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IRS Clarifies NQDC Rules for Teachers • Final Regs. on Dependent Care Expenses • Prop. Regs. on Dependency Exemption For Noncustodial Parent

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Alistair M. Nevius, J.D.

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FROM THE IRS

IRS Clarifies NQDC Rules for Teachers

Sec. 409A was effective on January 1, 2005, and applies to nonqualified de-ferred compensation (NQDC), that is, compensation earned in one year but not paid until a future year. If NQDC does not meet the requirements of Sec. 409A, it will be subject to additional taxes, including a 20% additional income tax (Sec. 409A(a)(1)(B)(i)).

Teachers who teach only during the academic year but are paid over 12 months are subject to the Sec. 409A rules. For example, a teacher who is paid $54,000 from September 1 through August 31 ($4,500 per month) but who teaches from September 1 through June 30 earns $5,400 per month for 10 months of teaching. The difference between the amount earned from September 1 through December 31 ($21,600) and the amount paid for that period ($18,000) is treated as NQDC and is subject to Sec. 409A since it is not paid until the following year.

Final regulations issued in April 2007 (TD 9321) allow teachers to elect to annualize their salaries (i.e., be paid over 12 months) if they meet certain requirements. The final regulations are effective January 1, 2008, and the Service has clarified (IR-2007-142) that this new rule will not affect teachers during the current school year. School districts that choose to offer the annualization election to their teachers do not need to make any changes prior to 2008, and their employees will not be subject to additional taxes under Sec. 409A. In addition, the IRS clarified that school districts are not required to offer their employees the annualization election. (For more on the Sec. 409A regulations, see “Current Developments in Em-ployee Benefits and Pensions,” p. 682.)

REGULATIONS

Final Regs. on Dependent Care Expenses

The Service has issued final regulations on the Sec. 21 credit for child and dependent expenses (TD 9354). The final regulations adopt, with changes, proposed regulations that were released in May 2006 (REG-139059-02). The final regulations apply to tax years ending after August 14, 2007.

Sec. 21 allows a credit for qualifying employment-related household and dependent care expenses that are paid to allow the taxpayer to be gainfully employed. The final regulations clarify the treatment of several types of costs, including costs of summer schools and camps, costs incurred during the taxpayer’s temporary absence from work, and costs of caregivers’ room and board.

Education costs do not qualify for the credit, but the regulations clarify that the full amount paid for a day camp or similar program qualifies even though the camp specializes in teaching a particular activity, such as soccer. For administrative convenience, no allocation is required in this situation be-tween the cost of care and amounts paid for learning the specialized skill. However, the regulations spell out that the costs of summer school and tutoring programs are not qualifying employment-related expenses because such programs provide education and not care.

The final regulations clarify that the Sec. 21(b)(2)(C) requirement that a dependent care center must comply with applicable state and local laws also applies to day camps. They also clarify that only day camps are eligible; no portion of the cost of an overnight camp is a qualifying employment-related ex-pense, even if the parents work at night.

The final regulations state that the additional cost of providing room and board for a caregiver over usual household expenses may be an employment-related expense and clarify that an increase in the cost of utilities attributable to providing room and board to a caregiver may also constitute a qualifying expense.

A taxpayer must generally allocate expenses between qualifying and nonqualifying costs on a daily basis during any period in which the taxpayer is employed only part of the time. However, the final regulations provide that if a taxpayer is absent from work for a short, temporary period, the costs of child or dependent care during that period can still qualify, as long as the caregiving arrangement requires the taxpayer to pay the costs during that period. The regulations create a safe harbor that treats an absence of no more than two consecutive calendar weeks as a short, temporary absence.

The regulations also explain that, for parents who work at night, the costs of overnight care and daycare—when one parent sleeps during the day—may be qualifying expenses.

Finally, the regulations make clear that the special dependency rule of Sec. 21(e)(5) applies to children of parents who live apart at all times during the last six months of the calendar year, as well as to the children of separated or divorced parents.

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© 2007 AICPA