US tax laws notoriously fail to treat foreign pensions as qualified plans. Instead, the IRS treats these plans as foreign trusts for US tax purposes and requires their US plan participants to meet the related reporting rules.
Failure to timely comply with these obligations can result in substantial penalties. For example, foreign pensions treated as grantor trusts—which is the most common reporting position—must be reported annually by the US plan participant via Forms 3520 and 3520-A. Failure to timely file these forms could result in penalties as low as $10,000 or as high as 5% of the pension value and 35% of the pension contribution or distribution amount.
Thankfully, the IRS recently released Notice 2022-36, which provides a complete exemption from the Form 3520 and Form 3520-A late filing penalties that may otherwise apply for the 2019 and 2020 tax years. The catch is that these late forms must be filed by Sept. 30, 2022. This provides taxpayers with a very short period to come into compliance without penalty exposure.
This article provides a brief summary of the US tax classification and reporting obligations with which US persons must comply in connection with their interest in a foreign pension, retirement account, and in some cases, Social Security programs, as well as the practical guidance on how to use IRS Notice 2022-36 to minimize the reporting penalty burden for 2019 and 2020. Any references in this article to a “foreign plan,” a “foreign pension,” or other similar phrases are meant to describe such plans.
Under Internal Revenue Code Section 401(a), a pension plan must be created or organized in the US to be a qualified plan. As a result, a foreign pension plan generally will not qualify. Instead, a US person participant of a foreign nonqualified plan may be treated for US tax purposes as a beneficiary of one of the following: a nonexempt employees’ trust under Section 402(b); a grantor trust under Sections 671-679; or a bifurcated trust, with a portion of the plan being taxable as an employee grantor trust under Treasury Regulation Section 1.402(b)-(1)(b)(6), and the remaining portion taxable as a nonexempt employees’ trust.
To determine the proper US tax classification of the plan, a taxpayer should examine who made the related contributions. If all contributions to the plan are considered employee contributions, then grantor trust treatment may be applicable. In contrast, if the employer contributions are equal to or greater than the employee contributions, the entirety of the plan may be treated as a nonexempt employees’ trust under Section 402(b).
Finally, a US person participant may be deemed the beneficiary of a bifurcated trust when both the employer and employee are treated as having contributed to the plan, and the employee contributions are ‘‘not incidental’’ when compared to the employer contributions. In such a bifurcated trust scenario, the taxpayer may be treated differently with regard to separate portions of the plan assets—the “not incidental” contributions being treated as contributions to, and subsequently as, assets of a grantor trust, and the remaining contributions being treated as contributions to, and subsequently as, assets of a nonexempt employees’ trust.
The classification of the plan not only will impact the US tax applicable to the contributions to earnings and growth within, and distributions from, the plan, but also may impact the information reporting obligations of the US plan participant. In particular, US participants of plans treated as grantor trust plans may be required to annually file Forms 3520 and 3520-A unless they qualify for relief under Revenue Procedure 2020-17. In contrast, US participants should not be required to file Forms 3520 and 3520-A annually to report their interest in a plan classified as a nonexempt employee trust under Section 402(b). Thus, US persons who previously may have failed to properly report their interest in a foreign pension may be motivated to evaluate whether their plan qualifies as an employees’ trust—as a finding of an employees’ trust classification may significantly reduce taxable income and penalty exposure.
Unfortunately, in cases where a plan should be reported as a grantor trust, the penalties for failing to timely file forms 3520 and 3520-A can be significant unless the IRS agrees there is reasonable cause for the late filing. Due to the lack of IRS Exam resources, obtaining a finding of reasonable cause and the full (or even partial) abatement of late filing penalties often requires the taxpayer to incur the expense of advocating for such abatement at the IRS Appeals level or even the US tax or district courts, which can be prohibitively expensive.
IRS Notice 2022-36 provides a short-term salve for such situations, at least regarding the 2019 and 2020 tax years. In addition to certain other penalties, Notice 2022-36 provides penalty relief for taxpayers who late file Forms 3520 and 3520-A to report their foreign pensions by Sept. 30, 2022. To reiterate, this is not a typo—the deadline to avoid the draconian penalties associated with not timely reporting your interest in a foreign pension may be less than a month away.
Tax practitioners are working around the clock to assist taxpayers in taking advantage of this unique opportunity. I’d recommend reaching out to your tax professionals to discuss the reporting of your foreign pensions as soon as possible.
This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Christopher Callahan co-chairs the International Tax and Wealth Planning practice group for Fox Rothschild LLP. One of his main practice focuses is on the US taxation of foreign pensions.
We’d love to hear your smart, original take: Write for Us