As of late, the “A” suffix has become synonymous with deferred compensation—evident by sections 402A, 404A, 408A, 409A, 457A and, recently, 877A of the Internal Revenue Code. Section 877A, which was enacted as part of the Heroes Earnings Assistance and Relief Tax Act of 2008, affecting the deferred compensation of certain expatriating individuals. On October 15, 2009, the IRS issued guidance (Notice 2009-85) clarifying these new “exit tax” rules.
Section 877A specifies the tax treatment of high net worth individuals who expatriate from the US after June 16, 2008. On the day prior to expatriation, such individuals are deemed to have sold property interests they are considered to own at that time and are taxed on the net unrealized gain resulting from such deemed sale (a “mark-to-market tax”). The mark-to-market tax applies to most types of property interests held by such individuals, with certain exceptions. Deferred compensation is among several items excepted from the mark-to-market tax, although it is subject to special rules, as described below. Employers and other payors of deferred compensation will have a withholding or reporting obligation under Section 877A with respect to the deferred compensation of certain expatriating individuals.
“Covered expatriates” generally include (i) any US citizen who relinquishes citizenship and (ii) any long-term resident of the US who ceases to be a lawful permanent resident of the US (a green card holder), provided such individual was a lawful permanent resident of the US in at least eight of the 15 taxable years ending with the taxable year that includes his or her expatriation date. The expatriation date for a US citizen is the date in which that individual relinquishes US citizenship and, in the case of a long-term resident of the US, the date on which that individual ceases to be a lawful permanent resident. However, certain dual citizens and individuals who relinquish US citizenship prior to attaining age 18½ are not treated as covered expatriates.
Section 877A applies to any covered expatriate who (i) has an annual average net income tax liability for the five-year period preceding the individual’s expatriation date that exceeds a specified amount (US$145,000 for 2009, adjusted annually); (ii) has a net worth of US$2,000,000 or more as of the individual’s expatriation date; or (iii) fails to certify on Form 8854 that he or she has complied with US Federal tax obligations for the five-year period preceding the individual’s expatriation date.
Generally, a covered expatriate is deemed to have sold any interest in property that he or she is considered to own. Pursuant to Notice 2009-85 (the “Notice”), a covered expatriate’s property is generally identified and valued in accordance with the Federal estate tax principles as if such individual had died on the day before his or her expatriation date as a citizen or resident of the US. Losses may be taken into account for the taxable year of the deemed sale, subject to loss-limiting provisions. Gains are recognized to the extent they exceed US$600,000. For 2009, this exclusion amount is US$626,000. Moreover, the amount of subsequent gains (or losses) realized on actual dispositions of property is to be adjusted for the gains (or losses) already taken into account under the deemed sale rule of Section 877A (without regard to the US$600,000 exemption). A covered expatriate may irrevocably elect to defer payment of the mark-to-market tax imposed until the actual disposition of the property, provided the individual enters into a tax agreement with the IRS, furnishes a bond (or other security), and appoints a US agent for the limited purpose of contacts with the IRS. In such case, the payment of the tax is deferred until the due date (without extensions) of the covered expatriate’s income tax return for the year in which the property is disposed (or, if earlier, the year that includes the individual’s date of death).
Special rules for Deferred Compensation Items
“Deferred compensation items” include interests in most qualified retirement plans and foreign pension plans, as well as any deferred compensation arrangement (i.e., an unfunded and unsecured promise to pay money in the future, including cash-settled equity rights) and any property other than money (e.g., stock-settled equity rights) that an individual is entitled to receive in connection with the performance of services, to the extent not previously included in income.
Eligible deferred compensation
With respect to an “eligible deferred compensation item,” a covered expatriate will not be treated as having received such deferred compensation on the day before his or her expatriation date. Instead, Section 877A requires the payor of any “eligible” deferred compensation item to deduct and withhold 30 percent of the taxable amount actually paid to the covered expatriate as if such individual continued to be subject to tax as a citizen or resident of the US on the date of payment. An eligible deferred compensation item is an item with respect to which: (i) the payor is either a US person or a non-US person who elects to be treated as a US person for this withholding requirement and (ii) the payee timely notifies the payor of his or her status as a covered expatriate and irrevocably waives his or her right to claim a withholding reduction under any treaty with the US.
On January 3, 2006, Corporation Z, a US corporation, granted A (an employee of Corporation Z) ten cash-settled stock appreciation rights (“SARs”) in connection with A’s performance of services. A can exercise the SARs at any time within ten years from grant. The SARs do not provide for a deferral of compensation under Section 409A of the Code. On January 3, 2006, the fair market value of the Corporation Z stock was US$10. As of November 18, 2009, A had not exercised any of the SARs and the value of a share of the stock was US$20. On November 19, 2009, A becomes a covered expatriate and timely notifies Corporation Z of her status and waives the right to claim a withholding reduction under any treaty with the US. On January 15, 2010, when the value of the Corporation Z stock is US$25, A exercises all of her SARs.
The SARs are eligible deferred compensation items. As such, A has no income inclusion on November 18, 2009 with respect to the SARs. On January 15, 2010, A is required to include US$150 in income (10 shares x (US$25 – US$10)); and Corporation Z is required to deduct and withhold tax equal to US$45 from the US$150 of income recognized by A (30 percent of the amount included in A’s gross income).
Ineligible deferred compensation
In the case of deferred compensation items that are not “eligible deferred compensation items,” the covered expatriate is generally treated as having received such deferred compensation on the day before his or her expatriation date. However, no “early distribution tax” under Section 72(t) or 409A of the Code will be imposed by reason of the tax treatment resulting from Section 877A. Upon the actual distribution of the ineligible deferred compensation item, appropriate adjustments must be made to take into account the tax already imposed as a result of the deemed distribution.
Assume the same facts as in Example 1, except that A did not timely notify Corporation Z of her status as a covered expatriate.
The SARs are ineligible deferred compensation items. As such, Corporation Z has no withholding obligation with respect to the SARs. A is required to include US$100 (10 shares x (US$20 – US$10)) in income on November 18, 2009, the date that the cash award is treated as received.
Upon A’s exercise of the SARs on January 15, 2010, A receives a cash payment of US$150 (10 shares x (US$25 – US$10)). The US$150 cash award is includible in A’s gross income on that date, although an appropriate adjustment is made as a result of A’s deemed receipt of US$100 on November 18, 2009 with respect to the SARs. Accordingly, only US$50 (US$150 – US$100) is includible in A’s gross income on January 15, 2010.
Deferred compensation attributable to services performed outside the US
The expatriate tax does not apply to deferred compensation items to the extent attributable to services performed outside the US while the covered expatriate was not a citizen or resident of the US.
Instructions to Payors of Deferred Compensation Items
A covered expatriate who has a deferred compensation item generally must furnish a Form W-8CE (Notice of Expatriation and Waiver of Treaty Benefits) to each payor within 30 days after the individual’s expatriation date. As a result of receiving the notice of expatriation, the payor may be required to withhold tax under Section 877A or to report information to the covered expatriate and the IRS. In the case of any eligible deferred compensation item, the payor must withhold 30 percent tax on any taxable payment to the covered expatriate. For any ineligible deferred compensation item, the payor must advise the covered expatriate within 60 days of receipt of Form W-8CE of the present value of the individual’s accrued benefit in the deferred compensation item on the day before the expatriation date. Pursuant to the Notice, the present value of the covered expatriate’s accrued benefit is determined accordingly:
- Defined contribution tax qualified plans: by the account balance;
- Defined benefit tax qualified plans: by using the IRS’ method for determining the source of pension payments to a nonresident alien individual from a defined benefit plan where the trust forming part of the plan has been established in the US (Rev. Proc. 2004-37, Section 4.02);
- Deferred compensation arrangements or foreign pension plans: by using principles set forth in the proposed regulations for determining income inclusion under Section 409A of the Code (with modifications specified in the Notice);
- Property: the fair market value of the property (reduced by the amount, if any, the covered expatriate must pay for the property); or for a right to a transfer of property in the future (e.g., a stock-settled SAR), by using the principles set forth in the proposed regulations for determining income inclusion under Section 409A of the Code (with modifications specified in the Notice).
The Notice also addresses the tax treatment of expatriating individuals with respect to other property excepted from the mark-to-market tax regime, which include: (i) specified tax-deferred accounts (i.e., individual retirement plans, qualified tuition plans, Coverdell education savings accounts, health savings accounts, and Archer MSAs) and (ii) interests in nongrantor trusts. However, future guidance will address gifts and bequeaths subject to a transfer tax under new Section 2801 of the Code.
The Notice may be applied in its entirety to individuals whose expatriation date is after June 16, 2008.