Tax Treatment of Deferred Compensation at Expatriation

Tax Treatment of Deferred Compensation at Expatriation

Deferred Compensation for Expatriates & Exit Tax Treatment

Deferred Compensation Exit Tax Treatment for Expatriates: We summarize Deferred Compensation Expatriation Tax Treatment. The Expatriation rules are complex. When a person is ready to expatriate, and learns they are a covered expatriate, the first step is usually to (immediately) take stock of their worldwide assets to determine the mark-to-market outcome on unrealized gain.

This article will discuss the deferred compensation rules.

IRS Treatment of Deferred Compensation 

Some assets held by the expatriate are not sold.

Rather, some items are deferred until payout (401k) and other are deemed distributed (foreign pension).

The Deferred Compensation Expatriation Tax Treatment requirements vary based on whether the deferred compensation is elgible or not. One of the most common types of deferred comp is a 401K. With a typical 401K, the employee and employee may contribute pre-tax dollars to the retirement investment.

It grows tax-free.

Then at retirement, when the participant is (presumably) in a lower tax bracket, the income is earned at a rate lower than pre-retirement (all things considered equal). Other types of deferred compensation are CPF accounts in Singapore, Superannuation in Australia, and Provident Funds in Hong Kong and throughout Asia.

First, is the deferred compensation eligible or ineligible.

A. Eligible Deferred Compensation

The eligible type of deferred compensation gets the better treatment. Let’s stay on the 401K as an example AND presuming you gave the plan administrator notice within 30-days of your expatriation.

A 401K is an eligible plan.

Therefore, at the time of expatriation, the expatriate is not deemed to have received a distribution of the money.

U.S. Plan Administrator

Having a U.S. Plan Administrator for the deferred compensation is what essentially  makes it eligible. Since the plan administrator is U.S. based, the IRS knows exactly where to go to make sure the proper amount is withheld.

And, for all you who think outside the box (we commend you) – the withholding is still 30%, even after you expatriate and presuming there is a treaty. The IRS is a step ahead of you, and you must irrevocably waive the right to claim treaty benefits and lower withholding.

Result: In the future, when the expatriate receives payments, the plan administrator will withhold 30%.

B. Other Deferred Compensation

If your plan is not eligible, the rules are not as kind to you.

If the plain is not eligible, then the IRS will deem the full amount of the present value of the accrued benefit in the plan as deemed distributed on the day before expatriation.

This can be a serious issue.

Example of the Harsh Tax Impact of Deferred Compensation Tax Treatment 

For example, Michelle is a U.S. citizen who resides overseas in Australia. She previously lived in Singapore. The bulk of her retirement is in an Australian Superannuation and Singapore CPF.

They are worth nearly $3M.

Even if Michelle does not have any stocks or other funds which could result in an MTM gain, she may be stuck with a significant tax bill if that money is deemed distributed. Essentially, she will lose ALL the benefit she accumulated working for the past 30-years. And, since this is not the result of an Mark-to-Market unrealized gain, but the money is actually in the account, the bond is not generally available.

Planning note: Many plans do not fully accrue until retirement, so the actual value on the day before expatriation is not the full amount of the plan, so there is some wiggle room.

Pre-U.S. Person Status

While the rules may be extremely harsh for Accidental Americans and other U.S. person who work and reside outside the U.S., for more recent long-term residents (Green Card Holders), there is some relief.

IRC 877A (d)(5) provides:

(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.

More detailed information on IRC 877A.

Interested in Expatriation from the U.S.?

Our firm specializes exclusively in international tax.

Contact our firm today for assistance.

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