How IRC §402(b) Taxes an Employee on a SIPP’s Investment Earnings

Hello, and welcome once again to The Friday Edition. Phil here, getting into the weedy weeds of foreign retirement plans and in particular U.K. SIPPs.

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A UK SIPP earns money on its invested assets. How is a U.S. citizen participant in the SIPP taxed (or not) on those plan earnings?

What a SIPP is

A quick recap.

A UK SIPP is a retirement plan. It holds all of its assets in a trust. From the perspective of the U.S. tax system, the trust is a foreign trust. It is specifically classified as an employees’ trust, and U.S. plan participants (beneficiaries of that trust) are taxed according to the rules in IRC §402(b).

The trust itself is a foreign trust–it is not a U.S. taxpayer. And it is overwhelmingly likely that it holds non-U.S. investments–it earns foreign-source income. Thus, the SIPP and its investment earnings are out of reach.

But one of the plan participants is a U.S. citizen working in the U.K. And that person is definitely within reach of the U.S. tax system. Let’s look at how IRC §402(b) treats the SIPP’s investment earnings–and when (not if) the employee is taxed on those earnings.

Grantor Trust Rules Do Not Apply

A SIPP is a trust. But it is not a grantor trust. The employee cannot be the owner of the trust. IRC §402(b)(3) tells us so:

A beneficiary of any trust described in paragraph (1) shall not be considered the owner of any portion of such trust under subpart E of part I of subchapter J (relating to grantors and others treated as substantial owners).

IRC §402(b)(1) (the “paragraph (1)” referred to above) applies to a trust that “is not exempt from tax under section 501(a).” And that’s true for a U.K. SIPP.

• The U.S. citizen employee resident in the U.K. is the beneficiary of the trust.
• A “trust describe in paragraph (1)” is a trust that is not exempt from tax under IRC §501(a). That’s true of a U.K. SIPP. It fails one of the basic requirements for tax exemption: that it is a domestic trust.

Therefore, the U.S. employee who has benefits in the SIPP cannot be the “owner of any portion of such trust” as that phrase is used in the grantor trust rules. Put another way, the trust’s earnings are not included in the employee’s gross income because of IRC §671.

(There is a situation where an employees’ trust, like a SIPP, can be partly treated as a grantor trust. This happens when employer contributions to the SIPP are less than the employee contributions. Reg. §1.402(b)-1(b)(6). Let’s save that for another time.)

An employees’ trust is not a nongrantor trust

Similarly, an employees’ trust taxable under IRC §402(b) cannot be a nongrantor trust. The normal Subchapter J rules for taxation of beneficiaries of nongrantor trusts do not apply. Reg. §1.641(a)-0(a) says:

[T]he provisions of subchapter J do not apply to employee trusts subject to subchapters D and F, chapter 1 of the Code, and common trust funds subject to subchapter H, chapter 1 of the Code.

IRC §402(b) is found in “subchapter D.” Therefore, if you determine that you have an employees’ trust subject to IRC §402(b), you will not apply the normal rules for determining the taxation of beneficiaries of nongrantor trust.

So the only place to look for answers is IRC §402(b)

This simplifies things. The Code closes off all other interpretations and says employees who are beneficiaries of nonexempt employees’ trusts must compute their U.S. income tax liability using the rules of IRC §402(b).

• IRC §402(b)(1) tells us when an employer’s contributions to a SIPP will be taxable income to the employee. Investment earnings are not an employer contribution. Therefore, IRC §402(b)(1) does not tell us how investment earnings are taxed to the employee.
• IRC §402(b)(2) deals with distributions. Plan earnings are not distributed to the employee. Therefore, IRC §402(b)(2) does not tell us how investment earnings are taxed to the employee.
• IRC §402(b)(3) tells us that the SIPP cannot be a grantor trust with the employee treated as the owner of the SIPP under IRC §671. Therefore, investment earnings do not flow through to the employee using IRC §402(b)(3).
• IRC §402(b)(4), however, gives us the extremely-not-easy-and-overly-complicated answer.

§402(b)(4)(A) Offers an Answer

But IRC §402(b)(4) helps us unravel the puzzle.

IRC §402(b)(4) deals with discriminatory retirement plans: those that are designed to discriminate against the average rank-and-file employee. And from this rule we can figure out how plan earnings are taxed.

What IRC §402(b)(4)(A) says

Here is the actual text of §402(b)(4)(A):

If 1 of the reasons a trust is not exempt from tax under section 501(a) is the failure of the plan of which it is a part to meet the requirements of section 401(a)(26) or 410(b), then a highly compensated employee shall, in lieu of the amount determined under paragraph (1) or (2) include in gross income for the taxable year with or within which the taxable year of the trust ends an amount equal to the vested accrued benefit of such employee (other than the employee’s investment in the contract) as of the close of such taxable year of the trust.

Here is what it says:

• Look at your employees’ trust.
• If it’s not exempt from tax under IRC §501(a), ask yourself why.
• There are probably a bunch of reasons. For a SIPP, it’s not exempt from tax under IRC §501(a) because the assets are held in a foreign (from the U.S. tax system’s point of view) trust.
• But in addition to that, the SIPP might not be exempt from tax under IRC §501(a) because it discriminates in favor of highly compensated employees.
• There are two sets of rules for figuring out whether the plan discriminates against regular employees and in favor of highly compensated employees. These are at IRC §401(a)(26) and IRC §410(b).

Highly compensated employees in discriminatory plans

If the SIPP is not exempt from tax under IRC §501(a) because it is discriminatory, then special rules apply to highly compensated employees. Those special rules are simply:

• Do not figure out the highly compensated employee’s taxation on employer contributions to the SIPP using IRC §402(b)(1), and
• Do not figure out the highly compensated employee’s taxation of distributions received using IRC §402(b)(1).
• Instead, use a mark-to-market method imposed by IRC §402(b)(4)(A).

And without looking too hard, you will quickly see that if you use an annual mark-to-market method to compute the taxable income of a highly-compensated employee, then annual plan investment earnings will be included in the employee’s gross income for U.S. income tax purposes every year.

Not highly compensated employees in discriminatory plans

IRC §402(b)(4)(A) does not apply to an employee who is not a highly compensated employee. It does not tell us what to do with plan earnings allocable to that type of person.

Both types of employees in nondiscriminatory plans

And it is silent about what happens when the employee is highly compensated (or not!) but the plan is not discriminatory. What do we do about plan earnings in that case?

The key to understanding IRC §402(b)

IRC §402(b)(4)(A) only gives us a direct answer to one of the four scenarios. We must reason our way to answer the other three. Here is how you do that.

• Remember that we are locked into using IRC §402(b) to determine the employee’s gross income from a nonexempt employees’ trust, like a SIPP.
• IRC §402(b)(1) (contributions) and IRC §402(b)(2) (distributions) state the default rules.
• IRC §402(b)(4)(A) states an exception to the default rules, applicable only to highly compensated employees who are participating in discriminatory plans.
• The IRC §402(b)(4)(A) exception does not apply to nondiscriminatory plans. Therefore, the only way to tax employees on plan earnings in nondiscriminatory plans is to apply IRC §402(b)(1) and IRC §402(b)(2).
• And the IRC §402(b)(4)(A) exception does not apply to people who are not highly compensated employees. Therefore, these people are subject to tax on plan earnings of any type of plan–discriminatory or not–using the default rules of IRC §402(b)(1) and IRC §402(b)(2).

Summary 2×2 matrix

As usual, the ubiquitous 2×2 matrix comes to the rescue:

Only one cell out of four produces current taxation of plan earnings to the employee: a highly compensated employee in a discriminatory plan. The other three cells all produce deferral — plan earnings are not taxed to the employee until distributed under §402(b)(2).

The mark-to-market mechanism of IRC §402(b)(4)(A)

This is going to be a cliffhanger. I will describe how it works in gruesome detail later.

Basically, employer contributions are taxable income to the employee, and the employee gets basis in the pension benefits. At the end of the year, do a mark-to-market computation. What are the vested plan benefits worth? The only untaxed increment must be attributable to plan earnings during the year. Those get taxed, and the employee gets basis for the amount included in gross income. Repeat.

Is a UK SIPP “discriminatory”? Who is a highly compensated employee?

This is the critical question. Now that we know how plan earnings are taxed to a plan participant, you need to know how to figure out whether your SIPP is discriminatory, and whether your U.S. citizen participant in the SIPP is a highly compensated employee.

That’s another cliffhanger. I will talk about the practical application of these rules next time.

What about IRC §402(b)(4)(B)?

There is another provision that overrides the default rules of IRC §402(b)(1) and IRC §402(b)(2). It will never, ever apply to a UK SIPP. Therefore, you can ignore it. But I want to tell you why you are safe in ignoring it.

Here is the text of IRC §402(b)(4)(B):

If a trust is not exempt from tax under section 501(a) for any taxable year solely because such trust is part of a plan which fails to meet the requirements of section 401(a)(26) or 410(b), paragraphs (1) and (2) shall not apply by reason of such failure to any employee who was not a highly compensated employee during — (i) such taxable year, or (ii) any preceding period for which service was creditable to such employee under the plan.

Notice the contrast in language. §402(b)(4)(A) uses the phrase “1 of the reasons.” §402(b)(4)(B) uses the word “solely because.”

A U.K. SIPP might fail to be tax-exempt because it is discriminatory in favor of highly compensated employees. But that will never be the sole reason why it fails to achieve tax-exempt status.

An exempt employees’ benefit trust is also referred to in the Code as a qualified trust. Those of you who are tax pros have heard the phrase “qualified plan” bandied about when talking about pension and ERISA stuff.

IRC §401(a) describes what a qualified plan is (emphasis added):

“A trust created or organized in the United States and forming part of a stock bonus, pension, or profit-sharing plan of an employer for the exclusive benefit of his employees or their beneficiaries shall constitute a qualified trust under this section—”

IRC §402(b)(4)(B) cannot apply to a UK SIPP under any circumstances. A UK SIPP will never have a U.S. trust to hold its assets, and therefore the “solely because” test in IRC §402(b)(4)(B) is never met.

Summary

Putting it all together, the complete chain of analysis for plan earnings in a UK SIPP is simple:

• Highly compensated employees participating in a discriminatory SIPP will be taxed annually on plan earnings annually.
• In all other situations, plan earnings accumulate in the SIPP and will be included in the employee’s gross income when distributed. Because the accumulation distribution rules don’t apply to employees’ trusts, the inclusion is just regular old ordinary income.

Cliffhangers await you:

• How the mark-to-market tax rules of IRC §402(b)(4)(A) work – which will take us deep into the weeds of IRC §72.
• How to figure out if your particular SIPP is a discriminatory employees’ trust.
• How to figure out if your particular employee is a highly-compensated employee.

Keep coming back! 🙂