All covered expatriates must pay exit tax. The exit tax is computed differently depending on the type of asset.
Over the last two months, I discussed two types of exit tax: the mark-to-market regime, and the tax on specified tax deferred accounts.
For most assets, the mark-to-market regime applies. Specified tax deferred accounts are an exception to the mark-to-market rules: these accounts are subject to a pretend lump sum distribution of the full plan value on the day before expatriation date.
This month, I am discussing another type of asset that is excepted from the mark-to-market rules: deferred compensation. This includes stuff like pensions, stock options, etc. Depending on whether your deferred compensation is classified as “eligible” or “ineligible”, you pay either a 30 percent flat rate tax on payments as they are made to you, or you are treated as receiving a lump sum distribution for the full value of the asset on the day before expatriation.
In this issue, I will explain what deferred compensation is, the difference between eligible and ineligible deferred compensation, how each type of asset is taxed on and after expatriation, and important timing concerns.
The following items are defined by the IRS as deferred compensation items.
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).”1 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 program2 is a “deferred compensation item” for exit tax purposes. Yes, you will have to wrangle with that pension you built up for decades before becoming a US resident.
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.
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.3
Once you know that you have an item of deferred compensation, you must figure out whether it is eligible deferred compensation or ineligible deferred compensation.
An eligible deferred compensation item means any deferred compensation item where:4
- The payor is either a US person or a non-US person who elects to be treated as a US 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.
Covered expatriates who have eligible deferred compensation must file Form W-8CE with the plan custodian.
Form W-8CE must be filed “on the earlier of (1) the day prior to the first distribution on or after the expatriation date or (2) 30 days after the covered expatriate’s expatriation date as defined in section 877A(g)(3)).”5
Form W-8CE instructs the payor to withhold tax on payments made to you.
Distributions from an eligible deferred compensation plan are taxed at 30 percent as payments are made.
The 30 percent tax is withheld from the payments and sent to the IRS by the payor. The remaining amount of the payment is sent to you, the covered expatriate.
Ineligible deferred compensation is any deferred compensation item that is not eligible deferred compensation.6
Just like covered expatriates who have items of eligible deferred compensation, owners of ineligible deferred compensation items must file Form W-8CE with the plan custodian, using the same deadlines.
For ineligible deferred compensation, Form W-8CE instructs the payor to provide the covered expatriate with the present value of the plan on the day before expatriation:
“Within 60 days of the receipt of a properly completed Form W-8CE, the payor of the ineligible deferred compensation item must advise the covered expatriate of the present value of the covered expatriate’s accrued benefit in the deferred compensation item on the day before the expatriation date.”7
Although there is a requirement for the payor to provide the present value, it is not uncommon for the payor to fail to do so. In that case, the covered expatriate must calculate the present value himself, using guidance for valuation methods for various types of assets found in Section 5 of IRS Notice 2009-85.
Ineligible deferred compensation items are taxed as if they were fully distributed to the covered expatriate on the day before expatriation; this is the reason that the payor must provide the present value of the plan to the covered expatriate when presented with Form W-8CE.
The covered expatriate must include the present value of his interest in the deferred compensation item in taxable income for the year of expatriation.
This can be problematic, because when the expatriate takes distributions from the plan in a later year, he may be subject to tax only in his country of residence, and he will not have the benefit of a foreign tax credit from the exit tax already paid for the year of expatriation. Depending on the country of residence, for some retirement plans this can cause the total tax rate to approach 80 percent.
It can be helpful to plan ahead to time your distributions carefully to minimize your overall tax rates. It may be impossible to completely eliminate the double tax problem, but it can usually be made less bad with some planning ahead.
For someone who accrued deferred compensation benefits outside the US before becoming a resident or citizen, there is a bit of a break. Those deferred compensation items are not subject to the exit tax rules.
If you were a US citizen or green card holder working abroad when you accrued the benefits, however, they are not excluded from the exit tax calculations.
There will be different exit tax results for covered expatriates depending on whether their deferred compensation items are “eligible” or “ineligible”.
Eligible deferred compensation items get taxed at a flat rate of 30 percent as payments are made after expatriation. Ineligible deferred compensation items are taxed fully on the day before expatriation, as if they were distributed in full on that date.
To avoid unwelcome double taxation results, plan ahead to time your pre-and post-expatriation distributions and optimize the amount of tax you pay over the long term.