Effectively Complicated Income

I ended my post on 60(j) rollovers with a cliffhanger, by hinting that the rate of US tax on a nonresident alien’s IRA or 401(k) distribution might depend on the extent to which the income is “effectively connected with the conduct of a trade or business within the United States”—a term of art from IRC § 871 that I quoted without the elaboration it deserves.

First, some background.

I. Introduction to ECI and non-ECI taxation

The US regime for nonresident aliens is bifurcated by two categories of US-taxable income, which map roughly to whether the income is from active economic activities or passive investment.

A. Effectively connected income

The category of “effectively connected income” (ECI), intended for income with some connection to an active business in the US, is taxed similarly to the normal income of a US citizen or resident: gross income is reduced by allowable deductions, and then taxed at graduated (progressive) rates under the standard tax brackets of IRC § 1.[1]IRC § 871(b)(1)

It’s important to note that ECI isn’t limited to business owners (e.g., Schedule C income). Employment compensation (wages) are also ECI when a nonresident alien performs services in the US,[2]IRC § 864(b) subject to a $3000 de minimis exemption for certain temporarily-present workers.[3]IRC § 864(b)(1)

I’ll also mention a historical detail about deferred income. When the ECI concept was first introduced, your compensation was ECI only if you performed services in the same tax year.[4]This follows from the text of § 864(b) (“performance of personal services … at any time within the taxable year”) as enacted by the Foreign Investors Tax Act of 1966, Pub. L. 89-809 § … Continue reading But after the Tax Reform Act of 1986 added § 864(c)(6) to the tax code[5]Pub. L. 99-514 § 1242, 100 Stat. 2580, the status of compensation income as ECI is not altered by deferring it to a future year.

B. US-source income that is not effectively connected

In the other category, US-source “non-ECI”, we find investment income such as dividends from US corporations, taxable to the payee on a gross basis (that is, without deductions) at a flat rate of 30%,[6]IRC § 871(a)(1) or—more often—a lower flat rate prescribed by the tax treaty between the US and the taxpayer’s country of residence.

Because the payor withholds at the same rate,[7]IRC § 1441(a) nonresident aliens whose US-source income is entirely non-ECI usually don’t need to file a US tax return. That’s by design: the non-ECI rules “reflect the difficulty of collecting taxes from foreigners who are neither physically present in the United States nor tied to this country by business operations”.[8]Bittker & Lokken, Federal Taxation of Income, Estates and Gifts (Thomson Reuters/WG&L 2019), ¶ 67.1.1

For those who do file a return, the structure of Form 1040-NR also displays this split: ECI is reported on the first page, and non-ECI is reported on a separate Schedule NEC (“Tax on Income Not Effectively Connected With a U.S. Trade or Business”).

Non-ECI is sometimes called “FDAP income”, from the phrase “fixed or determinable annual or periodical gains, profits, and income” in § 871(a)(1)(A) and § 1441(b). This is sloppy usage: FDAP and ECI are not mutually exclusive, and the 30% flat rate applies to FDAP “only to the extent the amount so received is not [also] effectively connected”.[9]IRC § 871(a)(1)

II. 401(k) distributions

Enter the 401(k) plan. Are distributions to a nonresident alien ECI?

In various rulings, most recently a 2007 memorandum[10]IRS Chief Counsel Memorandum PRESP-112729-07 about the United Nations Joint Staff Pension Fund (“the UNJSPF Memo”), the IRS has indicated that we should determine the US tax consequences of a payout from a qualified plan[11]The UNJSPF Memo examines the treatment of a domestic (US-situs) trust which is “a qualified trust under section 401(a)”. A 401(k) plan (more formally, a § 401(a) qualified trust with a § 401(k) … Continue reading by “disaggregating the distribution into (1) contributions by the employer, which are treated as compensation for services, and (2) the investment return (‘earnings and accretions’) on the contributions of the employer and employee.”[12]UNJSPF Memo p. 5, citing Rev. Rul. 79-388, 1979-2 CB 270

The “contributions” portion, representing deferred compensation, is ECI to the extent that the services in question were performed in the US.[13]supra, part I.A; §§ 864(b), 864(c)(6); Letter Ruling 8904035; UNJSPF Memo p. 7, note 10 (ECI portion subject to same withholding as non-ECI) (If you funded a 401(k) while working outside the US, those contributions are distributable tax-free as foreign-source income.[14]Rev. Rul. 79-388, 1979-2 CB 270)

What about the “earnings” portion? One might be tempted to argue that the earnings inside the plan are part of the taxpayer’s compensation. But the Court of Federal Claims essentially rejected that theory in Clayton v. United States.[15]33 Fed. Cl. 628 (1995) The plaintiffs, who were employed in Canada, asserted that the investment gains in their employee stock ownership plan were compensation, and therefore nontaxable as foreign-source income. But the court found that “the legislative history indicates that Congress understood and approved the IRS’ general policy of taxing the earnings and accretions of a qualified trust distribution.”[16]Clayton, at 645

Clayton counsels that the investment earnings in a qualified plan do not have the character of compensation—even though the court didn’t address whether the plaintiffs’ income would have been ECI if they had been employed in the US.

The IRS’s technical guidance consistently asserts that the earnings portion is US-source non-ECI. That was their conclusion in the UNJSPF Memo, where the taxpayer had worked abroad[17]UNJSPF Memo p. 9, and in Letter Ruling 8904035, where the taxpayers had worked in the US.[18]The ruling holds: “The Distributions [from the 401(k) plan], except for earnings and accretions, will be U.S. source income effectively connected with a trade or business within the United States. … Continue reading And it’s the answer that secondary authorities generally provide.[19]Blum, Cynthia, “U.S. Income Taxation of Cross-Border Pensions”, 31 Fla. Tax Rev. 259 (1996), § III.B.2 (“Assuming that the pension plan is located in the United States, the earnings and … Continue reading

III. IRA distributions

What about IRA distributions? The IRS has held that for an IRA funded by a rollover (e.g., from a 401(k) plan or another IRA), the rollover preserves the source of income as US or foreign.[20]Rev. Rul. 84-144, 1984-2 CB 129 By similar reasoning, we might infer that a rollover also preserves the character of income as ECI or non-ECI when later distributed.

The ruling does not address the case of an IRA funded by an individual’s direct contributions while US-resident, without the involvement of an employer. But it’s hard to see a basis for distributions being anything other than US-source non-ECI in that case.

IV. Example

Let’s apply our conclusions about 401(k) distributions to an example.

Gina is a Canadian citizen who lived and worked in the US for several years (but not before 1986). During that time she contributed a total of $100K to a 401(k) plan with her US employer, which grew with investment returns to $150K. She then moves back to Canada, ending her US tax residency, and cashes out the full balance in the year 2020. She has no other US-source income.

She reports the income from the payout on her US return as follows:

  • $100K contribution portion as ECI on Form 1040-NR Line 5b (taxable pensions and annuities)
  • $50K earnings portion as non-ECI on Schedule NEC Line 7 (pensions and annuities)

Her US tax payable on those amounts will be $33080[21](100000 × 24% – 5920.50) + (50000 × 30%), plus an additional $15000[22]150000 × 10% early distribution penalty if she’s below the age of 59½.[23]IRC § 72(t)

Notice that Gina has saved a substantial amount of tax by being aware of § 864(c)(6). If she had reported the entire amount on Schedule NEC, or accepted her broker’s withholding under § 1441(a) and not filed a return, then she would have paid an additional $11920 to the United States.[24]150000 × 30% = 45000, versus the correct amount of 33080

For modest plan balances, it will usually be beneficial to treat some of the payout as ECI rather than US-source non-ECI. That’s because the overall effective tax rate under the normal brackets is less than 30%, except at the highest income levels.[25]In 2020, the “crossover” point for a single filer is $504100 of taxable income: 504100 × 35% – 25205 = 504100 × 30%.

V. Treaty rate limits

The split between ECI contributions and non-ECI earnings is rendered irrelevant if the US tax on the distribution is reduced by the pension provisions of a tax treaty. If the treaty considers 401(k) plans to be pensions, and limits tax on pension distributions to a flat rate, then that rate limit applies to the entire distribution (not just the ECI or non-ECI portion).

For example, if Gina had moved to South Africa instead of Canada, and was 60 years old at that time, her US tax would be limited to $22500[26]150000 × 15% by the 15% treaty rate for pension distributions “whether paid periodically or as a single sum”.[27]US–South Africa tax treaty (1997), Art. 18(1), which applies provided that the payment “is not subject to a penalty for early withdrawal”

In that case, Gina should probably report the entire amount on Schedule NEC, notwithstanding that some of it is ECI under US law. That’s because Schedule NEC is the only place on the 1040-NR where treaty rate limits are expressly claimable; the designers of the form apparently didn’t anticipate such limits extending to ECI.

Gina probably can’t claim the treaty rate for a lump-sum payment in Canada.

VI. Does it matter?

With rulings, technical memoranda, and case law advising a split between contribution (ECI) and earnings (non-ECI) for a nonresident former US employee’s qualified plan withdrawal, surely we can expect to find some mention of this in the IRS’s published guidance for regular people, such as the Form 1040-NR instructions?

For example, we’d expect the instructions for Line 5b (pensions and annuities) to say something like “Enter only the portion of your pension distribution that represents contributions to the plan. Report the portion that represents a return of investment earnings on Schedule NEC Line 7.” Right?

Perhaps they would even design Form 1099-R to display taxable ECI distributions separately from taxable non-ECI distributions?

Nope, nope, and nope.

The current instructions for Line 5b make no mention at all of the contribution/earnings split, even while going into detail about a different ECI / non-ECI split:

“If you worked in the United States after December 31, 1986, the part of each pension distribution that is attributable to the services you performed after 1986 is income that is effectively connected with a U.S. trade or business.”[28]Form 1040-NR (2020) instructions, pp. 21-22

This is followed by an example illustrating a split between ECI and non-ECI for payments attributable to services partially performed before 1986, when § 864(c)(6) (providing that ECI is preserved by income deferral) was introduced.

Conspicuously absent from the example is any mention of attributing any portion of the payment to investment earnings inside the plan. Does the IRS really think the pre- / post-1986 services split is more important than the contribution vs. earnings split?

The ECI section of Form 1040-NR also provides a separate line for taxable IRA distributions (Line 4b). But Schedule NEC makes no mention of IRA distributions at all! The instructions contain a simple statement that “Payments from an IRA are reported on lines 4a and 4b”[29]Ibid., p. 20 (i.e., as ECI, to the extent they are taxable), with no mention of non-ECI IRA payments.

This wasn’t always the case. In 1995, the Form 1040-NR instructions said: “Use lines 16a and 16b to report effectively connected payments (distributions) you received from your individual retirement arrangement (IRA). … But if this income is not effectively connected with your U.S. trade or business, report it on line 73.” (Line 73 was the non-ECI “Pensions and annuities” line.) But in 1996, this instruction disappeared.

Perhaps the IRS wanted to simplify the instructions because taxpayers were persistently confused trying to understand the extent to which their pension distributions were non-ECI.

It’s also notable that the rulings and case law on point (such as Clayton and the UNJSPF Memo) are focused primarily on the US vs. foreign source distinction—which determines whether the income is taxable at all—and make only incidental mention of the ECI vs. non-ECI distinction within the umbrella of taxable US-source income.

At any rate it’s hard to resist the conclusion that the IRS doesn’t care that much whether your IRA or 401(k) distribution is taxed as ECI, non-ECI, or partly ECI. If they want taxpayers to split contribution and earnings properly, they’re doing a bad job of communicating the rules.

References
1 IRC § 871(b)(1)
2 IRC § 864(b)
3 IRC § 864(b)(1)
4 This follows from the text of § 864(b) (“performance of personal services … at any time within the taxable year”) as enacted by the Foreign Investors Tax Act of 1966, Pub. L. 89-809 § 102(d), 80 Stat. 1544.
5 Pub. L. 99-514 § 1242, 100 Stat. 2580
6 IRC § 871(a)(1)
7 IRC § 1441(a)
8 Bittker & Lokken, Federal Taxation of Income, Estates and Gifts (Thomson Reuters/WG&L 2019), ¶ 67.1.1
9 IRC § 871(a)(1)
10 IRS Chief Counsel Memorandum PRESP-112729-07
11 The UNJSPF Memo examines the treatment of a domestic (US-situs) trust which is “a qualified trust under section 401(a)”. A 401(k) plan (more formally, a § 401(a) qualified trust with a § 401(k) cash or deferred arrangement) is an example of such a trust.
12 UNJSPF Memo p. 5, citing Rev. Rul. 79-388, 1979-2 CB 270
13 supra, part I.A; §§ 864(b), 864(c)(6); Letter Ruling 8904035; UNJSPF Memo p. 7, note 10 (ECI portion subject to same withholding as non-ECI)
14 Rev. Rul. 79-388, 1979-2 CB 270
15 33 Fed. Cl. 628 (1995)
16 Clayton, at 645
17 UNJSPF Memo p. 9
18 The ruling holds: “The Distributions [from the 401(k) plan], except for earnings and accretions, will be U.S. source income effectively connected with a trade or business within the United States. Section 864(c)(6) of the Code. Withholding will be under section 3405 or, if inapplicable, under section 1441(a). The earnings and accretions portion of the Distributions will be U.S. source income not effectively connected with a trade or business and will be withheld on under section 1441(a).”
19 Blum, Cynthia, “U.S. Income Taxation of Cross-Border Pensions”, 31 Fla. Tax Rev. 259 (1996), § III.B.2 (“Assuming that the pension plan is located in the United States, the earnings and accretions are treated as U.S. source noneffectively connected income”); Andersen, Richard E., Analysis of United States Income Tax Treaties (Thomson Reuters/WG&L 2019), ¶ 14.01[2][c] (“the earnings and accretions portion of a pension distribution paid by a U.S. employee trust to a nonresident alien individual under a Section 401 qualified plan would generally be considered FDAPI and not effectively connected income”), citing Letter Ruling 8904035
20 Rev. Rul. 84-144, 1984-2 CB 129
21 (100000 × 24% – 5920.50) + (50000 × 30%)
22 150000 × 10%
23 IRC § 72(t)
24 150000 × 30% = 45000, versus the correct amount of 33080
25 In 2020, the “crossover” point for a single filer is $504100 of taxable income: 504100 × 35% – 25205 = 504100 × 30%.
26 150000 × 15%
27 US–South Africa tax treaty (1997), Art. 18(1), which applies provided that the payment “is not subject to a penalty for early withdrawal”
28 Form 1040-NR (2020) instructions, pp. 21-22
29 Ibid., p. 20

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