Keren Hishtalmut U.S. Tax Treatment: Part II

Last week, I presented the case that the Keren Hishtalmut – like an Israeli pension – would be treated like an employees’ trust for U.S. tax purposes. This week, I ask several non-expert questions about this.

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1. Is a Keren Hishtalmut really an employees’ trust?

My first question is whether the Keren Hishtalmut can really be considered an employees’ trust. After all, the employee has complete control over it. To be a “trust,” wouldn’t it need to be administered by the employer?

Admittedly, this question is somewhat silly considering that we made up the criteria for what constitutes an employees’ trust in the first place. However, we are having so much fun that we should think about this.

If you think that the Keren Hishtalmut is not an employees’ trust, then you would probably have to say the same thing about an Israeli pension. In both cases, the employee has complete control over the investments and the plans are not administered by the employer.

Perhaps you would argue that a pension is different because it has a set of clear and strict government regulations which make it more “trust-like.” However, if you did that, I would argue that the Keren Hishtalmut has an equally clear and strict set of government regulations.

The only way I could see that a distinction could be made between the Keren Hishtalmut and the pension would be if the IRS would explicitly rule them to be different. Or, perhaps more reasonably, if Israel and the United States were to update the tax treaty to explicitly treat them differently.

Updating the tax treaty to address Israeli pensions would be very nice and make sense. I personally volunteer to speak with John Kerry about this next time he is in the area. My recommendation will be that Israeli pensions should be treated like qualified retirement plans, and that Keren Hishtalmut would be treated explicitly like an employees’ trust.

2. Employees’ trust for the self-employed?

My second question is that assuming an Israeli pension and Keren Hishtalmut would be considered employees’ trust, could this also extend to the same plans set up by someone who is self-employed? In that case the employee is the owner.

Can you set up an employees’ trust for yourself?

I wouldn’t think so.

Fortunately, no one cares what I think. The answer should be “yes” because Section 402(i) specifically allows this.

3. Are the first 6 years different?

Does it make any difference that withdrawals are allowed from the Keren Hishtalmut after 3 years for educational purposes, or after 6 years for any reason?

Although this sounds like an important criteria that should somehow factor into our tax treatment, I can’t think of any tangible reason why this makes a difference.

It may sound relevant because it seems similar to “vesting.” In an employee’s trust, the contributions and earnings are taken into income only once they belong to the employee. You may want to say that this happens only after the Keren Hishtalmut “unlocks” after 6 years. However, I do not think this is correct.

In a Keren Hishtalmut, the money is yours the moment it is deposited. The limitation on withdrawal from the Keren Hishtalmut prior to 6 years is only an Israeli tax consequence. You could withdraw money early; you would just need to pay tax on it.

The vesting component for employees’ trust may applying to severance pay, but that is a separate question. Fortunately, no one has accidently asked me that question so I don’t need to answer it.

4. What about the fact that the Keren Hishtalmut is exempt from FATCA reporting?

Finally, is the fact the Keren Hishtalmut is exempt from FATCA reporting have any impact on this question?

Like the 6 years, this also sounds like it should somehow factor into our tax treatment. However, I don’t think it does.

Specially, the IRS regulations for FATCA in 1.1471-5 (b)(2)(i) allows exemptions from reporting for (A) foreign “retirement and pension accounts,” and (B) foreign tax-advantaged “non-retirement savings accounts.”

For (B), the regulations exempt accounts that are “tax-favored with regard to the jurisdiction in which the account is maintained, subject to government regulation as a savings vehicle for purposes other than for retirement.” There are several conditions that must be met to qualify for this exemption, and I believe the Keren Hishtalmut meets all of them.

This is a very nice bit of accidental research which explains why your Keren Hishtalmut provider never asked you to fill out a W9 form. However, I do not think there is any reason why this would have an impact on how the contributions and the earnings in the account should be treated for U.S. tax purposes.

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Conclusion?

I am now convinced that the Keren Hishtalmut can be treated as an employees’ trust. This brings us to the critical question regarding PFICs.

If the money in the employees’ trust is invested in a foreign mutual fund, does it need to be reported as a PFIC or not? 

Keren Hishtalmut U.S. Tax Treatment: Part I

Accidental readers everywhere want to know whether or not they will get eaten by PFIC if they have a Keren Hishtalmut.

It is important to keep in mind that this is an important tax issue, which means that you shouldn’t listen to anything you read by accident on a blog. Instead, you should ask your accountant for guidance.

Unless you don’t like what your accountant has to say on the topic. In that case, you should do exactly what you would do if you wanted an answer from your rabbi. Keep asking until you get the answer you want. When you find it, please post it in the comments so that we can all take part.

And that is how it came to be that no one visiting Israel observes two days of chag.

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Keren Hishtalmut as a Brokerage Account

If we didn’t know any better, we would just assume that a Keren Hishtalmut is no different than a regular brokerage account.

The logic behind this way of thinking would be that although the Keren Hishtalmut has special tax treatment in Israel, that doesn’t mean anything for U.S. taxes. The only way it would be different is if there was a special agreement in the tax treaty between the United States and Israel. There isn’t.

This a very simple and clean way to think about the Keren Hishtalmut, but I don’t like it very much. It would mean that you will get eaten completely by PFIC if you own a mutual fund in your Keren Hishtalmut. I have a Keren Hishtalmut and I don’t want to get eaten.

Keren Hishtalmut like a Pension

For us to avoid (or, lessen the impact of) the PFIC, we need find an alternative tax treatment for the Keren Hishtalmut. To do this, we simply need to read the U.S. tax code and find something that sounds similar enough to a Keren Hishtalmut that is more favorable. Our best option in this regard is to treat the Keren Hishtalmut the same way that we would treat an Israeli pension plan.

Foreign Pensions

In the U.S., pension plans have special tax treatment. For example, if you have a 401(k) plan in the U.S., you and your employer can make contributions into the plan which are tax deductible. You also do not pay any tax on the gains inside of the 401(k) each year. Rather, you will pay income tax when you withdraw the money, either at retirement age or earlier under special conditions.

This special tax treatment is only available to “qualified plans” that meet the requirements of section 401(a).

One of these requirements is that the plan is created in the United States. If you were an expert, you could easily conclude that this means that foreign pension plans are automatically not qualified.

However, if you were not an expert, you would know that according to 402(d), foreign plans can still be qualified, provided that they meet all of the requirements of 401(a). Unfortunately, not being an expert in this case will not get you very far. If you don’t believe me, read 401(a) and use it to determine whether your Israeli pension plan meets these requirements. (Hint: it will not. The ability to withdraw the severance pay component from the pension would break the rules. Also, the Israeli pension will fail to meet the requirement of rollover to other eligible plans.)

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The only way you will be able to convince your accountant to treat your foreign pension plan as a qualified retirement plan would be to show him that there is a special arrangement made in a tax treaty. This will not work for Israel. As with most countries, the United States does not have a special provision with Israel to allow pension plans to be treated as if they are qualified.

However, it will be very easy to convince your accountant to observe only one day of chag, especially if he already lives in Israel.

For foreign pension plans that do not have special treatment under a tax treaty, the common understanding is that they should be treated the same way a non-qualified plan would be treated in the United States. Plans like these in the United States are called, “employees’ trusts.”

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A trust may not be qualified for special tax treatment for any number of reasons. For example, employers may set aside money in a supplementary retirement savings that exceeds the contribution limits for qualified retirement plans. Or, an employer may set aside money in special incentive plan that vests over many years in a type of deferred compensation plan.

In the case of one of these non-qualified plan, you can read section 402(b) to learn how the tax is assessed. Or, I could just tell you that the contributions and gains (as soon as they are “vested”) are considered taxable income each year.

The regulations never state explicitly how a plan must be structured to be considered an employee’s trust. However, we can imply a lot from various IRS rulings on the topic and from random searches that I have done on the internet. Basically, it would need to be at least that, (a) the employer contributions to the plan are greater than the employee’s, and (b) that the plan is only available through an employer.

The first requirement is very important because otherwise the trust would have entirely different properties. In the case where the employee puts in all of the money (or most of it), the trust would a “grantor trust.” In that case, you directly own the trust and a whole set of other tax consequences would apply. The most significant would the requirement to report your ownership in a foreign trust using Forms 3520 and 3520-A.

In the case of an employees’ trust you should think of this as precisely not a “grantor trust.” Or, you could say that an employees’ trust is a type of “nongrantor trust.”

I suppose that there could be other types of nongrantor trusts as well. If that sounds confusing to you, just think of it like a potato pastry. All potato pastries are knishes, but not all knishes are filled with potato.

Or, maybe the potato pastry could also be a bereka. Well, either way, I think my point is clear.

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In practice, treating your Israeli pension as an employees’ trust would mean that in any year, all of your contributions and your employer’s contributions would be considered taxable income. Also, any increase in value in your pension would be considered taxable income.

The good news is that because this money came through your employment – and is in an employees’ trust – this income is not passive income. This means you can apply a credit for income tax that you paid to Israel to cover any tax due on your U.S. return for this money.

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Keren Hishtalmut

Treating a Keren Hishtalmut like an Israeli pension is a rather natural extension. The only practical difference between them in the way they are structured is that the pension restricts distributions until retirement age (or, in the case of severance pay, to termination from employment). This sounds like it may be significant, but it really isn’t. The tax treatment for the Israeli pension plan had nothing to do with the fact that it is a retirement account. It is based on the account being an employees’ trust.

Like an Israeli pension, the Keren Hishtalmut could be a considered an employees’ trust because (a) the employer contributions to the plan are greater than the employee’s, and (b) the plan is only available through an employer.

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If so, the tax treatment for the Keren Hishtalmut would be the same as a pension. In each year, the contributions (yours and your employer’s) would be considered taxable income. Likewise, any increases in the value of the Keren Hishtalmut would be considered taxable income.

Also in this case, because the income is related to your employment, it would not be considered passive. You could happily apply a credit for income tax that you paid to Israel to cover any taxes due to the United States.

Conclusion?

Treating the Keren Hishtalmut and the pension as employees’ trusts is fairly well established in the accounting business. However, I am not fairly well-established in the accounting business. I have several questions on this that I will ask next week.

Running Away from a Keren Hishtalmut?

It may be somewhat of surprise to you, but it’s true: Getting Eaten by PFIC is far and away Investing by Accident’s most popular blog.

Or, maybe that isn’t at all surprising. It is consistent with Investing by Accident being #1 in the internet search results for “pfic israel keren hishtalmut.”

Unfortunately, this significant internet achievement brings me to a challenge of conscious. In Getting Eaten by PFIC, I contended that a Keren Hishtalmut is not a PFIC, but I never explained why. It turns out that my contention was so contentious, that one Accidental Reader contacted me to ask me about it.

Ordinarily, I would refuse to answer his question because he asked it on purpose. However, I was so impressed that he was willing to drive all the way from Jerusalem to meet me that I am making an exception.

Also, I think I was wrong and need to set the record straight.

Is a Keren Hishtalmut a PFIC?

I have pondered this question for at least as long as it was asked to me, and in my estimation there are exactly three ways that you could go about answering it.

1. Your first option is to completely ignore the question.

In my non-expert observation, most people choose this path by accident. You probably just decided to do this. You assume that your accountant will handle this for you. In a worst case scenario when the IRS starts asking you questions, you could just say that you only read as far as this sentence in my blog.

Unfortunately, you no longer have any excuses because you can read my blog using the Skipping Tags. You will enjoy a good amount skipping, as it will take many blog postings to fully deal with this question.

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2. Your second option would be to search the internet to find someone who has already posted an answer to this question. Unfortunately, this will not work because no one has done this. In fact, if you decide to take this path, you will just end up right back at this blog where you started.

3. Your third option is to perform your own non-expert research on the topic. While this sounds like an extremely daunting task, it is really only very daunting. I have already performed this research and can provide you with a simple, short list of resources for you to use in your own research.

Do-It-Yourself Non-Expert Research

Here is what you’ll need:

Tax Treaty. It is always a good idea to begin research on any topic by reviewing a tax treaty. For example, when I need to find a creative new recipe to entertain guests, I always start by checking if there is an article in the tax treaty that may be relevant.

The tax treaty between the U.S. and Israel is available from the IRS website. Be sure not to miss the “savings clause” in Article 6, paragraph 3, which may mean that you do not need to read the treaty at all. No one knows when the United States will invoke it, and most people assume that they always will.

But if the savings clause is always invoked, then why is there a tax treaty in the first place? This is a good question with no answer. Perhaps it exists to provide a place to keep the personal correspondence from Jimmy Carter.

401’s. You will want brush up on Section 401 of the tax code, which talks about the special tax treatment for qualified retirement plans. As an alternative, you could just check the balance in your 401(k). It is about equally as understandable.

402’s. After finishing 401, you should read section 402, especially part (b). This is the section that talks about the taxation of plans that are not qualified. Or, since it is more-or-less the inverse of section 401, you could just look at your 401(k) statement in the mirror.

In any case, while you are in the 402’s, it is worthwhile to take a look at parts (d) and (i) as well.

FATCA. You can read the proposed regulations from the IRS on when foreign financial institutions are required under FATCA to report accounts held by Americans.

Or, you could not read it. It really doesn’t make a difference.

It sounds like FATCA should be relevant to the question of whether a Keren Hishtalmut is a PFIC, but it isn’t. However, it will explain why your Keren Hishtalmut provider has never asked you to complete a W9 form. That isn’t what you are researching, but it never hurts to learn things by accident.

Comparisons. The best part of your research will be finding other types of foreign accounts that are similar to the Keren Hishtalmut and compare how they are taxed by the United States.

Actually, this isn’t true because you won’t find any. 

But that is ok, because this part is more about the journey than the destination.

A good place to start would be in this blog about the Tax Implications of Foreign Pension Plan Participation.

You will want to look up his sources, including reading up on a Registered Retirement Savings Plan in Canada. This one is especially fun because you can then read about it in Article 18 of the tax treaty between the United States and Canada. Who knows? Maybe they also have a create way to make chicken with maple syrup.

Whatever happens in your research, make sure not to miss the Individual Savings Account (ISA) from the U.K. This one is an especially good treat because you can read this blog about whether an ISA is a PFIC which is so good that it may as well have been written by a non-expert.

To finish it off, I recommend this scholarly-sounding piece that talks about the Singapore Central Provident Fund.

YouTube. Next, you will want to watch this video about what really motivates us. This has nothing at all to do with taxation of the Keren Hishtalmut. I am just testing to see if you are still reading this blog. Also, I think it is great how they draw words and pictures with the voice over. When I grow up, I want to make videos like this.

                                                                                           

IRS Regulations. Finally, you should read the IRS regulations on what constitutes ownership in a PFIC. I suppose that you could have just started and finished with this and skipped all of the other research. But, what kind of journey would that have been?

Is the Keren Hishtalmut a PFIC?

What will all of this non-expert research tell you about whether the Keren Hishtalmut is a PFIC?

There is no way for you to know for sure without doing the research. Actually, there is. I could tell you because I did the research.

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The answer about whether the mutual fund holdings in a Keren Hishtalmut would be considered a PFIC is:

I think so.

I’m sorry. I know this isn’t the answer you were looking for.

However, the good news is that I do not believe you will get eaten by this PFIC in the same way as you would in a regular brokerage account. In the weeks ahead, I’ll explain why.