Classifying foreign pension plans for U.S. tax reporting can be confusing and contain many pitfalls.
Further complicating matters is that other countries consider their plans to be social security plans, but they are not treated as such under U.S. tax law. This leads to incorrect application of tax treaty benefits to foreign pensions.
Grantor Trust vs. Employee’s Trust
Foreign pensions (i.e., defined contribution plans) are trusts. Since they are not “qualified” for U.S. tax purposes, they are nearly always either grantor trusts or nonexempt employee’s trusts.
A plan established by an employer in connection with the performance of services is generally a nonexempt employee’s trust. Under Section 402(b)(3), a beneficiary of such a trust is not treated as the owner of any portion of it under the grantor trust rules, and Reg. §1.679-4(a)(2) excepts transfers to 402(b) trusts from Section 679. Grantor trust treatment arises instead where the member controls the fund, such as with a self-managed super fund.
Nonexempt employee’s trusts are governed by IRC Section 402(b). Examples of such trusts include:
- Singaporean CPF
- Indian EPF
- Australian Superannuations (but not self-managed supers)
Contributions to Nonexempt Employee’s Trusts
Section 402(b)(1) states that employer contributions to employee’s trusts are included as taxable income in accordance with IRC 83.
IRC 83 provides that employer contributions are included in gross income if funds are not “subject to a substantial risk of forfeiture.” Funds of most common foreign pensions such as those listed previously are not subject to substantial risk of forfeiture. Hence, employer contributions are generally included in gross income when made. Where a plan has a genuine vesting schedule, inclusion is deferred until vesting.
Growth and Distributions from Employee’s Trusts
Section 402(b)(2) provides that the amount actually distributed or made available to an employee by a nonexempt employee’s trust shall be taxable in the year which distributed or made available to the employee. Distributions are taxed under Section 72, so amounts previously included in income under 402(b)(1) constitute investment in the contract and are recovered tax-free.
Under Treas. Reg. 1.451-2, funds are made available whenever a participant would be entitled to receive the distribution upon giving notice of intent to withdraw those amounts. While distributions are often conditioned upon reaching retirement age, in some cases, the funds can be withdrawn for a wide variety of situations such as with Singapore CPFs. In such cases, the growth would be taxable.
Under Section 402(b)(4), if an employee is “highly compensated” in a non-broad based plan, then there is no tax deferral, even if funds have not yet been distributed or made available.
Tax treaties should be reviewed since they can alter the above, as is the case with Australian superannuations.
Form 3520 and 3520-A
Under Section 402(b)(3), the beneficiary of an employee’s trust is not considered the owner of any portion of such trust.
FBAR and Form 8938
Foreign pensions should be reported on the FBAR and Form 8938.
What should non-compliant taxpayers do?
If taxpayers are non-compliant with the foreign asset and income reporting requirements, they should consider applying to one of IRS’s voluntary disclosure programs: