Pension Valuation for the Net Worth TestJuly 18, 2017 - Phil HodgenExpatriation
The net worth test rates you as a covered expatriate if your net worth is $2,000,000 or more.1 Pensions and retirement plans are assets that you include in calculating your net worth.2
How do you figure out how much your pension is worth?
Government Guidance: Embarrassing
There is scant (and by “scant” I mean nothing at all) guidance on how to compute the value of your pension benefits. The Instructions to Form 8854, for instance, say absolutely nothing at all.3
Notice 2009-85 merely points you to Notice 97-14 for guidance on how to calculate your net worth.4 (As you will see below, however, I encourage you to bootleg a concept from an unrelated section of Notice 2009-85 to help you understand what to do).
Notice 97-19 does not refer to computing the value of pensions. Instead, it tells us to use the principles of IRC §2512 (the “this is how to value a gift”) rules to figure out net worth:
In determining the values of interests in property for purposes of the net worth test, individuals must use the valuation principles of section 2512 and the regulations thereunder without regard to any prohibitions or restrictions on such interest. Although individuals must use good faith estimates of values, formal appraisals are not required.5
Two Types of Pensions
Let’s do the government’s work for it, shall we?
Start with the proposition that your right to receive pension benefits is an “interest in property”.
Notice 97-19 tells us to use gift tax principles to value interests in property for the net worth test. Let’s think about what a pension is. It is either a lump of money you can get at any time (e.g., you can take all of the money out of your Individual Retirement Account) or it is a promise to pay you an income stream when you retire.
There are generally two types of pensions:
- Defined contribution plans, where you (or your employer, or both) contribute to the plan. Whatever it grows to at retirement, that’s yours. In other words, the contribution is fixed, but the payout is variable.
- Defined benefit plans, where you are guaranteed a specific payout at retirement, and your employer puts enough money into the pension to fund that payout. In other words, the benefit is fixed, and the contribution varies to hit the targeted benefit.
Let’s see if we can cobble together some help for the afflicted expatriate who needs to compute a value for one or both of these types of pensions.
Defined Benefit Plans: Treat Like an Annuity
It will not surprise you to learn that the gift tax valuation rules of Section 2512 do not talk about gifts of pension rights. I defy you to find a gift of pension rights. It simply does not happen.
But defined benefit plans are basically annuities. Your employer promises to pay you $2,500 per month for life upon retirement. That’s an annuity income stream. We know how to compute lump sum values for annuities, and Regs. §25.2512-5(d)(2)(iv) tells us precisely how to do it.
And Notice 2009-85 indirectly gives us guidance for valuation of pension benefits for the purpose of the net worth test.
A covered expatriate is taxed on ineligible deferred compensation income (think “pension” in English) as if a lump sum payment is made on the day before expatriation. Notice 2009-85 tells us to calculate a defined benefit plan’s present value based on accrued pension rights up to the date of expatriation.6 We are not told how to calculate present value, but we are told to use accrued pension benefits–not future pension benefits you expect to get after expatriation.
So let’s take the idea of “use accrued pension rights up to the date of expatriation” and marry it to a “compute lump sum value of an annuity stream” to calculate the value of your pension benefits in a defined benefit plan.
This is a two step process. First, figure out what your accrued benefits are as of the date of expatriation. (Good luck. The easiest and probably only way to do this is to ask the pension plan administrator).
Second, compute the lump sum value of an annuity income stream. I see three possible methods for computing the lump sum value of the annuity income stream from the pension:
- The method given to us in Regs. §25.2512-5(d)(2)(iv); or
- The method given to us in Rev. Proc. 2004-37, Section 4.02; or
- Get a number from the pension plan administrator that is computed using some random, idiosyncratic (but reeking of actuarial science) method that bears no resemblance whatsoever to anything found anywhere in the Internal Revenue Code, Treasury Regulations, or any administrative pronouncement from the Internal Revenue Service.
I will bet $5 that the three different methods will give you three different values to use for the net worth test.
Since Notice 97-19 permits you to use a “good faith estimate of value”, I don’t know how the government can whine if you use any one of these three methods.
Choose wisely. 😉
Defined Contribution Plans: Account Balance
Defined contribution plans are a lot easier to value.
Defined contribution plans take a fixed contribution every year (dollar amount, percentage of compensation, etc.). The contributions are invested and the pot grows in size.
At some point in the future you are entitled to receive a payout. Think of a 401(k) plan as an example. If you pull the money out early, you may pay a penalty. But you will get all of the contributions plus the investment earnings at some point.
Here, the valuation rule for the net worth test can be inferred from the way that Notice 2009-85 taxes ineligible deferred compensation: it is the account balance.7
I hope you have gleaned the essential truth for defined benefit plans: there is no spoon (YouTube). In close calls, this can make the difference between covered expatriate status or not. Brush up on your mathematical skills, and delve deeply into what constitutes a “good faith estimate of value” and be prepared to defend it. Add a lot of time to your expatriation planning to get data back from the pension plan administrator. You will need it.
- IRC §877A(g)(1)(A), which in turn cross-references to IRC §877(a)(2)(B). ↩
- See, Form 8854, Part V, Schedule A, Lines 6 and 7. ↩
- C’mon, people. Write some decent instructions. ↩
- Notice 2009-85, Section 2(B). ↩
- Notice 97-19, Section III. ↩
- Notice 2009-85, Section 5(D). ↩
- Notice 2009-85, Section 5(D). ↩