By Koh Fujimoto

Support cross-border life

In this article, I will discuss how the IRS will treat your foreign defined benefit plan under its exit tax regulations. I will also discuss briefly the treatment of a defined contribution plan.  This article is helpful if you have any interests in a foreign pension at the time of abandoning the green card or U.S. citizenship.

  1. Net Worth Test -$2 million
    First of all, how do you evaluate defined benefit pensions when calculating your net assets? You must identify the fair market value of your assets in the plan. In the case of a defined contribution pension, you can easily find out the value on a real-time basis from the website of such a plan. The invested funds are being traded daily on the market, therefore, one can find the fair market value.
    However, in the case of defined benefit pensions, one must find the present value of future payments. I think there are two ways to find this value.
    a. Directly contact the organization that keeps the corporate pension. As with U.S. pension organizations, this present value is an important number that supports the business of pension companies, and the business should always keep track of such numbers for each account holder. You should present W-8CE to the company, and explain the background.
    b. Following the guidance provided by the IRS, there are two. They are: [i]
    b.1  Section 4.02 of /rev. Proc. 2004-37, 2004-1 C.B.1099 (Eligible Deferred Compensation)
    b.2 Prop. Treas. Reg. Section 1.409A-4(Ineligible Deferred Compensation)
    Eligible Deferred Compensation is relatively easy to calculate, but Ineligible deferred compensation seems more complicated.  I recommend that you use a and b to derive the value that is acceptable to the IRS. See the difference between eligible and ineligible deferred compensation in the next section.
    You must find the value day before the date of permanent residence abandonment. Then, you must include it in the net worth test calculation. Even if the company still employs you, and you have not completely met the requirement of the pension (i.e. you are not fully vested), under the exit taxation, you must treat the plan as if you are already vested.
  2. Taxation methods as Deferred Compensation[ii]
    Your pensions are taxed as “deferred compensation”, separately from the capital gains calculation method called Mark to Market. The taxation method is divided into two parts.
    (1) Taxation at the time of withdrawal of 30% -Eligible deferred compensation
    The company must withhold 30% of your distribution, and submit the amount to the IRS. [iii]You can obtain the 30% withholding by filing a 1040 NR tax return if your resident country has an income tax treaty that allows a only resident country to tax pension and other similar remuneration. For instance, Japan has such a treaty with the U.S. [iv] Even if your resident country does not have a treaty with the U.S., the withheld taxes can be trued up by filing 1040 NR. Please consult your tax advisor for further details.

To qualify your deferred compensation to be “eligible deferred compensation”[v]:

  • 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 sections 877(d)(1) 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.

(2) Full taxation at the time of renunciation of permanent residency-Ineligible deferred compensation
If your company does not elect to be treated as a U.S. person, then, your plan becomes an ineligible deferred compensation. [vi] 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 schedules. [vii] In other words, you must pay taxes at the time of filing your 1040 NR-dual status returns.

3, Proration between U.S. resident period and non-resident period
There are very few people who earned pension rights in the U.S. from start to finish. Many people spent years in foreign countries and some years as permanent residents in the U.S.
The 877A stipulates that deferred compensation earned while working outside the United States does not bear the exit tax. [viii]   I think that the underlying logic here is reasonable. The purpose of exit tax is that the U.S. taxes income earned during the U.S. residency period.

The guidance of 877A states that you should determine the value by using a reasonable method. IRS references Treas. Reg. Section 1.861-4(b)(2), Revenue Ruling 79-388, and Revenue Procedure 2004-37).  It also states that you should use good faith Interpretation of Section 877A(d)(5).

Please note that this proration only applies to your tax on ineligible deferred compensation. As for the net worth test, you must include the entire value of your assets in your total net worth.

CDH provides tax filing services for individuals living in the U.S. and strives to resolve and explain their various problems and questions every day. In addition, these people’s issues are complex and wide-ranging, including U.S. and Japanese tax laws, immigration laws, life insurance, and retirement rules.  I intended to make this article as easy as possible to understand the points of complex tax laws and regulations. So there are many exceptions. If you take action, be sure to consult with a tax and legal professional.

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[i] Internal Revenue Bulletin:2009-45, Notice 2009-85, Section 5, D

[ii] ibid Section 5, B, C, D

[iii] ibid Section 5, C

[iv] https://www.treasury.gov/resource-center/tax-policy/treaties/Documents/japantreaty.pdf, Article 17, Pge 27

[v] Internal Revenue Bulletin:2009-45, Notice 2009-85, Section 5, B, (2)

[vi] Ibid Section 5, B, (3)

[vii] ibid Section 5, D.

[viii] ibid Section 5, E