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.