The Pension Protection Act Blog has a concise, clear explanation of the effective dates of the final regulations for church 403(b) plans.
The post is at http://qualifiedpensionconsulting.com/ppablog/2008/08/21/final-403b-regulation-date-tricky-for-church-plans/
Friday, September 5, 2008
New Teacher Pay Rule from IRS
On July 21, 2008, in Notice 2008-62, the IRS created a new rule on public school teacher compensation. In a nutshell, the rule says that “recurring part year compensation” will not be treated as deferred compensation under Section 457(f) as long as “(1) 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 (2) does not defer from one taxable year to the next taxable year the payment of more than the applicable dollar amount under 402(g)(1)(B) in effect for the calendar year in which the service period begins ($15,500 for 2008).” “Recurring part year compensation” is defined at Regs. 1.409A-2(a)(14) as follows:
“the term recurring part-year compensation means compensation paid for services rendered in a position that the service recipient and service provider reasonably anticipate will continue on similar terms and conditions in subsequent years, and will require services to be provided during successive service periods each of which comprises less than 12 months (for example, a teacher providing services during a school year comprised of 10 consecutive months), and each of which periods begins in one taxable year of the service provider and ends in the next such taxable year. The rules of this paragraph (a)(14) apply to a particular amount of compensation only once, so that an amount deferred under this rule may not again be treated as recurring part-year compensation for purposes of this paragraph and subject to a second deferral election under this paragraph (a)(14).”
The reason for creating this rule is to allow teachers and other eligible public school employees to annualize their compensation. Typically, this allows a teacher to receive pay in equal amounts from the beginning of a school year (say, September) to the beginning of the next school year (say, the following August). The unwillingness of the IRS to extend the rule to non-teachers, incidentally, serves as an example of the clout of K-12 teachers and otherwise has absolutely no justification. So far, so good.
There are two problems with this rule.
First, the very notion of regulating deferral of compensation within a year is bizarre. Note the limitation that the rule does not allow deferral to a new taxable year of the teacher. However, the rule not only limits how much may be deferred between the two years but how those amounts must be paid within the second year. The rule certainly could have been written more clearly in terms of the inter-year deferral, and in ways that do not regulate the payment structure in the second year. For example, the rule could have allowed deferrals of recurring part year compensation up to a limit of the lesser of the 402(g) limitation or the inter-year deferral amount, and then defined that second amount as the compensation that would have been paid in the first year minus the amounts actually paid. This would more clearly define the amounts limit the regulatory impact to inter-year deferrals and make the rule more easily applied.
Second, how does the Section 402(g) limitation get involved here? At no point does either 457(f) or 409A refer to 402(g) and neither of them contains the detailed language necessary to address an issue as narrow as annualized compensation elections. There is certainly no support in the statute for this add-on and, given the real-world reasons for and ubiquity of teacher annualization, I can think of no legitimate regulatory purpose for it. This is simply another example of the IRS making up the rules on the fly and of a disregard for the difference between interpretive regulations (in which the IRS is supposed to flesh out the rules in the statute) and legislative regulations (where the IRS is authorized to make up new rules).
At the least, the fact of application of the 402(g) limitation shows what deferral is being regulated, the inter-year deferral. The absurdity of regulating intra-year deferral supports this premise.
Of course, one of the problems in dealing with the entire non-401(a) compensation area is collateral implications. Absent the specific language of proposed regulations, it is difficult to resolve these issues, so the following comment are just tentative. What effect does this rule have on 457(b) and 403(b)? Or, for that matter, on 401(k)? The major possible issues are:
1. Section 401(a).
(a) The annualized compensation structure may affect plan operations. Assume the qualified plan has a compensation measurement year and a limitation year of 8/1-7/31. In that case, an annualization election will have the effect of shifting some compensation accrued during on compensation/limitation year back one year. This affects both the application of 415 and the compensation base for determining or allocating contributions. Setting aside the potential for a 415 violation as minor, the deferral could certainly affect a contribution of, say, 6% of compensation or a matching contribution of, say, 100% of the first 6% of compensation, particularly if the contribution rate varies between years. (And fixing that differential would involve individually designed plan-type features, the calculation of compensation separately for allocations and testing and the running of a general nondiscrimination test.)
(b) The annualization can reduce the ability of TPAs to catch unreported severances. Many TPAs rely on the cessation of compensation as a backup for employer reporting of severances. To the extent the amounts not yet paid on severance of an annualized teacher are not paid in a balloon payment, this backup will not work until the annualization period is completed.
(c) The annualization structure creates the potential for some of the compensation to be paid more than 2-1/2 months after severance, particularly if the “annualization” uses a 13-month period. Since the 415 regulations only allow the plan to take into account compensation paid before the later of 2-1/2 months from severance or the end of the limitation year, this could have a meaningful effect on severance. Using the same plan and assuming a 13-month annualization from 9/1 of the first year and termination on 6/1 of the second year, the 2-1/2 months expires on 8/15, while compensation continues to be paid through 9/30. Since the limitation year ends on 7/31, compensation paid after 8/15 is not taken into account under 415. The 9/1 and 6/1 dates are admittedly artificial, and the more likely scenario is 8/15 and 6/15, in which a 12-month annualization coincides with the end of the 2-1/2 months, more or less, so that the issue is minor, It can, nonetheless, cause violations.
(d) At no point does the rule say that the annualized amounts can or cannot be the subject of cash or deferred elections. Because of the 2-1/2 month limitation under the 415 regulations, it is possible that annualized amounts will not be eligible for deferral because the amounts would not be included in 415 compensation. Given that the employer and TPA may not have properly classified the employee as terminated, this is a specific risk of the annualized compensation structure that does not get fixed easily, with a higher risk of error when the fact pattern occurs than, say, a matching or employer contribution determination made after the end of the plan year.
(e) If the qualified plan has an active service requirement (say, employed on the last day of the plan year), the employee could lose a match or employer contribution as to the amount pushed into the plan year of termination. In addition, the last day rule may not be applied properly in the year of severance because of the continuation of compensation after the date of severance.
(f) The deferral limits are personal, and based on the taxable year of the employee. Thus, shifting within that year has no effect on how they are determined or applied. There is, of course, the possibility that changing elections will change deferrals (For example, increasing deferrals for the summer because of other compensation from summer employment is a possibility.); this simply afford more flexibility. The higher risk of administrative errors is a constant.
2. Section 403(b). The issues are essentially the same, except that the 415 limitation is not really relevant because the 403(b) rules are based on the employee's taxable year. As a result, the limitation that the annualization not defer to subsequent years of the employee prevents any non-technical 415 significance. In addition, most 403(b) plans will use a calendar year for all purposes to avoid the need to calculate the 415 limitation and other compensation-related items on separate bases.
3. Section 457. Ditto for 457. The limitations in 457 are based on taxable years of service providers and most are calendar year plans.
“the term recurring part-year compensation means compensation paid for services rendered in a position that the service recipient and service provider reasonably anticipate will continue on similar terms and conditions in subsequent years, and will require services to be provided during successive service periods each of which comprises less than 12 months (for example, a teacher providing services during a school year comprised of 10 consecutive months), and each of which periods begins in one taxable year of the service provider and ends in the next such taxable year. The rules of this paragraph (a)(14) apply to a particular amount of compensation only once, so that an amount deferred under this rule may not again be treated as recurring part-year compensation for purposes of this paragraph and subject to a second deferral election under this paragraph (a)(14).”
The reason for creating this rule is to allow teachers and other eligible public school employees to annualize their compensation. Typically, this allows a teacher to receive pay in equal amounts from the beginning of a school year (say, September) to the beginning of the next school year (say, the following August). The unwillingness of the IRS to extend the rule to non-teachers, incidentally, serves as an example of the clout of K-12 teachers and otherwise has absolutely no justification. So far, so good.
There are two problems with this rule.
First, the very notion of regulating deferral of compensation within a year is bizarre. Note the limitation that the rule does not allow deferral to a new taxable year of the teacher. However, the rule not only limits how much may be deferred between the two years but how those amounts must be paid within the second year. The rule certainly could have been written more clearly in terms of the inter-year deferral, and in ways that do not regulate the payment structure in the second year. For example, the rule could have allowed deferrals of recurring part year compensation up to a limit of the lesser of the 402(g) limitation or the inter-year deferral amount, and then defined that second amount as the compensation that would have been paid in the first year minus the amounts actually paid. This would more clearly define the amounts limit the regulatory impact to inter-year deferrals and make the rule more easily applied.
Second, how does the Section 402(g) limitation get involved here? At no point does either 457(f) or 409A refer to 402(g) and neither of them contains the detailed language necessary to address an issue as narrow as annualized compensation elections. There is certainly no support in the statute for this add-on and, given the real-world reasons for and ubiquity of teacher annualization, I can think of no legitimate regulatory purpose for it. This is simply another example of the IRS making up the rules on the fly and of a disregard for the difference between interpretive regulations (in which the IRS is supposed to flesh out the rules in the statute) and legislative regulations (where the IRS is authorized to make up new rules).
At the least, the fact of application of the 402(g) limitation shows what deferral is being regulated, the inter-year deferral. The absurdity of regulating intra-year deferral supports this premise.
Of course, one of the problems in dealing with the entire non-401(a) compensation area is collateral implications. Absent the specific language of proposed regulations, it is difficult to resolve these issues, so the following comment are just tentative. What effect does this rule have on 457(b) and 403(b)? Or, for that matter, on 401(k)? The major possible issues are:
1. Section 401(a).
(a) The annualized compensation structure may affect plan operations. Assume the qualified plan has a compensation measurement year and a limitation year of 8/1-7/31. In that case, an annualization election will have the effect of shifting some compensation accrued during on compensation/limitation year back one year. This affects both the application of 415 and the compensation base for determining or allocating contributions. Setting aside the potential for a 415 violation as minor, the deferral could certainly affect a contribution of, say, 6% of compensation or a matching contribution of, say, 100% of the first 6% of compensation, particularly if the contribution rate varies between years. (And fixing that differential would involve individually designed plan-type features, the calculation of compensation separately for allocations and testing and the running of a general nondiscrimination test.)
(b) The annualization can reduce the ability of TPAs to catch unreported severances. Many TPAs rely on the cessation of compensation as a backup for employer reporting of severances. To the extent the amounts not yet paid on severance of an annualized teacher are not paid in a balloon payment, this backup will not work until the annualization period is completed.
(c) The annualization structure creates the potential for some of the compensation to be paid more than 2-1/2 months after severance, particularly if the “annualization” uses a 13-month period. Since the 415 regulations only allow the plan to take into account compensation paid before the later of 2-1/2 months from severance or the end of the limitation year, this could have a meaningful effect on severance. Using the same plan and assuming a 13-month annualization from 9/1 of the first year and termination on 6/1 of the second year, the 2-1/2 months expires on 8/15, while compensation continues to be paid through 9/30. Since the limitation year ends on 7/31, compensation paid after 8/15 is not taken into account under 415. The 9/1 and 6/1 dates are admittedly artificial, and the more likely scenario is 8/15 and 6/15, in which a 12-month annualization coincides with the end of the 2-1/2 months, more or less, so that the issue is minor, It can, nonetheless, cause violations.
(d) At no point does the rule say that the annualized amounts can or cannot be the subject of cash or deferred elections. Because of the 2-1/2 month limitation under the 415 regulations, it is possible that annualized amounts will not be eligible for deferral because the amounts would not be included in 415 compensation. Given that the employer and TPA may not have properly classified the employee as terminated, this is a specific risk of the annualized compensation structure that does not get fixed easily, with a higher risk of error when the fact pattern occurs than, say, a matching or employer contribution determination made after the end of the plan year.
(e) If the qualified plan has an active service requirement (say, employed on the last day of the plan year), the employee could lose a match or employer contribution as to the amount pushed into the plan year of termination. In addition, the last day rule may not be applied properly in the year of severance because of the continuation of compensation after the date of severance.
(f) The deferral limits are personal, and based on the taxable year of the employee. Thus, shifting within that year has no effect on how they are determined or applied. There is, of course, the possibility that changing elections will change deferrals (For example, increasing deferrals for the summer because of other compensation from summer employment is a possibility.); this simply afford more flexibility. The higher risk of administrative errors is a constant.
2. Section 403(b). The issues are essentially the same, except that the 415 limitation is not really relevant because the 403(b) rules are based on the employee's taxable year. As a result, the limitation that the annualization not defer to subsequent years of the employee prevents any non-technical 415 significance. In addition, most 403(b) plans will use a calendar year for all purposes to avoid the need to calculate the 415 limitation and other compensation-related items on separate bases.
3. Section 457. Ditto for 457. The limitations in 457 are based on taxable years of service providers and most are calendar year plans.
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