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Deferred Compensation Exit Tax Exception
Deferred Compensation Exit Tax Exception
Deferred Compensation Exit Tax Exception: When it comes time for a U.S. Person to expatriate from the United States, one of the biggest concerns is whether or not they will be considered a covered expatriate. If the person is considered a covered expatriate, then the concern will be whether or not they will be subject to any exit tax on their unrealized gain on mark-to-market assets or deemed distributions from certain deferred income. Even if a person has deemed distributions such as ineligible deferred compensation that would be potentially grossed up into their total income at expatriation, they may still be able to avoid including that income as part of expatriation if the income was earned before the expatriate was considered a US person.
Let’s review IRC 877A(d) and the deferred compensation exit tax exception.
IRC 877A (d) Treatment of Deferred Compensation Items
Internal Revenue Code section 877A (d)(1) refers to the general treatment of eligible deferred compensation.
It provides the following:
(1) Withholding on Eligible Deferred Compensation Items
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(A) Treatment of deferred compensation items (1)Withholding on eligible deferred compensation items (A)In general In the case of any eligible deferred compensation item, the payor shall deduct and withhold from any taxable payment to a covered expatriate with respect to such item a tax equal to 30 percent thereof.
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(B)Taxable payment For purposes of subparagraph (A), the term “taxable payment” means with respect to a covered expatriate any payment to the extent it would be includible in the gross income of the covered expatriate if such expatriate continued to be subject to tax as a citizen or resident of the United States. A deferred compensation item shall be taken into account as a payment under the preceding sentence when such item would be so includible.
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What does this Mean?
This means that when a expatriate is a covered expatriate and has eligible deferred compensation it would generally not be deemed distributed at the time of expatriation. Rather, the IRS will require withholding of 30% such as a 401K.
(2) Other Deferred Compensation Items
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In the case of any deferred compensation item which is not an eligible deferred compensation item—
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(A) (i)with respect to any deferred compensation item to which clause (ii) does not apply, an amount equal to the present value of the covered expatriate’s accrued benefit shall be treated as having been received by such individual on the day before the expatriation date as a distribution under the plan, and (ii)with respect to any deferred compensation item referred to in paragraph (4)(D), the rights of the covered expatriate to such item shall be treated as becoming transferable and not subject to a substantial risk of forfeiture on the day before the expatriation date, (B)no early distribution tax shall apply by reason of such treatment, and (C)appropriate adjustments shall be made to subsequent distributions from the plan to reflect such treatment.
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What does this Mean?
This means that when deferred compensation is not eligible, but is rather ineligible, then the income is deemed distributed the day before expatriation. One common example is money held in a foreign pension plan — which is typically considered to be ineligible deferred compensation and therefore deemed distributed on the day before expatriation, and grossed up on the expatriate’s tax return.
(5) Exception
- Paragraphs (1) and (2) shall not apply to any deferred compensation item to the extent attributable to services performed outside the United States while the covered expatriate was not a citizen or resident of the United States.
What does this Mean?
IRC 877A(d)(5) is an exception to the harsh rule that says deferred compensation (especially the ineligible deferred compensation rules) may be subject to exit tax. It provides that in situations in which the deferred compensation was earned for services performed outside of the US and the covered expatriate was neither a citizen nor resident of the United States — the money may be exempt from exit tax.
For example, if a person was earning deferred compensation as a nonresident before they became a permanent resident, but now they qualify as a Long-Term Resident and Covered Expatriate at expatriation — the ineligible deferred compensation rules will not apply to the income the expatriate earned before that person became a resident or citizen of the U.S.
Notice 2009-85
As provided in prior Notice 2009-85:
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Section 877A(d)(5) provides that the rules of sections 877A(d)(1) and (2) shall not apply to any deferred compensation item to the extent attributable to services performed outside the United States while the covered expatriate was not a citizen or resident of the United States.
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Thus, in the case of an eligible deferred compensation item, the amount of a taxable payment under section 877A(d)(1)(A) with respect to such item will not include the portion of such item that is attributable to services performed outside the United States before or after the expatriation date while the covered expatriate was not a citizen or resident of the United States.
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To the extent that a portion of an ineligible deferred compensation item is attributable to services performed outside the United States before or after the expatriation date while the covered expatriate was not a citizen or resident of the United States, the amount includible in income under section 877A(d)(2)(A) with respect to such item will not include such portion.
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Until further guidance is issued, taxpayers may use any reasonable method that is consistent with existing guidance (including Treas. Reg. § 1.861-4(b)(2), Revenue Ruling 79-388, and Revenue Procedure 2004-37) and is based upon a reasonable, good faith interpretation of section 877A(d)(5) to determine the portion of a deferred compensation item that is attributable to services performed outside the United States while the covered expatriate was not a citizen or resident of the United States.
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In conclusion, for some taxpayers who are US citizens or Long-Term Residents (LTR), it is impossible to avoid the covered expatriate status. In these types of situations, it is important to look at every avenue to try to avoid or minimize exit tax, and IRC 877A(5) is one avenue to consider.
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