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Tax Liability for Deferred Pay Shifted

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WASHINGTON--Less than a year after passage of the most sweeping federal tax-reform law ever, many of the nation's top school administrators may once again be faced with making changes in their personal-finance plans.

This time, the Congress, which last year sacrificed a host of tax breaks favorable to educators in order to make across-the-board cuts in income-tax rates, is not the culprit.

Rather, education groups are mobilizing to do battle with the Internal Revenue Service, which has fixed its sights on a key loophole left untouched by Congressional tax reformers.

At stake are a number of arrangements used by highly paid administrators to defer compensation until future years. By spreading their salary payments out or deferring compensation until retirement, these employees can greatly reduce their current tax liability in any one year.

Such arrangments include special retirement annuities; deferred bonuses; and severance-pay plans, such as the generous "golden parachute'' agreements negotiated by some top school officials.

But, experts say, even lower-ranking employees could find themselves faced with added tax demands, depending on how broadly the I.R.S. extends its new rules.

If the agency has its way, education lobbyists warn, most deferred-compensation plans will be effectively banned. And if the I.R.S. decides to apply the new rules retroactively, they add, many administrators could face staggering demands for back taxes.

Because the new rules would not apply to private-sector employees, education lobbyists say, school districts may find it even harder to compete for qualified executives.

"We think it would clearly injure the governmental sector in recruiting talented people,'' said Katherine Herber, a lawyer for the National School Boards Association.

At issue is an obscure section of the federal tax code enacted by the Congress in 1978. The law set limits on how much of their compensation government employees, including school executives, could defer to future years.

'Incredibly Unfair'

Under the law, deferred compensation becomes immediately taxable once an employee exceeds his or her yearly limit. The 1986 tax law reduced that limit to a maximum of $7,000 a year.

But until recently, tax experts assumed that the law's restrictions on deferred compensation only applied to so-called "elective'' plans, such as the popular 401(k) retirement accounts, in which employees can choose how much money they wish to defer each year.

Because few districts offer such plans, such an interpretation imposed little hardship on public-school employees.

In January, however, the I.R.S. issued new guidelines to taxpayers, saying that the agency will now apply the annual limits to any agreement or plan that it considers to be a form of deferred compensation, whether elective or not.

According to the agency's critics, the new interpretation means that employees will have to pay taxes immediately on money that they will not receive for years to come.

"It's incredibly unfair,'' Ms. Herber said. "It violates the basic principle that you don't tax people until they at least have the opportunity to use the income that's being taxed.''

The problem, at least from the I.R.S.'s point of view, is that it can be difficult or impossible to tell the difference between a plan selected by an employee and one imposed by an employer, according to a tax lawyer knowledgeable about the issue.

"The [I.R.S.] really can't go behind the scenes,'' explained Gary Quintiere, a lawyer with the Washington-based firm of Morgan, Lewis, and Bockius. "There is no way to know if a 'non-elective' plan was actually adopted at the request of the employee.''

Mr. Quintiere is representing a group of public-sector employers, including the American Association of School Administrators, that is challenging the I.R.S.'s new position.

No matter how bad an enforcement problem the old interpretation creates for the tax agency, it clearly carries the endorsement of the Congress and cannot be changed without its approval, Mr. Quintiere claimed.

A lawyer for the I.R.S. said, however, that the agency has been unable to find any evidence that the Congress intended to exempt non-elective plans.

"If there is anything, it is rather ambiguous,'' she said. "We don't think Congress meant to make that distinction, and we haven't seen anything that would indicate otherwise.''

Many May Be Affected

Some statistics indicate that a large number of school administrators could be affected if the I.R.S.'s new interpretation prevails.

In a recent study of compensation trends for school executives, for example, the Educational Research Service reported that nearly 14 percent of all superintendents have special pension plans paid for by their employers.

Among large districts--those with more than 25,000 students--more than 21 percent of all superintendents are covered by such agreements, the study found.

While such individual-retirement agreements are the most common deferred-compensation plans, a number of other salary and bonus plans will be affected, Mr. Quintiere warned.

Because the I.R.S.'s new interpretation is so sweeping, he said, school employees who are allowed to accumulate unused sick leave and vacation time from year to year could even face tax problems.

"Once you start trying to quantify what a [non-elective] benefit is, you are starting down a slippery slope,'' Mr. Quintiere said. Ms. Herber agreed, saying that the new rules could be an "administrative nightmare'' for many school districts.

One key question left hanging by the I.R.S. is the effective date of its new interpretation.

In similar situations, the agency has been known to apply its revised position on a law as far back as the date the law was enacted--in this case, 1978.

An I.R.S. spokesman said the agency has not decided whether to apply the new rule retroactively.

While the agency's January guidance did not directly address the issue, Mr. Quinteire warned that the signs are not good.

"The notice ... makes it appear that this is the way they have always interpreted the law,'' he said. "So for them, at least, I would say the question of retroactivity remains open.''

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