By Anthony Diosdi
In an increasingly global economy, U.S. workers are experiencing unprecedented mobility. As such, U.S. citizens or residents (hereinafter U.S. persons) living in a foreign country, even for a limited time, often participate in a pension or retirement plan; participation might even be mandatory. In most cases, pretax money is contributed into retirement accounts where it accumulates tax-free until retirement. U.S. beneficiaries of foreign pension plans will likely need to report these plans on one or more information reporting forms with their U.S. tax returns. Foreign retirement accounts may also trigger unusual income tax consequences on the beneficiary of such a plan. This article will discuss the special U.S. reporting and tax consequences of foreign retirement plans.
FBAR – Duty to Report Foreign Financial Accounts
In 1970, Congress enacted what has commonly become known as the Bank Secrecy Act (“BSA”), as part of the Currency and Foreign Reporting Act. This was codified in Title 31 (Money and Finance) of the U.S. Code. The purpose of the BSA was to prevent money laundering by requiring the filing of reports where doing so would be helpful to the U.S. government in carrying out criminal, civil, tax, and regulatory investigations. One of the most important provisions of the BSA is Title 31 of United States Code Section 5314(a) which provides in relevant part that:
“The Secretary of the Treasury shall require a resident or citizen of the United States or a person in, and doing business in, the United States to file reports, when the resident, citizen, or person makes a transaction or maintains a relation for any person with a foreign financial agency.”
Section 5314(a) U.S. persons to disclose foreign financial accounts annually on a Foreign Bank Account Report, FinCen Form 114 (“FBAR”). To fully understand a U.S. beneficiary of a foreign retirement plan legal duty in regards to disclosing the plan on an FBAR, it is first necessary to understand the applicable instructions promulgated by the Internal Revenue Service (“IRS”) to prepare an FBAR. According to the instructions, a person must file an FBAR if all of the following conditions are met: 1) a “U.S. person,” 2) had a “financial interest” in, or “signature authority” over, or “other authority” or 3) one or more “financial accounts,” 4) located in a “foreign country,” 5) and the aggregate value of such account(s) exceeded $10,000, 6) at any time during the calendar year. The instructions provide that a “U.S. person” means a U.S. citizen, U.S. resident (green card holder or an alien residing in the United States). In ascertaining whether one has a “financial interest” in or, “signature authority” over, or “other authority” over one or more foreign financial accounts, and if the aggregate value of such accounts exceeds $10,000 requires a closer look at the instructions.
A person has “signature authority” over an account if the person can control the disposition of assets held in a foreign financial account by direct communication (whether in writing or otherwise) to the bank or other financial institution that maintains the financial account.
The definition of “financial account” located in a “foreign country” can be difficult to understand. According to the instructions, a financial account includes securities, brokerage, savings, demand, checking, deposit, time deposit, or other account maintained with a financial institution. A financial account also includes a commodity future or option account, an insurance policy with a cash value (such as a whole life insurance policy), an annuity policy with a cash value, and shares in a mutual fund or similar pooled fund. For reporting purposes, the term “foreign country” includes all geographical areas except the United States, Guam, Puerto Rico, American Virgin Islands, District of Columbia, Northern Mariana Islands, and Indian lands.
A foreign retirement can be classified as an account maintained with a financial institution in a foreign country in which a U.S. beneficiary has “signature authority.” This means as long as the foreign retirement account surpasses the above discussed $10,000 threshold, a U.S. beneficiary has an obligation to timely disclose the foreign retirement account on an FBAR. Failure to report a foreign pension plan on an FBAR can have disastrous consequences. The IRS may penalize any U.S. person who fails to annually timely disclose a foreign retirement account on an FBAR as follows: in cases of non-willful violations, the IRS may annually assess a $10,000 penalty. In cases of willful violations, the IRS can assert an annual penalty of $100,000 or 50 percent of the balance of the foreign retirement account.
Form 8938- Report to Disclose Specified Foreign Financial Assets
Internal Revenue Code Section 6038D requires U.S. persons to disclose specified foreign financial assets on a Form 8938 annually. The Form 8938 is attached to an individual income tax return. Specified foreign financial assets include financial accounts maintained by foreign financial institutions, and certain foreign financial assets that are held for investment. Among these foreign financial assets include interests in foreign entities, stocks or securities issued by non-U.S. persons, financial instruments or contracts in which a non-U.S. person is an issuer or counterparty, foreign corporation-issued stocks, and interests in foreign trusts or estates. Since a foreign retirement plan can be considered an interest in a foreign trust, interest in an account maintained by foreign financial institution, and a contract with a non-U.S. person, a U.S. beneficiary of a foreign retirement account may need to disclose the plan on an IRS Form 8938.
Whether or not a foreign retirement plan is required to be disclosed on a Form 8938 depends on the value of the plan. Beneficiaries of foreign retirement plans must attach to their tax returns Form 8938 for any year in which the aggregate value of the plan and other specified foreign assets is greater than $50,000 (or higher dollar amounts decided by the IRS). Adjusting for different reporting circumstances, the Form 8938 is required with the reporting threshold indicated as follows: 1) an unmarried taxpayer having specified foreign financial assets that have a value of more than $50,000 on the last day of the year or $75,000 at any time during the year; 2) married taxpayers residing in the United States and filing a joint return having specified foreign financial assets of more than $100,000 on the last day of the year or $150,000 at any time during the year; 3) married taxpayers filing separate returns and residing in the United States having specified foreign financial assets of $50,000 on the last day of the tax year or more than $75,000 at any time during the year; and 4) taxpayers living abroad a) not filing a joint return and having specified foreign assets of more than $200,000 on the last day of the year or $300,000 any time during the year, and b) filing a joint return and having specified assets of $400,000 on the last day of the year or $600,000 any time during the year.
As with FBARs, the failure to timely annually disclose a foreign retirement plan on a Form 8938 may have serious consequences. The IRS can assess a $10,000 penalty per violation. The penalty can increase to a maximum of $50,000 if the U.S. beneficiary of a foreign retirement plan does not quickly properly report the foreign pension on a Form 8938.
Form 3520 and Form 3520-A Duty to Report Foreign Trusts
Besides the need to disclose a foreign retirement plan on an FBAR and Form 8938, U.S. beneficiaries of foreign retirement plans may need to disclose the plan on Form 3520 and Form 3520-A. By way of background, U.S. persons are required to file Form 3520 Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Gifts or Form 3520-A Annual Information Return of Foreign Trust With a U.S. Owner or both in situations where transactions with foreign trusts are conducted.
Form 3520 generally must be filed within 90 days of certain “reportable events” such as the creation of any foreign trust by a U.S. person or when a U.S. person transfers any money or property (directly, indirectly, or constructively) to a foreign trust. If any U.S. person beneficiary receives (directly, indirectly, or constructively) a distribution from a foreign trust during a tax year, that person is required to make a return with respect to the trust using IRS Form 3520, show the name of the trust, the amount of the aggregate distributions received, and any other data the IRS may require under Internal Revenue Code Section 6048(c). Each U.S. person treated as an owner of any portion of a foreign trust under Internal Revenue Code Sections 671 through 679 is responsible for ensuring that the foreign trust files Form 3520-A and that the required annual statements are provided to its U.S. owners and U.S. beneficiaries. The form provides information about the foreign trust, its U.S. beneficiaries, and any U.S. person who is treated as an owner of any portion of the foreign trust. A foreign trust with a U.S. owner must file Form 3520-A in order for the U.S. owner to satisfy its annual information reporting requirements as provided under Internal Revenue Code Section 6048(b).
In many cases, a foreign retirement plan can be classified as a foreign trust. Consequently, any contributions (directly, indirectly, or constructively) in the form of cash or other property by a U.S. beneficiary to foreign pension plan can trigger a Form 3520 (and Form 3520-A) reporting requirement. In addition, a distribution from a foreign pension plan (directly, indirectly, or constructively) to a U.S. beneficiary can result in a requirement to file a Form 3520 and Form 3520-A.
As with FBARs and Form 8938, the penalty associated with not timely for not filing a Form 3520 and Form 3520-A is substantial. The penalty for not timely filing a Form 3520 is equal to $10,000 or 35 percent of the gross reportable amount” whichever is greater. The penalty for not timely filing a Form 3520-A is the greater of $10,000 or 5 percent of the gross reportable amount of the trust.
There are a number of exceptions to the 3520 and 3520-A reporting requirements. For example, Canadian Registered Retirement Savings Plans (“RRSP”) are not required to be disclosed on a Form 3520. IRS Rev. Proc. 2020-17 also provides an exemption to disclosing certain foreign retirement plans on Form 3520 and Form 3520-A for “applicable tax-favored foreign trusts.” Tax-favored foreign retirement trusts generally have the following requirements:
1) The trust must be created to operate exclusively or almost exclusively to provide, or to earn income for the provision of, pension or retirement benefits.
2) The trust generally must annually report information with respect to the trust to the relevant tax authorities in the trust’s jurisdiction.
3) The trust must only permit contributions with respect to income earned from the performance of personal services.
4) Contributions to the trust must: a) be limited by a percentage of earned income of the participant, b) be subject to an annual contribution limit of $50,000 or less, or c) be subject to a lifetime contribution limit of $1,000,000 or less.
5) Withdrawals from the trust must be conditioned upon reaching a specified retirement age, disability, or death, or penalties must apply to withdrawal made before such conditions are met. However, an exception is provided for early withdrawals for hardship or education purposes, or for the purchase of a primary residence.
6) If the trust is employer-maintained, then certain additional requirements must be met: a) the trust must be nondiscriminatory insofar as a wide range of employees, including rank and file employees, are eligible to make or receive contributions or accrue benefits under the terms of the trust; b) the trust must actually provide significant benefits for a substantial majority of eligible employees, c) the benefits actually provide under the trust to eligible employees must be nondiscriminatory
Any U.S. beneficiary of a foreign retirement plan should carefully review the 3520 and 3520-A rules governing the reporting of these plans to determine the applicable filing requirements.
Income Tax Considerations
As with U.S. retirement plans, foreign retirement plans often invest in mutual funds. The problem is U.S. beneficiaries of foreign mutual funds are subject to special income tax rules. Distributions from these mutual funds can trigger the passive foreign investment company (“PFIC”) provisions. Under the PFIC rules, often known as the “excess distribution regime,” a U.S. beneficiary of a foreign retirement plan that invests in foreign mutual funds is not taxed on the income of the plan until he or she actually receives a distribution from the plan. Under Internal Revenue Code Section 1291, any excess distribution or gain from a disposition must be ratably allocated to each day in the U.S. person’s holding period. The amount of any gain or excess distribution allocated to the tax year of disposition or distribution of the excess distribution and to years the mutual fund was a PFIC. Distributions from a foreign retirement plan classified as PFICs are taxed as ordinary income. The amounts allocated to any other tax year would be subject to U.S. federal income tax at the highest tax rate applicable to ordinary income in each such year, and an interest charge would be imposed on the tax liability for each such year, calculated as if the tax liability had been due in such a tax year.
Besides the aforementioned PFIC rules, in some cases, beneficiaries of foreign retirement plans are subject to throwback interest on accumulated income in the plan. The potential tax burden of the throwback rules may equal to 100 percent of the value of the accumulation distribution in the foreign retirement plan. IRS Notice 97-34 clarifies the procedure for characterizing the U.S. income tax treatment of distributions from foreign trusts to a U.S. beneficiary, providing that such distributions will be treated as accumulation distributions includible in gross income and subject to U.S. income tax plus interest charges if adequate records are not provided to the IRS to determine the proper treatment of the distribution.
Many U.S. persons that are beneficiaries of foreign retirement plans are unaware of the reporting requirements and income tax consequences associated with offshore pension plans until the IRS contacts them. If a foreign pension plan is not properly reported on an income tax return and on information returns, the IRS can assess additional tax, interest, and significant penalties that greatly exceed the value of the foreign pension plan. In these cases, the foreign pension plan beneficiary should be prepared to present a strong case to the IRS and potentially later to a court. On the contrary, if a U.S. beneficiary of a foreign pension plan notices it was not properly disclosed on a tax return and information returns prior to being contacted by the IRS, there are a number of options available to correct the problem before it is discovered by the IRS. U.S. beneficiaries of foreign pension plans should retain the assistance of a qualified international tax attorney with substantial experience with international compliance requirements, IRS disclosure programs, and tax litigation. We have consulted and represented hundreds of clients with international compliance matters.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.
He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or firstname.lastname@example.org.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.