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?