A quick expatriation topic for you.
Covered expatriate defined
Covered expatriates are U.S. citizens or long-time green card holders who terminate that status and are either:
- “Bad”–their tax obligations were not fully satisfied for the previous five years, or
- “Rich” – they have net worth of $2 million or more, or average Federal income tax liability over the previous five years of $201,000 (2024 expatriations).
IRC Section 877A(g)(1)(A), then follow the cross-references to IRC Section 877, and look up the applicable Rev. Proc. for the inflation adjustments for the year of expatriation and look at (probably) §3.37 of the Rev. Proc.
Tax on deferred compensation items
The jackpot for achieving covered expatriate status is a set of income tax rules that we colloquially refer to as the exit tax. They are found in IRC Section 877A.
One of those rules imposes tax or withholding on a covered expatriate’s “deferred compensation items.” IRC §877A(d).
I will oversimplify and refer to deferred compensation items as pensions in this discussion (less typing). But deferred compensation items will also include all of the funky stuff that BigCorp America does with executive compensation.
Deferred compensation items come in two flavors:
- Eligible, and
- Ineligible.
Eligible deferred compensation items
You want an eligible deferred compensation item.
The income tax consequence to a covered expatriate is relatively benign: 30% withholding tax is imposed on each distribution as it is made. IRC §877A(d)(1)(A).
Then the covered expatriate is taxed on that distribution income as would any other nonresident alien. Look at IRC Section 871 and maybe an applicable income tax treaty and you can figure out how much tax the U.S. government is entitled to on that distribution.
Maybe (because of a treaty) the U.S. is entitled to impose tax on that pension distribution at exactly $0. In that case, the covered expatriate files a Form 1040-NR, claims a refund, and in due course actually gets a paper check.
Ineligible deferred compensation items
You do not want an ineligible deferred compensation item.
The income tax consequence to a covered expatriate is dire: a deemed distribution of a lump sum of the present value of the covered expatriate’s pension benefits on the day before expatriation. IRC §877A(d)(2)(A).
If you have a fairly large vested pension benefit but you are not at retirement age, you have to scrounge up the cash from somewhere to pay this tax when you expatriate. Most people don’t have that kind of cash lying around (and people who have that type of cash lying around typically don’t have pensions).
Worse yet, what happens when you retire (now a nonresident of the United States) and start receiving pension distributions? Guess what! The country where you live will treat that as taxable income and you will pay income tax again on the pension.
Reverse alchemy: eligible into ineligible
An eligible deferred compensation item satisfies three requirements:
- It has a U.S. payor. IRC §877A(d)(3)(A).
- The covered expatriate notifies the U.S. payor of his/her covered expatriate status. IRC §877A(d)(3)(B)(i).
- The covered expatriate waives the right under a treaty to reduced withholding on pension distributions. IRC §877A(d)(3)(B)(ii).
Fail any one of those three requirements and you now have an ineligible deferred compensation item. IRC §877A(d)(2).
A domestic pension plan is a bucket of money held and managed in such a way that it is a qualified plan, and that guarantees that the entity holding the money is a U.S. entity. You will have a U.S. payor.
Destiny is in the hands of the covered expatriate for items 2 and 3. Screw one of those up and you have an ineligible deferred compensation item.
How notice is given to the payor
You notify the domestic pension plan administrator of covered expatriate status (IRC §877A(d)(3)(B)(i)) by delivering Form W-8CE.
The Code specifies a legal requirement. The IRS has power to collect information and publish the forms required to enforce that law. IRC §6001. Form W-8CE is legit.
When notice is given to the payor
When do you give notice? The Code is silent. And there are no regulations–proposed, temporary, or final.
Notice 2009-85 is the only thing the IRS has published on the exit tax rules (so far). At Section 5.F it tells you the filing deadline for Form W-8CE:
The covered expatriate must notify the payor of his or her covered expatriate status by submitting Form W-8CE to the trustee on the earlier of (1) the day prior to the first distribution on or after the expatriation date or (2) 30 days after the expatriation date.
Invariably the “30 days after the expatriation date” comes before the first pension distribution. As often as not, people blow the deadline.
If you blow the 30-day deadline, are your doomed? Did your deferred compensation item fail to satisfy the requirement of IRC §877A(d)(3)(B)(i) – notify the payor of the deferred compensation item – thereby failing the test to be an eligible deferred compensation item?
That would be dreadful. That would make the pension an ineligible deferred compensation item, and you would be taxed on a deemed lump sum distribution.
So. Is that 30-day requirement in Notice 2009-85 legit?
No.
There is no valid published deadline
Here’s why. Notice 2009-85 is the only place where a deadline is set, and the Notice is of no force and effect as a matter of law.
Notice 2009-85 is a carefully-written the IRS’s opinion on a few topics. If you are a lawyer, think of this as the government’s memorandum of points and authorities in support of a motion for summary judgment. That’s how much weight Notice 2009-85 has – it’s an opening position in a debate.
You would be a damn fool to ignore the Notice entirely. That’s dumb strategy. You’re playing poker with the government and they just showed you their hand. You know what they think. You know what the upcoming audit or Tax Court case will look like.
Treat Notice 2009-85 as an instructive tell by your opponent in the poker game. Don’t treat it as The Word of God. (You find that in Title 26, United States Code).
Why am I so dismissive?
Because in order for a missive from a Federal agency (like the Treasury Department, home of the Internal Revenue Service) to have any enforcement teeth, it must satisfy the requirements of the Administrative Procedures Act.
The Administrative Procedures Act requires publication, public comments, then finalization. You see this in action when Regulations are written: the IRS publishes Proposed Regulations, after which it solicits comments, then digest the comments and publishes final Regulations.
The recent Aroeste v. United States case – a District Court case with no weight as precedent but extremely interesting nevertheless – summarily dismissed Notice 2009-85 as nonbinding (emphasis added):
Aroeste responds that Notice 2009-85 is not binding authority as it fails to comply with the Administrative Procedures Act (“APA”). * * * * The Court agrees. In Mann Construction, Inc. v. United States, 27 F.4th 1138 (6th Cir. 2022), the court found that Notice 2007-83 failed to comply with the APA’s notice-and-comment procedure. Similarly here, because Notice 2009-85 has not been subject to a notice-and-comment procedure, it does not comply with the APA and thus is not binding. As such, Aroeste was not required to file Form 8854 with his amended returns [in order to provide notice to the government of commencement of treaty nonresident status].
Therefore, the 30-day time deadline in Notice 2009-85 is unenforceable.
While you can’t cite Aroeste v. United States as binding authority, you can (and should) cite the Mann case that the Aroeste judge relied on. And then you should quote the Aroeste opinion anyway.
Covered expatriates with domestic pensions: do this
Until the IRS publishes something that complies with the Administrative Practices Act, your best practice is to get the Form W-8CE filed with the pension plan administrator as promptly as possible, so the correct withholding can commence.
But don’t fear that you will convert a normal pension, with taxation at the time of distribution, into an ineligible deferred compensation item, with taxation as a ginormous lump sum at the time of expatriation.
See you in a couple of weeks
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