IRC Treatment of Distributions from U.K. SIPP

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This is the next installment of my Field Guide to U.S. Income Taxation of U.K. SIPPs. This time, I am writing about how the Internal Revenue Code looks at SIPPs and specifically how the Internal Revenue Code looks at distributions from SIPPs. The next installment will look at how the income tax treaty between the USA and the U.K. treats distributions.

Remember this is only a draft. If you have comments or corrections, I would appreciate hearing from you!

1. A SIPP Is a Nonexempt Employees’ Trust

1.1 A SIPP Is an Employees’ Trust

A trust is a legal entity by which a trustee receives assets and holds them for someone else’s eventual benefit (the beneficiary). When an employer puts money into a retirement plan for the benefit of an employee, a trust is created; the plan administrator is the trustee.

We usually see trusts funded by gifts. When an employer makes the contributions on account of services rendered, it’s not a gift, but compensation. We call such a trust an “employees’ trust.”

A SIPP funded by employer contributions on account of services rendered is an employees’ trust for U.S. income tax purposes.

1.2 A SIPP Cannot Be a Qualified Plan: IRC §401(a)

When it comes to employees’ trusts, the jargon gets confusing. Employees’ trusts are taxed in one of two ways, but people use different language to describe them. Employees’ trusts can be exempt or nonexempt, qualified or nonqualified.

An exempt employees’ trust—also referred to as a qualified plan—has the features you expect:

contributions are not included in the employee’s income,
earnings inside the trust are tax free, and
distributions to the employee are taxed as ordinary income.

IRC §§401(a), 501.

To be a qualified plan, the employees’ trust must (among many, many other things) be a “domestic” trust—created or organized in the United States. A SIPP is established under U.K. law and therefore is a “foreign” trust. It cannot satisfy the definition of being a qualified plan, and therefore cannot get the U.S. income tax treatment given to qualified plans. IRC §401(a); Treas. Reg. §1.401-1(a)(3)(i).

1.3 A SIPP Is Therefore a Nonqualified Plan: IRC §402(b)

Because a SIPP is an employees’ trust that cannot be a qualified plan under IRC §401(a), it is a nonqualified employees’ trust, taxed under IRC §402(b).

1.4 A Note on Jargon

The literature on foreign retirement plans is a mess. Authors use different words for the same thing, and the Code doesn’t help.

A “qualified plan” is a “plan” that is “exempt” from tax under IRC §501(a) because it satisfies the requirements of IRC §401(a). A “nonqualified plan” is one that doesn’t—it’s “nonexempt” from tax under IRC §501(a), so we tax it under IRC §402(b).

And “trust” vs. “plan”? The Code uses both. A plan is the arrangement; a trust is the legal vehicle that holds the assets. For our purposes, the distinction doesn’t matter.

Sometimes you’ll hear people call these trusts an “employees’ trust” and sometimes an “employees’ benefit trust.”

For the rest of this article, I’m going to K.I.S.S. and refer to a U.K. SIPP as a “Section 402(b) trust.” It’s short and unambiguous and tells you where to look to figure out the income tax treatment.

When you see that phrase, it means a retirement plan (in our case, a foreign retirement plan) in the form of a trust that cannot qualify for income tax treatment under IRC §401(a) and is therefore taxed under the rules of IRC §402(b).

But that, alone, does not tell us how a distribution to a U.S. employee-beneficiary will be taxed under the Internal Revenue Code. And of course, there is another method of taxing the U.S. employee-beneficiary–the rules in the income tax treaty–that I will cover in the next chapter.

Four Types of Section 402(b) Trusts

2.1 The Four Types

There are four types of nonqualified employees’ trusts under IRC §402(b):

discriminatory employees’ trust,
nondiscriminatory employees’ trust,
grantor trust, or
bifurcated trust.

Each has distinct rules for how a U.S. employee-beneficiary is taxed on contributions, earnings, and distributions.

2.1.1 Nondiscriminatory Employees’ Trust

The Internal Revenue Code abhors discrimination. This is a consequence of dentists and doctors abusing retirement plans for their own benefit at the expense of their employees in the 1970s and the 1980s. This culminated in a turgid block of prose that we refer to as ERISA—and when I hear that acronym I back away warily.

As a result, the first thing we need to do with a U.K. SIPP—a Section 402(b) trust—is decide if it runs afoul of the anti-discrimination rules. A nondiscriminatory employees’ trust is one that satisfies the coverage requirements of IRC §410(b). Your average U.K. SIPP is exceedingly unlikely to be “nondiscriminatory” under IRC §410(b).

Without getting into the weeds, you play the discrimination game is done by looking at the pool of participant-employees to make sure they are all treated equally. Exclude nonresident aliens from the pool. Therefore a U.S. taxpayer participant in a SIPP will likely be the only participant for discrimination testing purposes. When you have a testing pool of N = 1, the results are predictable.

When you are analyzing your SIPP for tax treatment, you will need to go through the analysis under IRC §410(b), but I’m going to bet that the SIPP fails the tests in IRC §410(b).

2.1.2 Discriminatory Employees’ Trust

A plan that fails IRC §410(b) is discriminatory. Almost invariably, the situations I see fall into this category.

Typical example: a limited company with one person as shareholder and employee, who happens to be a U.S. citizen resident in the U.K. Employer contributions are therefore made exclusively for that person. That’s the model I am discussing here.

For a discriminatory employees’ trust, the tax consequences depend on whether the participant is a “highly compensated employee” under IRC §414(q). A highly compensated employee is any employee who, during the year or the preceding year:

was a 5% owner of the employer at any time, or
received compensation exceeding $160,000 (for 2026, adjusted annually for inflation).

IRC §414(q)(1); Notice 2025-67.

For the typical U.S. citizen entrepreneur in the U.K.—owning and operating a limited company—the 5% owner test is a slam dunk. The participant is both the employer and the employee, owns 100% of the company, and therefore a highly compensated employee by definition. Regardless of salary!

When a highly compensated employee participates in a discriminatory plan, the income tax treatment is punitive during the contribution and accumulation phases but benign at distribution. We’ll see why in Section 3.

2.1.3 Grantor Trust

Ordinarily, an employees’ trust cannot be a grantor trust. IRC §402(b)(3) explicitly provides:

“A beneficiary of [a nonexempt employees’] trust shall not be considered the owner of any portion of such trust under subpart E of part I of subchapter J.”

This forecloses grantor trust treatment by default. However, a portion of a nonexempt employees’ trust may be treated as a grantor trust if the plan is bifurcated. IRC §402(b)(3). For the purposes of this discussion (and in most real-world situations) a SIPP will not be a grantor trust.

2.1.4 Bifurcated Trust

But an employees’ trust can be partly a grantor trust–if it is a bifurcated trust.

A bifurcated trust arises when employee contributions exceed employer contributions. In that case, the portion attributable to excess employee contributions is treated as a grantor trust, while the remainder is treated as a nonexempt employees’ trust. Treas. Reg. §1.402(b)-1(b)(6) says:

“In general, a beneficiary of a trust to which this section applies may not be considered to be the owner under subpart E, part I, subchapter J, chapter I of the Code of any portion of such trust which is attributable to contributions to such trust made by the employer after August 1, 1969, or to incidental contributions made by the employee after such date. However, where contributions made by the employee are not incidental when compared to contributions made by the employer, such beneficiary shall be considered to be the owner of the portion of the trust attributable to contributions made by the employee, if the applicable requirements of such subpart E are satisfied. For purposes of this paragraph (6), contributions made by an employee are not incidental when compared to contributions made by the employer if the employee’s total contributions as of any date exceed the employer’s total contributions on behalf of the employee as of such date.”

While it is common to have employee contributions to SIPPs, for the purposes of this article I am going to assume that the SIPP receives employer contributions only. Therefore, I will not analyze the bifurcated trust situation.

2.2 Conclusion

Under our assumed facts—a U.S. citizen entrepreneur who owns 5% or more of the employer—the participant qualifies as a highly compensated employee under IRC §414(q)(1)(A)(i) regardless of compensation level.

Separately, the IRC §410(b) coverage tests exclude nonresident aliens who receive no U.S.-source income from the testing pool. IRC §410(b)(3)(C). If the U.S. citizen highly compensated employee is the only person remaining in the testing pool, the plan fails the coverage requirements: it benefits highly compensated employees but does not benefit non-highly compensated employees.

The SIPP is therefore discriminatory.

Distributions From U.K. SIPPs

Now that we have laid the groundwork (the U.K. SIPP you are dealing with is a discriminatory Section 402(b) trust with a highly compensated employee as participant), it is easy to figure out the income tax treatment for a U.S. employee-beneficiary when receiving a distribution.

3.1 Distributions Are Included in Gross Income

A distribution from a nonexempt employees’ trust is taxable to the distributee. IRC §402(b)(2) says:

“The amount actually distributed or made available to any distributee by any trust described in paragraph (1) shall be taxable to the distributee, in the taxable year in which so distributed or made available, under section 72 (relating to annuities), except that distributions of income of such trust before the annuity starting date (as defined in section 72(c)(4)) shall be included in the gross income of the employee without regard to section 72(e)(5) (relating to amounts not received as annuities).”

Important to note:

Taxable to the distributee. That could be the employee, or it could be the successor in interest after the employee’s death, e.g., a surviving spouse.
Taxable in the year “distributed” or “made available.”
The taxable amount included in gross income is determined using the rules in IRC §72. That’s where you find the applicable basis rules (or, as IRC §72 quaintly calls it, “investment in the contract”).

3.2 Basis Includes Employer Contributions, Employee Contributions, and Plan Earnings

Basis (investment in the contract) under IRC §72 consists of amounts previously included in the participant’s gross income. For a highly compensated employee in a discriminatory plan, this includes:

employer contributions,
employee contributions, and
plan earnings.

3.2.1 Employer Contributions

Vested employer contributions to a Section 402(b) trust are included in the employee’s gross income under IRC §402(b)(1), applying the rules of IRC §83 (property transferred in connection with services). IRC §402(b)(1) states:

“Contributions to an employees’ trust made by an employer during a taxable year of the employer which ends with or within a taxable year of the trust for which the trust is not exempt from tax under section 501(a) shall be included in the gross income of the employee in accordance with section 83 (relating to property transferred in connection with performance of services), except that the value of the employee’s interest in the trust shall be substituted for the fair market value of the property for purposes of applying such section.”

Since an employer’s contribution to a U.K. SIPP creates fully vested benefits for the employee, IRC §83 dictates that the employee must include the value of the contribution in the employee’s gross income. IRC §72(c)(1) will treat this contribution as an “investment in the contract” or, in mere mortal terms, basis. IRC §72(f)(1) makes that explicit:

“In computing, for purposes of subsection (c)(1)(A), the aggregate amount of premiums or other consideration paid for the contract, and for purposes of subsection (e)(6), the aggregate premiums or other consideration paid, amounts contributed by the employer shall be included, but only to the extent that . . .such amounts were includible in the gross income of the employee under this subtitle or prior income tax laws[.]”

The employer’s contribution was included in the gross income of the employee because of IRC §83. That’s what creates basis, or “investment in the contract.”

3.2.2 Employee Contributions

Employee contributions are made from after-tax income and therefore create basis under IRC §72. This article ignores employee contributions and how they create IRC §72 “investment in the contract” in the interests of brevity.

3.2.3 Plan Earnings

For qualified plans (i.e., “exempt” retirement plans) like your 401(k), the idea is that money grows tax-free inside the retirement plan and is taxed on distribution.

For a highly compensated employee who is a participant in a discriminatory Section 402(b) trust, the rules are different: plan income is taxable to the employee annually. It’s a mark-to-market mechanism. IRC §402(b)(4)(A) says:

“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.”

Because earnings are taxed currently, they create additional basis for the employee. Treas. Reg. §1.402(b)-1(b)(5) says:

“The basis of any employee’s interest in a trust to which this section applies shall be increased by the amount included in his gross income under this section.”

The regulation does not use the quaint “investment in the contract” language of IRC §72, so congratulations you’ve found a place in the law where they used a bit of bubble gum and bailing wire. That’s close enough for science.

3.2.4 Conclusion: Basis Approximates Plan Value

Each year’s inclusion — contributions plus earnings — adds to the participant’s “investment in the contract.” Each employer contribution adds to the participant’s “investment in the contract.” If I did my math right, 100% of contributions and 100% of earnings added together = 100% of the distributable assets in the Section 402(b) trust that so happens to be a U.K. SIPP.

Basis equals the distribution. For U.S. income tax purposes, the taxable portion of the U.K. SIPP distribution is zero.

3.3 Conclusion: Taxation of Distributions Under IRC

For a U.S. citizen who is a highly compensated employee in a discriminatory SIPP, the distribution results in full basis recovery and zero taxable income for U.S. income tax purposes under the Internal Revenue Code.

A different outcome entirely occurs when the taxpayer invokes the tender mercies of the USA/UK income tax treaty. That is the subject of the next chapter.