Employee Benefits & Pensions
In this increasingly global economy, an employee is more likely to perform services both within the United States and abroad. Such cross-border transfers of employees affect their pension plans and other deferred compensation arrangements. In some of these instances, some or all of the amounts may be subject to U.S. taxation.
Generally, unfunded deferred compensation arrangements are not subject to U.S. taxes until the funds are distributed. Funded domestic deferred compensation arrangements that do not satisfy the qualified plan requirements are subject to taxation under Sec. 402(b). Amounts contributed to, or accrued under, foreign pension plans and funded deferred compensation arrangements that are subject to U.S. taxes also are taxed under Sec. 402(b). There is little guidance, however, on how Sec. 402(b) applies to these foreign plan amounts. This item outlines the potential tax consequences under Sec. 402(b) for individuals who are subject to U.S. taxes and participate in funded foreign pension plans or other deferred compensation arrangements. In addition, it discusses the open issues that require guidance from Treasury and the IRS.
Overview of Sec. 402(b)
Sec. 402(b) governs the taxation of funded employee benefit trusts that are not tax exempt under Sec. 501(a), which exempts trusts that satisfy the requirements of Sec. 401(a) (i.e., qualified plans). Therefore, Sec. 402(b) generally applies to funded nonqualified deferred compensation arrangements. Sec. 402(b)(1) provides that employer contributions to a nonexempt employees’ trust (402(b) trust) are included in an employee’s gross income in accordance with Sec. 83, except that the value of the employee’s interest is substituted for the property’s fair market value when applying Sec. 83. This generally means that the value of the contributions is includible in the employee’s gross income in the first year in which the contributions are transferable or no longer subject to a substantial risk of forfeiture. The presence of a substantial risk of forfeiture is determined under Sec. 83 and its regulations.
Sec. 402(b)(2) provides that amounts held in a 402(b) trust are not taxed until they are distributed or made available to the individual and taxed under Sec. 72, with the exception that distributions of income before the annuity starting date (as defined in Sec. 72(c)(4)) are included in the individual’s gross income without regard to Sec. 72(e)(5) (relating to special rules for amounts not received as annuities). This means that the amounts are taxed as an annuity; i.e., a portion of the amounts is treated as nontaxable basis recovery, and the remainder is treated as taxable income.
Taxation under Sec. 402(b) depends on whether the nonexempt trust is discriminatory. A 402(b) trust is considered discriminatory if one of the reasons it is not an exempt trust under Sec. 501(a) is the plan’s failure to satisfy the requirements of either Sec. 401(a)(26) (participation requirements for qualified defined benefit plans) or Sec. 410(b) (coverage requirements for qualified defined contribution and defined benefit plans). If the 402(b) trust is not discriminatory, employees who participate in the underlying plan are taxed under Secs. 402(b)(1) and (2).
By contrast, if the trust is discriminatory, highly compensated employees (as described in Sec. 414(q)) are taxed under Sec. 402(b)(4), which provides that they are taxed each year on the employee’s vested accrued benefit as of the close of the trust’s tax year, less the employee’s investment in the contract. Also, if the sole reason a trust is not exempt under Sec. 501(a) is a failure of the underlying plan to comply with Sec. 401(a)(26) or 410(b), then non–highly compensated employees will not be subject to taxation under Sec. 402(b), but they will be taxed as if the plan were a qualified plan (i.e., benefits are subject to income taxes upon distribution). The IRS provided some insight in Rev. Rul. 2007-48 into how Sec. 402(b)(4) applies to a funded trust.
Overview of Rev. Rul. 2007-48
In Rev. Rul. 2007-48, released on July 2, 2007, the IRS analyzed the income and employment tax consequences for the employer, the trustee, and the highly compensated employees who had interests in a 402(b) trust. The ruling involved a deferred compensation plan for 50 key executives of the employer, all of whom were highly compensated employees within the meaning of Sec. 414(q). The plan failed to satisfy the requirements of Sec. 410(b) as well as other qualification requirements of Sec. 401(a). The plan was funded using a domestic trust that was not subject to the claims of the employer’s creditors. Only the employer could make contributions to the trust, and contributions vested after two years of service beginning on the initial date of participation in the plan. Distributions were made to participants upon death, disability, or termination of employment. The trustee was required to make distributions to each participant each year equal to reasonable estimates of income and employment taxes attributable to the increase in the participant’s vested accrued benefit in the trust for each such year.
Because the plan did not satisfy the requirements of Sec. 410(b) and the participants were highly compensated employees, the revenue ruling held the plan was discriminatory, and a participant’s interest in the trust was subject to taxation under Sec. 402(b)(4). As a result, in the year a participant’s interest vested, the participant was required to include in gross income the value of the vested accrued benefit. This amount was equal to the fair market value of the participant’s account in the year in which the amount vested, less the participant’s investment in the contract as of the end of the prior tax year. Each year after vesting, the participant was required to include in gross income the earnings on the vested accrued benefit. The employer was allowed a deduction under Sec. 404(a)(5) in the year the participant included the amount in income, provided separate accounts were maintained for each participant. The deduction was equal to contributions made to the trust once the contributions vested. The trust was allowed a deduction equal to the distributable net income allocable to participants in a trust year.
The amount included in income was considered wages for FICA, FUTA, and income tax withholding purposes. Contributions to a 402(b) trust are taken into account as wages for FICA and FUTA purposes only once, at the time of either contribution or vesting. The employer is responsible for withholding and reporting FICA and FUTA taxes with respect to contributions to the trust that are vested when made; the trustee is responsible for withholding and reporting FICA and FUTA taxes from contributions that are not yet vested when made. Once the contributions are subject to FICA, the earnings on those amounts are not subject to FICA upon subsequent income inclusion under Sec. 402(b)(4) or distribution.
Although FICA withholding is triggered based on the vesting date, income tax withholding is triggered based on the timing of income inclusion under Sec. 402(b)(4). The ruling provided that, due to the different objectives underlying the federal income tax withholding rules and FICA withholding rules, the vested accrued benefit under a 402(b) trust is subject to income tax withholding on the last day of the tax year of the trust. Treated as the employer, the trust is responsible for all federal income tax withholding with respect to amounts included in gross income pursuant to Sec. 402(b)(4).
Unanswered Questions/Outstanding Issues
The ruling does not discuss the treatment of funded foreign plans. Sec. 402(b) taxation usually arises in connection with a foreign funded plan when a foreign national on assignment in the United States continues to participate in his or her home country plan and the employer makes contributions to the plan while the assignee is performing services in the United States and is subject to U.S. taxes. The home country plan is generally a funded, broad-based retirement plan that is subject to the requirements of local law. Practitioners must review the facts and circumstances of each case to determine how Sec. 402(b) should apply, based on the statutes and regulations. Some questions and possible answers concerning the application of Sec. 402(b) that were not addressed in Rev. Rul. 2007-48 follow.
1. Are contributions to, or benefits accrued under, home country plans on behalf of inbound assignees while performing services in the United States subject to taxation under Sec. 402(b)(1) or (b)(4)?
Sec. 401(a) requires a qualified plan to maintain its funds in a trust created or organized in the United States. Generally, a plan that is funded using a foreign trust does not satisfy this requirement. Thus, for U.S. tax purposes, the home country plan is considered a funded nonqualified plan, and its participants who are subject to U.S. taxation are subject to Sec. 402(b). In this instance, the assignee is required to include in gross income the value of his or her vested accrued benefit under the plan as of the end of the tax year in which the individual becomes a U.S. resident.
Whether the participant is subject to taxation under Sec. 402(b)(1) or (b)(4) depends on whether the plan is considered discriminatory (i.e., fails to satisfy the requirements of Sec. 401(a)(26) or 410(b), as applicable). Sec. 401(a)(26) applies to defined benefit plans and generally requires the plan to benefit at least the lesser of (1) 50 employees or (2) the greater of (a) 40% of all employees or (b) two employees (one employee if there is only one). Sec. 410(b) and associated regulations generally set forth two methods of meeting the minimum coverage requirements, the ratio-percentage test and the average-benefit test. Under the ratio-percentage test, the ratio of non–highly compensated employees who benefit under the plan to highly compensated employees who benefit under the plan must be at least 70%. The average-benefit test is generally satisfied if the plan benefits a class of employees that does not discriminate in favor of highly compensated employees and the average-benefit percentage for non–highly compensated employees is at least 70% of the average-benefit percentage for highly compensated employees. See Regs. Sec. 1.410(b)-5 for how to calculate average-benefit percentages.
In general, for Sec. 410(b) testing purposes, excludible employees are not taken into account with respect to a plan even if they benefit under it. Excludible employees include nonresident aliens who have no U.S.-source income. As a result, most participants in the foreign plan, except for the inbound assignee and any U.S. citizens and Green Card holders, would be excluded from the coverage test. In most instances, the assignee is a highly compensated employee and would be considered the only participant in the plan for testing purposes. Thus, the regulations could be interpreted as providing that the plan does not satisfy the ratio-percentage test or the average-benefit test and therefore is considered discriminatory. The assignee, a highly compensated employee, is taxed under Sec. 402(b)(4), which results in income inclusion as of the date of vesting and income inclusion with respect to earnings for years after vesting, to the extent that the assignee is subject to U.S. taxation.
Rev. Rul. 2007-48 does not provide an analysis of how the plan failed to satisfy the requirements of Sec. 410(b) and does not involve participants who are non-U.S. taxpayers. As a result, it is unclear how the IRS would apply Sec. 410(b) coverage tests to funded foreign plans in which the participants continue to participate while on assignment in the United States. In some cases, the foreign plan is a broad-based retirement plan that is subject to qualification requirements that are similar to the requirements of Secs. 401(a) and 410(b). It is not known whether the IRS might consider these local requirements when determining whether a foreign plan is discriminatory for Sec. 402(b) purposes.
2. May an inbound assignee exclude from taxation under Sec. 402(b) benefits that vest before the assignee enters the United States?
It is unclear how vested benefits under a home country plan are treated under Sec. 402(b) when an inbound assignee comes to the United States to perform services. Although Rev. Rul. 2007-48 does not address this issue, there are arguments that Sec. 402(b) should not apply to amounts that vested before the assignee arrived in the United States, since those amounts are not U.S.-source income. That is, Sec. 402(b)(4) should not apply when vested amounts are not connected to the United States and the nonresident alien was neither a U.S. taxpayer nor performing services in the United States when the income was earned. Similarly, vested benefits should be taxed under Secs. 402(b)(1) and (2) only when contributions are made on behalf of the assignee, or distributions are received, while the assignee is performing services in the United States.
In addition, the legislative history of Sec. 402(b) indicates that taxation under Sec. 402(b)(4) was not intended to apply to plans that benefit a broad range of individuals, including non–highly compensated employees. The rules of Sec. 402(b)(4) were enacted as an enforcement mechanism to deter employers from establishing plans that discriminated against non–highly compensated employees. Rev. Rul. 2007-48 does not address these technical and policy arguments, and there is little guidance on the subject. Thus, it is unclear how the IRS would view these arguments.
3. How are amounts that are unvested upon an assignee’s arrival in the United States treated under Sec. 402(b)?
Alternatively, an inbound assignee may arrive in the United States with some unvested benefits under a home country plan. It is unclear whether all or a portion of the unvested benefits that vest while in the United States are subject to Sec. 402(b)(4). Some argue that, to the extent amounts are subject to U.S. taxation, they are subject to taxation under Sec. 402(b)(1) rather than Sec. 402(b)(4). Such arguments for this scenario are similar to the technical and policy arguments for the scenario in which an assignee arrives with vested benefits.
There are some ways to plan around U.S. taxation in these circumstances. If the company knows the assignee will be working in the United States and has unvested benefits in a funded home country plan, then it should consider accelerating vesting for these amounts before the assignee arrives in the United States and ceasing accruals under the plan while the assignee is in the United States. Or the company may consider delaying vesting while the assignee is in the United States and providing a bonus in consideration of the delay.
4. How are distributions that are received while in the United States taxed under Sec. 402(b)?
For assignees who are nonresident aliens, there are questions about distributions from a funded foreign retirement arrangement that they receive while in the United States. Generally, these amounts are subject to U.S. taxes, even if they are attributable to services performed outside the United States. While the assignee may be eligible for a treaty benefit that reduces the tax rate, it is unclear how Sec. 402(b) applies to these amounts.
Sec. 402(b) provides that the taxable portion of a distribution is determined under Sec. 72, which sets forth the rules for taxing annuities. Under Sec. 72, amounts distributed are divided into taxable and nontaxable portions using an exclusion ratio. The exclusion ratio is determined by dividing the amount the employee previously included in income (i.e., the investment in the contract or basis) by the total amount of the expected payout of the trust interest (i.e., the expected return). Sec. 72(w) generally provides that non-U.S.-source compensation and any earnings thereon for services performed by an individual who is a nonresident alien at the time services are performed are not included in basis if the contribution was not subject to U.S. or any foreign income tax (and would have been subject to income tax if paid as cash compensation when the services were rendered). Under these rules, nonresident aliens do not receive basis for amounts earned for services performed outside the United States or earnings on these amounts. As a result, the U.S.-taxable portion of the exclusion ratio increases. The IRS has not provided guidance on how Sec. 72(w) applies to amounts paid from a 402(b) trust. For a participant who is not a U.S. citizen or does not plan to retire in the United States, distributions should not be made while he or she is a U.S. taxpayer, because of the uncertainty about how distributions are taxed under U.S. law. If plan terms are changed to provide that no distributions are made while in the United States, the distributions should be restricted from employee control so that the constructive-receipt doctrine is not triggered.
Rev. Rul. 2007-48 provides guidance on Sec. 402(b) taxation for domestic employee trusts. In practice, however, Sec. 402(b) taxation may also apply to cross-border transfers of employees, which generally concern nonresident aliens who perform services in the U.S. for a finite period. Treasury’s 2011–2012 Priority Guidance Plan includes planned guidance on the application of Sec. 402(b) to participants in foreign nonqualified deferred compensation plans. Yet this does not guarantee that the IRS actually will release guidance or that it will address all of the unanswered questions about taxation under Sec. 402(b). Nonetheless, if the IRS releases guidance, it is expected to address some of the issues described in this item.
Jon Almeras is a tax manager with Deloitte Tax LLP in Washington, DC.
For additional information about these items, contact Mr. Almeras at (202) 758-1437 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Deloitte Tax LLP.