International work assignments — both inbound and outbound, short-term and long-term — have become more common as the world gets “smaller” and “flatter.”While on foreign soil, most employees feel that they deserve additional compensation and that they should be at least somewhat released from the growing number of domestic tax rules that restrict compensation packages. Some of the more irksome rules restricting compensation arrangements lately are contained in the final regs under Code Sec. 409A on nonqualified deferred compensation.
While businesses breathed a collective sigh of relief at the end of last year when the deadline for overall compliance with the new nonqualified deferred-comp rules was extended, the new deadline — Dec. 31, 2008 — again looms. While the employee pays the price of realizing additional income should 409A trigger acceleration of any deferrals (and a 20 percent penalty), the employer frequently must ultimately pick up the tab under hold-harmless agreements. Addressing Code Sec. 409A compliance strategies for inbound and outbound workers is one of the tasks that need prompt assessment and action as year-end 2008 gets closer.
GENERAL RULES
A nonqualified deferred-compensation plan is any plan that provides for the deferral of compensation other than a qualified employer plan or any bona fide vacation leave, sick leave, compensatory time, disability pay or death benefit plan. Deferred compensation, for these purposes, is defined broadly and includes not only traditional elective deferral compensation, but also stock-based arrangements, salary, bonuses, supplemental and excess executive retirement plans, mirror 401(k)s, severance arrangements, medical and other reimbursement arrangements including tax gross-ups, and employment agreements if any of these could delay payment of compensation into a subsequent tax year. In other words, there’s a lot that can go wrong.
Ignoring for a moment the specific exceptions pertinent to inbound and outbound workers, the application of the nonqualified deferred-compensation rules generally follows the determination of whether the worker is subject to U.S. income taxation at the time that the compensation is earned. From this general rule, two specific circumstances may be addressed:
* Foreign plans can subject the worker to Code Sec. 409A rules if the worker is subject to U.S. tax (and certain exceptions don’t apply); and,
* Employees covered by domestic deferred-compensation arrangements generally cannot be treated differently simply because they are foreign workers in the U.S. or U.S. citizens working abroad.
THE EXCEPTIONS
The special exceptions, as they relate to inbound and outbound workers, are not particularly generous but, nevertheless, should be reviewed by any worker or employer involved in inbound or outbound services:
* Treaties/bilateral agreements. If there is a treaty or bilateral agreement covering an arrangement under which contributions made by or on behalf of an individual are excludable for federal income tax purposes, Sec. 409A does not apply. This includes both foreign workers employed in the U.S. and U.S taxpayers working abroad.
* Unused foreign earned income credit. If the amount deferred by a U.S. taxpayer working abroad does not equal the excess of their permissible foreign earned income exclusion over the exclusion actually taken, income is not considered deferred for Sec. 409A purposes to the extent of that excess.
* Broad-based foreign retirement plans. Non-elective deferrals for foreign earned income made under a broad-based foreign plan are exempted, to the extent the deferrals do not exceed the Sec. 415 limits and the worker is not an eligible participant in a U.S. plan.
* Tax equalization agreement exemption. Compensation paid under a tax equalization agreement is not considered deferred comp subject to Sec. 409A, provided the payment under the agreement is made fairly promptly (within approximately two years, depending on when the tax year of the service provider ends).
OFFSHORE FUNDING
Funding a nonqualified comp plan with assets outside of the U.S. usually results in acceleration of income if the initial compensation would have been subject to U.S. tax if not deferred. This rule was primarily established to stop the use of offshore rabbi trusts. However, if substantially all of the services to which the deferred compensation relates were performed in the foreign jurisdiction in which the assets are located, Sec. 409A acceleration does not apply. Unlike other parts of the Sec. 409A regulations, this provision became effective Jan. 1, 2008, and carries no additional year’s grace period.
FOREIGN WORKERS
Planning for inbound workers requires attention to de minimis rules and deadlines for amending plans to comply with Code Sec. 409A.
* Past services. If the compensation being deferred would not have been subject to U.S. tax by a nonresident when earned for services provided at that time (generally for services outside of the U.S.), the general rule is that 409A will not apply and the amounts deferred will not be included in gross income. For unvested deferred compensation attributable to service outside the U.S., however, the plan should be amended under grace period rules during the calendar year in which U.S. residence is established.
* Section 415 amounts. Under a de minimis exception, a foreign plan is not considered to provide for a deferral of compensation if the amounts deferred based on services performed by a nonresident alien in the U.S. do not exceed the applicable dollar amount for elective deferrals for the calendar year (i.e., $15,500 for 2007 and 2008). If the amounts deferred under the foreign plan exceed the applicable dollar amount, an amount of such deferrals equal to such amount is treated as not deferred under a nonqualified deferred-compensation plan.
* Nonresidents. Under another de minimis exception, for foreign workers without physical presence in the U.S. long enough to create U.S. resident status, a $10,000-per-year small deferral exception also exists to provide relief to service providers who are not U.S. citizens or lawful permanent residents, are participating in a foreign plan, and perform services in the U.S. for which they are compensated. The IRS, however, has refused to extend this to cover all amounts deferred by nonresident aliens under foreign plans to the extent that the nonresident alien provides only temporary services in the U.S.
* Broad-based plans. Finally, amounts deferred under a broad-based retirement plan for non-U.S. citizens working in the U.S. are excepted from the reach of Sec. 409A. A broad-based foreign retirement plan includes a wide range of employees, substantially all of whom are active-participant nonresident aliens, and provides significant benefits for a substantial majority of such covered employees on a nondiscriminatory basis.
The regs provide a grace period for amending an arrangement for a resident alien subject to Sec. 409A. For any calendar year in which the service provider becomes a resident alien, the service recipient/employer has until the end of the calendar year to amend the plan with respect to that service provider for compliance. The service provider also can make deferral elections for the initial year up until the later of the last day of the year, or by the 15th day of the third month following initial resident alien status.
CITIZENS ABROAD
No blanket exclusion exists for all U.S. citizens working in the U.S. for a foreign employer. Nor does one exist for a U.S. citizen or resident alien who works for either a foreign employer or a U.S.-based business. However, several exceptions apply.
* Excess foreign earned income exclusion. For expatriates whose foreign earned income does not exceed the foreign earned income exclusion amount, being covered under a non-U.S. deferred-compensation arrangement should not present a 409A issue. A foreign earned income exclusion applies to an amount equal to or less than the difference between the maximum Sec. 911 exclusion for the year ($87,600 in 2008) and the amount actually excluded for the year. No carryover of the excess is permitted from year to year.
The provision was intended to provide relief from the Sec. 409A requirements for U.S. expatriates who intend to work full-time outside the U.S. for compensation that is less than the exclusion amount under Sec. 911, “because it would severely disadvantage such workers to expect them to request that their potential foreign employers modify standard plans to accommodate them, or to expect such workers to otherwise be able to determine how to avoid or comply with Sec. 409A.”
* Broad-based foreign plan. An exception also exists for U.S. citizens or residents working outside of the U.S. who become participants in a broad-based foreign deferred-comp plan. As long as the worker is not eligible to participate in a U.S.-based plan, the amounts deferred are not elective, and the amounts do not exceed the Sec. 415 limits, amounts deferred under the broad-based foreign plan are excepted from the reach of Sec. 409A. The exclusion applies regardless of whether the plan is sponsored by a foreign or U.S. employer. However, the IRS rejected a safe harbor that would treat any plan granted favorable tax treatment under the laws of a foreign jurisdiction as qualifying for the exclusion; too broad and not administrable, it claimed.
This exception also covers participation by a U.S. citizen or lawful permanent resident who works overseas during only part of a year, and therefore is not a bona fide resident of a foreign country “for an uninterrupted period that includes an entire taxable year, or is not present in the foreign country at least 330 full days during a period of 12 consecutive months.”
In all cases, however, U.S. citizens or lawful permanent residents are exempt from tax only on non-elective deferred amounts of foreign earned income that do not exceed the contribution and benefit limitations for U.S. defined-contribution and defined-benefit plans under Sec. 415.
DON’T DEFER AT ALL?
One strategy to avoid tangling with Sec 409A is to come under the exceptions already noted. Another is to use the grace periods provided for compliance.
Still another solution, however, is not to come under the definition of nonqualified deferred compensation for purposes of Sec. 409A at all. Compensation is not considered deferred if it is actually or constructively received by the service provider within two-and-a-half months from the end of the first tax year (of the service provider or the service recipient) in which the amount is no longer subject to a substantial risk of forfeiture.
CONCLUSION
The restrictions under Sec. 409A, as interpreted by the final regulations, have a long reach. Not only is the definition of nonqualified deferred comp so broad as to have strictly domestic businesses terribly concerned about meeting the Dec. 31 deadline, but the international aspects of Sec. 409A literally “span the globe.”
Since most transfers across borders are planned well in advance of the actual start date, there is time to analyze and customize certain compensation packages “on the fly” to avoid Sec. 409A penalties. Nevertheless, employers with more than one or two employees ready for “foreign worker” status in the near future do not have much time to meet the approaching year-end deadline.
George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at CCH Tax and Accounting, a Wolters Kluwer business.
