans in August and September.