Deferred compensation items (think “pensions”) will either be taxed as a lump-sum distribution or tax will be withheld as distributions are made to you. This applies, however, only to Covered Expatriates.
This stuff is strange and you really should hire an expert to figure this out for you.
Section 1. What Are They?
The mark-to-market taxation rules explicitly do not apply to any “deferred compensation item.” Instead, the tax treatment depends on whether the item is an “eligible deferred compensation item” or an “ineligible deferred compensation item.”
An “eligible deferred compensation item” is taxed at a flat 30% rate. When the payor makes a payment to the Covered Expatriate, 30% of the payment is withheld as tax.
An “ineligible deferred compensation item” is generally treated as if the Covered Expatriate received a lump sum distribution on the day before the expatriation day. A present value calculation is made and tax is imposed.
The following items are defined by the IRS as “deferred compensation items.”
Normal Domestic Pension-Like Arrangements
First, there are things that look like normal types of plans. These are defined as “any interest in a plan or arrangement described in section 219 (g)(5).” This means:
- a plan described in section 401(a) that includes a trust exempt from tax under section 501(a),
- an annuity plan described in section 403(a),
- a plan established for its employees by the United States, by a State or political subdivision thereof, or by an agency or instrumentality of any of the foregoing, but excluding an eligible deferred compensation plan (within the meaning of section 457 (b)),
- an annuity contract described in section 403(b),
- a simplified employee pension (within the meaning of section 408(k)),
- a simplified retirement account (within the meaning of section 408(p)), or
- a trust described in section 501(c)(18).
An interest in a foreign pension plan or similar retirement arrangement or program is a “deferred compensation item” for exit tax purposes. Yes, we will have to wrangle with that pension you built up for decades before becoming a U.S. resident.
Special stuff identified in Notice 2009-85
Deferred compensation items also include things that are defined in Section 5.B(4) of Notice 2009-85. This is a “catch-all” provision. If you have the right to get some compensation, the IRS wants to deal with it for the exit tax.
No Section 83 Election
Sometimes employees are given property (like stock in the employer company) as compensation. They can make an election to treat themselves as having received the full value of that property in the year of receipt. The provision of the Code is Section 83. Alternatively, they might not make the election, in which case they wait until some future date to take the item into income.
The exit tax rules say that if you made the Section 83 election, the item is not a deferred compensation item. (Makes sense. It is now an asset that is taxed under the mark-to-market rules.) But if you did not make the Section 83 election, then it is a deferred compensation item and must be dealt with accordingly for exit tax purposes.
Section 2. Eligible or Ineligible
Eligible Deferred Compensation Item
Once you have decided that you have a deferred compensation item, the next thing you have to do is figure out whether it is an “eligible” deferred compensation item or an “ineligible” one.
An eligible deferred compensation item means any deferred compensation item where:
- The payor is either a U.S. person or a non-U.S. person who elects to be treated as a U.S. person for purposes of the exit tax; and
- The Covered Expatriate notifies the payor of his or her status as a Covered Expatriate and irrevocably waives any right to claim any withholding reduction under any treaty with the United States.
Payments from an eligible deferred compensation item are taxed at 30% as distributions are made. The withholding applies to the portion that would be gross income to you. The payor is required to withhold the tax and send the balance to you, the Covered Expatriate.
Ineligible Deferred Compensation Item
An ineligible deferred compensation item is anything that is not an eligible deferred compensation item.
Ineligible deferred compensation plans are taxed immediately upon expatriation. Calculate the present value of the Covered Expatriate’s interest in the deferred compensation item and include it in taxable income for the year of expatriation.
Section 3. Services Performed Outside USA
For someone who accrued deferred compensation benefits outside the United States before becoming a resident or citizen, there is a bit of a break. Those deferred compensation items are not subjected to the exit tax rules.
If you were a U.S. citizen or green card holder working abroad when you accrued the benefits, however, they are not excluded from the exit tax calculations.