Sec. 402(b) and foreign pension plans.

• Author: Almeras, Jon

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 arc 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...