For many non-resident aliens (NRA), the United States is their “Plan B”, i.e. the place to live when everything goes awry in their home country. NRAs still the see the U.S. as a both safe haven politically and economically. The wealthy NRA who has rock star visibility in his home country can blend into the crowd in Miami or New York without fear of kidnap or blackmail. In spite of its current problems, the U.S. is still the bastion of political and economic stability. As a result, many NRAs have made substantial investments in U.S. residential and commercial real estate as well as farm land. Many NRAs have started businesses. The EB-5 and EB-2 visa programs have created a basis for long term residency based on investment in a U.S.-based business and creation of jobs in the U.S. as a result of the NRAs investment.
This article is focused on how qualified retirement plans in the U.S. can be used as an effective vehicle for reducing and deferring U.S. income taxation as well as eliminating both income and estate taxes on these tax-deferred dollars.
Qualified Retirement Plans Overview
Qualified retirement plans are complex from the standpoint of tax and labor law (ERISA). Most of these rules are designed to prevent the business owner from making large contributions for key employees while excluding rank and file employees.
Taxpayers have two different types of pension plan designs to choose from – defined contribution and defined benefit. Profit sharing, 401(k), and money purchase are examples of defined contribution plans. . The defined contribution plan is typically based upon a percentage of the participant’s compensation being contributed to the Plan.
The contribution is tax deductible to the employer and non-taxable to the employee until distribution from the Plan. Investment earnings within the Plan accumulate on a tax-deferred basis. The ultimate retirement benefit is dependent upon the account balance of the participant at retirement.
The maximum contribution on behalf of a participant under a defined contribution plan is $50,000. An employee can make a salary deferral of $17,000 (with a $5,500 catch up provision for participants that are age 50 or older). The maximum salary that may be considered for contribution purposes is $250,000.
A defined benefit plan provides a fixed monthly benefit at retirement. The retirement benefit is typically based on income and years of service. A typical formula looks at the employee’s final three year average income preceding retirement. Employer contributions are not capped by the $50,000 contribution cap of defined contribution plans. The maximum retirement benefit is $200,000 per year. The maximum salary for contribution purposes is $250,000 per year.
Generally speaking, defined benefit plans provide the largest tax deductible contribution with the greatest amount of benefit certainty. Defined benefit plans are ideal for business owners that are at least 45 years older. Contributions well in excess of $50,000 can be made for older business owners.
Tax Review for NRAs
An NRA on his real estate investment income is subject to the 30 percent withholding tax under IRC Sec 871 without the benefit of any deductions unless he makes an election under IRC Sec 871(d) to have it treated as effectively connected income (ECI) to a U.S. trade or business. This election allows the NRA to take deductions. Obviously, any U.S. based business generates ECI for the NRA.
A qualified retirement plan would allow the NRA to take an additional tax deduction for the contribution to the Plan. Investment earnings within the Plan would not be currently taxable to the employee or employer. Absent a tax treaty provision, distributions from the Plan would be subject to the 30 percent withholding tax under IRC Sec 871. Fortunately, most of the income tax treaties with the U.S. provide an exemption from U.S. income taxation and withholding on pension and annuity income. As a result, the NRA would only be taxable in his home jurisdiction.
An NRA is subject to U.S. estate taxes on his U.S. situs property. The current exemption equivalent for NRAs is $60,000. The marital deduction is not available to NRAs. The NRA’s pension account would be considered U.S. situs property for federal estate tax purposes. Estate taxation might be averted by converting the NRA’s pension account into a “life only” annuity prior to death. Under IRC Sec 2039, a “life only annuity” is not included in a decedent’s taxable estate. Additionally, the NRA could also implement the Pension Rollback technique outlined in a prior blog post (but outlined below) to provide long-term U.S. income deferral and estate tax avoidance.
Juan Valdez, age 65, is a Mexican citizen, who lives in Mexico City. Juan is married to Lupita who is also age 65. The Valdez family has a portfolio of commercial real estate investments in New York City valued at $10 million generating taxable income of $750,000. The family also has other U.S. Investment income that is subject to withholding tax- $250,000. The real estate income will be taxed at a combined marginal tax rate of fifty percent –federal, state, and municipal. The investment income will be subject to state taxation as well as the federal withholding tax under IRC Sec 871.
Juan forms a series LLC in Delaware – Acme Investments. The business purpose of Acme is investment management. Juan and Lupita are the managing members through a separate LLC – Acme Management. Juan and Lupita assign their interests in Acme Management to a South Dakota irrevocable trust – Valdez Family Trust.
Juan and Lupita assign their investment accounts and real estate holdings to various series under Acme. John will receive a management fee of $175,000 per year. Lupita will also receive a management fee of $175,000 per year from Acme Management. .
Acme Management adopts a new fully defined benefit plan. The combined contribution is $500,000. Juan will have a retirement benefit of $10,020 per month at age 70. Lupita will have a benefit of $10,200 per month at age. As an additional bonus Juan and Lupita could each contribute an additional $22,500 each into a 401(k) plan. Acme Management can also contribute an additional six percent into a profit sharing plan based on compensation – an additional $10, 500 each for Juan and Lupita. The cumulative contribution is $566,500.The combined contribution provides a tax benefit of $283,250.
Juan and Lupita use the pre-tax dollars within the pension to invest in commercial real estate and land. Once required minimum distributions (RMD) are required, Juan will elect a “life only” annuity payout which will terminate upon his death resulting in no estate inclusion for his pension account balance.
The actuarial gain will revert to the Plan which is wholly owned in the Acme Management Defined Benefit Plan. Acme Management is wholly owned by the Valdez Family Trust outside of the taxable estate. Acme Management will also be able to employ the Valdez children and grandchildren so that they accrue a pension benefit.
Under the terms of the U.S.-Mexican Income Tax Treaty (Article 18) none of the pension distributions will be subject to U.S. income taxation or withholding tax. The pension contributions will reduce U.S. taxation on U.S. income. Investment earnings will continue to accrue on a tax deferred basis. Based on the planning design above, the pension assets will never be subject to U.S. estate taxes across multiple generations.
Qualified retirement plans are not typically a planning solution for NRAs for reducing taxable income on U.S. business and investment income. The purpose of this blog post is to alert advisors to NRAs to the idea that qualified retirement plans can provide a substantial income tax benefit while also avoiding U.S. estate taxes.