We do a lot of expatriation work — people giving up U.S. citizenship or permanent resident status. There is a tax consequence to this. If you are “too rich” (as defined by the IRS) you are a “covered expatriate.” For most of your assets, you are treated as if you sold them the day before you gave up your citizenship. After some exemptions, you pay tax on any of the “pretend” profit you made on that “pretend” sale.
[Geez I’m using a lot of quotation marks. There is a shortage. Must. Stop. Now.]
But there are some other types of assets that take a tax hit because you give up your green card or citizenship. One major (and excessively complicated) topic is deferred compensation. Pensions. Stock options. Etc.
This post is about Restricted Stock Units, which are a common employee compensation tool in large corporations.
For exit tax purposes, if the employer is a U.S. company, a covered expatriate will be taxed at 30% as payments are made to him/her. If the employer is a non-U.S. company, the covered expatriate will be treated as receiving the present value of the Restricted Stock Units on the day before he/she expatriates. Yes. A giant lump of “pretend” taxable income.
Restricted Stock Unit Defined
For exit tax purposes, a Restricted Stock Unit is defined as follows, at Notice 2009-85, Section 5.B(7):
Restricted stock unit means a right to receive compensation in cash, shares of stock, or other property, as defined in section 5.B(5) of this notice, following the satisfaction of a specified vesting condition. A restricted stock unit is a stock-settled restricted stock unit to the extent that the compensation payable under such restricted stock unit is in the form of a transfer following the satisfaction of such vesting condition of shares of stock or other property or a right to receive property in the future. A restricted stock unit is a cash-settled restricted stock unit to the extent that it is not a stock-settled restricted stock unit.
In other words, if you can wait out the vesting period, a Restricted Stock Unit will give you shares of stock, or cash. For your purposes, you will have Restricted Stock Units if your HR Department or whoever is handling compensation tells you that you have one. Trust me. You know.
Restricted Stock Unit = Deferred Compensation Item
A Restricted Stock Unit is a “deferred compensation item.” See Notice 2009-85, Section 5.B(1)(d).
This is important because deferred compensation items are not taxed by the default method of “mark-to-market” that operates in the exit tax system. (What the IRS calls “mark-to-market” I call “pretend sale”). The taxation of deferred compensation items for exit tax purpose is governed by its own special set of rules.
Eligible vs. Ineligible Deferred Compensation Item
For exit tax purposes, a deferred compensation item is either “eligible” or “ineligible.”
An eligible deferred compensation item is one where the person paying you is a U.S. person (such as a U.S. corporation that employs you and granted you those Restricted Stock Units), and where you do the correct paperwork. Notice 2009-85, Section 5.B(2) says:
Eligible deferred compensation item means any deferred compensation item with respect to which: (i) 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 section 877A(d)(1) and (ii) 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. See section 8 of this notice for the applicable filing and reporting requirements. Separate guidance will be issued under section 877A(d)(3)(A) providing rules for a non-U.S. person to elect to be treated as a U.S. person for purposes of section 877A(d)(1).
An ineligible deferred compensation item is anything that is not an eligible deferred compensation item. Notice 2009-85, Section 5.B(3).
Look at it this way. If the payments are coming from a U.S. source — a source that the IRS can punish with ease — then the deferred compensation item is an “eligible” item. It is “eligible” for slightly better tax treatment. On the other hand, if the payments are coming from a non-U.S. source, the IRS can huff, and it can puff, but it can’t . . . . well, you know the story. These are ineligible for the slightly better tax treatment.
Exit Taxation of Eligible Deferred Compensation Item
Eligible deferred compensation — including Restricted Stock Units that are eligible — are taxed on a pay-as-you-go arrangement. Notice 2009-85, Section 5.C says:
If a deferred compensation item qualifies as an eligible deferred compensation item, the payor must deduct and withhold a tax equal to 30 percent of any taxable payment to a covered expatriate with respect to such an item. Section 877A(d)(1)(B) provides that a taxable payment is any payment to the extent it would be includible in gross income of the covered expatriate if such person continued to be subject to tax as a citizen or resident of the United States. Because the covered expatriate must waive his or her right to claim treaty benefits with respect to an eligible deferred compensation item, the 30 percent withholding tax cannot be reduced or eliminated by treaty. See section 5.E of this notice for rules with respect to an amount of deferred compensation attributable to services performed outside the United States while the covered expatriate was not a citizen or resident of the United States. See section 5.F of this notice for information concerning the application of the withholding rules.
So. Restricted Stock Units issued by a U.S. corporation. You do all of the paperwork correctly. Result: 30% withholding on payouts to you.
Exit Taxation of Ineligible Deferred Compensation Item
Ineligible deferred compensation — including Restricted Stock Units in that category — are taxed on a lump sum basis. Notice 2009-85, Section 5.D says:
With respect to any ineligible deferred compensation item described in section 5.B(1)(a), 5.B(1)(b), and 5.B(1)(c) of this notice, an amount equal to the present value of the covered expatriate’s accrued benefit is treated as having been received by the covered expatriate on the day before the expatriation date as a distribution under the plan and must be included on the covered expatriate’s Form 1040 (or other schedule, as provided in Treas. Reg. § 1.6012-1(b)(2)(ii)(b)) for the portion of the taxable year that includes the day before the expatriation date.
There is a lot of additional information about vesting and present value calculations in Notice 2009-85, Section 5.D. Read it carefully to figure out what it means to you.
(Non)-Application of the Mark-to-Market Gain Exclusion
OK. So we know as a general principle if you have Restricted Stock Units from a U.S. employer you’re going to be taxed at 30% as payments are made to you, and if you are a covered expatriate with Restricted Stock Units from a non-U.S. employer you’re going to be taxed as if you received the present value of a lump sum distribution on the day before expatriation.
“Aha!” you say. “At least I have that one-time gain exclusion from the exit tax I’ve been hearing about.” And in fact such an exclusion exists:
For taxable years beginning in 2012, the amount that would be includible in the gross income of a covered expatriate by reason of § 877A(a)(1) is reduced (but not below zero) by $651,000.
See Rev. Proc. 2011-52, Section 3.27. (PDF)
This will not work. The exclusion does not apply to the taxable income you derive from deferred compensation items (eligible or ineligible).
The $651,000 exclusion applies to income that is triggered under Section 877A(a)(1). That’s the mark-to-market stuff in the exit tax rules. But these rules do not apply to deferred compensation items (including Restricted Stock Units). Section 877A(c)(1) says:
Subsection (a) [the mark-to-market rules] shall not apply to any deferred compensation item (as defined in subsection (e)(2)).
Since the taxable income on the Restricted Stock Units does not arise from the operation of the mark-to-market rules, it follows that the exclusion of mark-to-market gain cannot be applied to the Restricted Stock Units.
It’s Just a Timing Question
You’re hosed. Your only way out of the taxation of your Restricted Stock Units is to not be a covered expatriate. Then the exit tax rules will not apply to you. However, I would not be in such a hurry. In the long run it is more a question of timing rather than a question of paying tax or not.
If you did not give up your citizenship or green card and simply held the Restricted Stock Units until they vested, you’d pay income tax. Right?
If you give up your citizenship or green card and you are not a covered expatriate, you do not suffer the tax consequences described above (30% pay-as-you-go or present value lump sum distribution). Instead you wait and when the Restricted Stock Units vest, you pay income tax.
If you give up your citizenship and you ARE a covered expatriate, then you pay the 30% tax when you get payment. You will still own the Restricted Stock Units. A part of the gain has already been taxed. When the Restricted Stock Units later vest and you exercise, you will have some additional gain (you hope) but for the amount you paid tax on already, there will be no additional income tax. (See Notice 2009-85, Section 5.D for more information about this).