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Expatriation – eligible vs ineligible compensation

Summary of the Exit Tax

The exit tax is made up of three main components:

  1. Pensions and Retirement Schemes: These can be taxed either immediately upon expatriation or on a deferred basis.
  2. Nongrantor Trusts: Beneficiaries of these trusts will face a withholding tax on distributions that represent ordinary income.
  3. Other Assets: All other assets not included in the previous categories are subject to a mark-to-market tax on unrealized gains, as if they were sold on the day before expatriation.

Tax Rates: These taxes range from about 20-40%. The first $767,000 of gains (adjusted for inflation) from the mark-to-market tax is exempt. Future transfers of assets to U.S. citizens or residents could be subject to a 40% inheritance tax.

Deferred Compensation Items

Deferred compensation refers to a portion of an employee’s earnings that is set aside to be paid out at a later date, often during retirement. It can take various forms, including pensions, retirement plans, and stock options. 

Deferred compensation is treated differently depending on whether it is “eligible” or “ineligible.”

Here’s how eligible and ineligible deferred compensation differ:

Eligible deferred compensation receives deferred treatment. Ineligible Deferred Compensation (such as most foreign pensions) are deemed distributed the day before expatriation.

With eligible deferred compensation, there may be no immediate tax liability.

What is Eligible Deferred Compensation?

Eligible deferred compensation refers to any deferred compensation item that meets the following criteria:

  • The payor is either a U.S. person or a non-U.S. person who chooses to be treated as a U.S. person under section 877A(d)(1).
  • The covered expatriate informs the payor of their status as a covered expatriate using Form W-8CE.
  • The covered expatriate waives any right to claim withholding reduction on this compensation item based on any treaty with the United States (as specified in Form 8854).

– The Secretary may provide separate guidance providing a procedure for a payor who is a non-U.S. person and wishes to elect to be treated as a U.S. person for purposes of section

For  purposes of this subsection, the term “deferred compensation item” means—

(A) any interest in a plan or arrangement described in section 219(g)(5)

(B) any interest in a foreign pension plan or similar retirement arrangement or program

(C) any item of deferred compensation, and

(D) any property, or right to property, which the individual is entitled to receive in connection with the performance of services to the extent not previously taken into account under section 83 or in accordance with section 83.

Tax Regimes

Section 877A provides alternative tax rules for eligible and ineligible deferred compensation items:

  • Section 877A(c) exempts deferred compensation items, specified tax deferred accounts, and interests in a non-grantor trust from the mark-to-market regime. This exemption applies if the covered expatriate was a beneficiary of the trust on the day before their expatriation date.

If the covered expatriate is treated as the owner of any portion of a trust under the grantor trust rules (sections 671 through 679) on the day before the expatriation date, the assets held by that portion of the trust are subject to the mark-to-market regime (except for coordination with section 684). 

outlines alternative tax regimes:

  • For “eligible deferred compensation items,” the payor must withhold 30% tax from taxable payments to a covered expatriate. (877A(d)(1)(A))
  • For “ineligible deferred compensation items,” the covered expatriate is treated as having received an amount equal to the present value of their accrued benefit on the day before the expatriation date.( 877A(d)(2)(A))
  • Section 877A(e)(1)(A) treats any interest in a specified tax deferred account held by a covered expatriate on the day before the expatriation date as a distribution of the entire interest in that account.
  • Section 877A(f) requires trustees to withhold 30% of the taxable portion of any direct or indirect distribution of property to a covered expatriate from a nongrantor trust where the covered expatriate was a beneficiary on the day before the expatriation date. If the fair market value of the distributed property exceeds its adjusted basis, this withholding applies.
  • Section 877A(i) The Secretary of the Treasury is authorized to create regulations necessary to implement the purposes of Section 877A.

The Treasury Department and the IRS plan to issue regulations that incorporate the guidance outlined in the notice.

  1. Overview of the Notice:
    • The notice consists of nine sections, each addressing different aspects of Section 877A:
      • Section 1: Background on the general application of Section 877A.
      • Section 2: Rules for determining whether an individual is subject to Section 877A.
      • Section 3: Explanation of the mark-to-market regime.
      • Section 4: Interaction between Section 877A and other Code provisions (including Section 877).
      • Section 5: Application of Section 877A to deferred compensation items.
      • Section 6: Application of Section 877A to specified tax deferred accounts.
      • Section 7: Application of Section 877A to interests in nongrantor trusts.
      • Section 8: Filing and reporting requirements for expatriates covered by Section 877A, including changes to Form 8854 (Expatriation Information Statement) and an introduction to Form W-8CE (Notice of Expatriation and Waiver of Treaty Benefits).
      • Section 9: Future guidance will address gifts and bequests subject to a transfer tax under new Section 2801.

Other Considerations:

  • Mark-to-market rules do not apply to deferred compensation items, specified tax deferred accounts, and interests in nongrantor trusts where the covered expatriate was a beneficiary before expatriation.
  • If a covered expatriate holds an interest in a specified tax-deferred account, it is treated as a distribution of their entire interest on the day before expatriation.
  • In the case of property distribution from a non-grantor trust, the trustee withholds 30% of the taxable portion. If the fair market value exceeds the adjusted basis, the trust recognizes gain as if the property were sold.

Ineligible Deferred Compensation

 refers to certain types of deferred compensation that do not qualify as “eligible deferred compensation.”

  • Typically, this category includes foreign pensions or other similar arrangements.
  • The key consequence of having ineligible deferred compensation is an immediate tax liability. It is treated as if it were distributed to the individual upon expatriation (deemed distributed).

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