Teachers and other school employees returning from summer vacations are dealing with the prospect of an IRS rule change on deferred compensation that could see their taxes increase by 20 percent if they aren't careful.

The rule involves deferred compensation and applies to school districts that offer employees who work for 10 months but are paid over a 12-month period the option of having their payments spread out throughout the year, as many school districts do. In 2004, Congress changed the law on deferred compensation in the American Jobs Creation Act to keep corporate executives from avoiding taxes on deferred salary. A rule change by the IRS meant that the law applied to school employees as well.

The IRS issued guidance that allowed employees to submit a form in which they elect to participate in a deferred-pay system for the 12 months. Generally the election needs to be made before the start of the school year. Many teachers and school districts were concerned about the IRS rule change last year, but the IRS sent out a news release last summer saying it would not apply until this year.

However, now that another school year has arrived, there are fresh worries about the rule change. Some school districts have warned employees that if they don't submit the election form, they could be subject to the additional 20 percent tax. One school district in Guilford County, N.C., has even warned teachers that if a teacher's form is lost, not only that teacher might be subject to the additional tax, but a single lost form could make all the other teachers in the county subject to the additional tax.

However, the IRS has proposed newer rules that it hopes will alleviate some of the worries. The IRS has released Notice 2008-62, which provides that no deferral income will occur if both of the following conditions apply.

* 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. For example, if the service period begins in August 2008, all compensation must be received by Sept. 30, 2009.

* The total amount deferred is less than a dollar amount provided under Section 402(g)(1)(B) of the Tax Code for that year. For 2008, this amount is $15,500.

The IRS has published similar guidance for plan administrators in a special back-to-school edition.

The Treasury Department and the IRS anticipate that these rules should exclude from coverage most arrangements for public school teachers and other school-year employees under which they are permitted to annualize school-year compensation, whether or not they are given individual elections.

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