Advising Clients on Expatriating
Advising U.S. Citizens and Long-Term Residents On Expatriating: What to Ask and Why it Matters Critical Questions to Provide Good Advice
Notice 2009-85 issued by the Internal Revenue Service on November 9, 2009 provides helpful guidance to practitioners advising clients who wish to give up their U.S. citizenship. By relinquishing citizenship, clients avoid further U.S. tax compliance, as well as U.S. taxation on worldwide income. The Notice answers many questions left open by the statute adopted as part of the Heroes Earnings Assistance and Relief Tax Act of 2008 (P.L. 110-245). That Act added new Code sections 877A and 2801 effective for individuals relinquishing U.S. citizenship or ceasing to be lawful permanent residents of the United States on or after June 17, 2008. For those individuals, Internal Revenue Code section 877A creates an exit tax regime. This article sets forth the questions practitioners should ask their clients who have an interest in expatriating. These questions will allow the practitioner to elicit information necessary to properly advise clients regarding their exposure to the U.S. exit tax.
Are you a citizen or lawful permanent resident of the United States?
The exit tax of Code Section 877A is potentially applicable not only to U.S. citizens, but also individuals who have resided in the United States for at least eight out of fifteen taxable years (“Long-Term Resident”). The fifteen-year period ends with the year in which the individual ceases to be a lawful permanent resident of the United States or becomes a resident of a non-U.S. jurisdiction under the provisions of a tax treaty between the United States and the other country. (Code Section 877A(g)(5), referring to Code Section 877(e).)
What is your net worth? What is your annual U.S. income tax liability?
These questions provide an initial screen to determine which clients are subject to the exit tax imposed by Code section 887A. Unless the taxpayer’s net worth exceeds $2 million dollars (the “Net Worth Test”) or the taxpayer’s average annual net income tax liability for the five preceding taxable years prior to the year of expatriation exceeds the $124,000 amount set forth in Code Section 887(a)(2)(A), as adjusted for inflation ($145,000 for individuals expatriating in 2010) (the “Tax Liability Test”) the exit tax imposed by the statute does not apply. Any U.S. citizen or Long-Term Resident who satisfies the Net Worth Test or the Tax Liability Test is characterized as a “covered expatriate” and subject to the exit tax. However, the converse is not necessarily true. That is, a taxpayer who does not satisfy either of these tests is not necessarily exempt from the exit tax.
Have you filed all required U.S. tax returns for the last five years?
In order to avoid the exit tax, the taxpayer who is expatriating must also be U.S. tax compliant: that is, all U.S. tax returns (including employment, gift tax, and information returns) must have been filed by the individual for each of the five taxable years preceding the taxable year in which expatriation occurs and all relevant tax liabilities, interest, and penalties must have been paid. (Code Section 877A(g)(1)(A) cross referencing Code Section 877(a)(2)(c).)
Notice 2009-85 clarifies that U.S. tax compliance includes filing all information returns. This would include Form TDF 90-22.1 Report of Foreign Bank and Financial Accounts, as well as other information returns required by U.S. persons owning foreign accounts, entities, and other assets.
How did you become a U.S. citizen?
There are a variety of ways in which someone may acquire U.S. citizenship, but the most common are either to be born in the United States or to have a parent who is a U.S. citizen. Code Section 877A(g)(1)(B) creates a loophole for individuals who become dual citizens at birth.
Have you ever lived in the United States?
Even if an individual meets the Tax Liability Test or the Net Worth Test, the individual may still avoid the exit tax if the expatriate became a U.S. citizen and a citizen of another country at birth and has continued to be a citizen and taxed as a resident of that other country.
Example. Mr. Smythe’s mother was a U.S. citizen residing in Canada at the time Mr. Smythe was born. As a result, Mr. Smythe has dual Canadian-U.S. citizenship. Although his net worth is in excess of $2 million dollars, if Mr. Smythe has been a U.S. resident for ten or fewer years during the fifteen year period ending with the taxable year during which expatriation occurs, he can avoid the exit tax. (See Notice 2009-85, Section 2A.)
How old are you? How long did you live in the United States?
A further exception to the exit tax exists for individuals with a net worth in excess of $2 million dollars or average annual tax liabilities in excess of $145,000 if U.S. citizenship is renounced before age 18 ½. (Code Section 877A(g)(1)(B)(ii). In this case, the taxpayer must not have been resident in the United States for more than ten taxable years before relinquishing citizenship. (Id.)
How do you plan to relinquish U.S. citizenship?
Section 1481 of Title 8 of the United States Code describes seven ways in which a U.S. citizen can lose his nationality, including committing an act of treason. However, treasonous acts and most of the other acts described in Section 1481 are insufficient to enable an individual who is a United States citizen or long term resident to expatriate for U.S. income tax purposes. The one act within the scope of Section 1481 which is effective is “making a formal renunciation of nationality before a diplomatic or counselor officer of the United States in a foreign state in such a form as may be prescribed by the Secretary of State” (8 USC Section 1481(a)(5)). The author understands it is the practice in most U.S. embassies to insist upon submission of Form DS-4079 Questionnaire Information for Determining Possible Loss of U.S. Citizenship and a Statement of Understanding Concerning the Consequences and Ramifications of Relinquishment or Renunciation of U.S. Citizenship, along with a copy of the individual’s passports (both from the United States and from the second country of the individual’s nationality).
Code Section 877A(g)(4) provides that citizenship will be lost on the earliest of
(1) the date the taxpayer renounces his or her U.S. nationality before a diplomatic or counselor officer in a foreign embassy;
(2) the date the taxpayer furnishes the United States Department of State a signed statement of voluntary relinquishment of U.S. nationality confirming either
(a) naturalization in non-U.S. jurisdiction,
(b) taking an oath or making an affirmation or other formal declaration of allegiance to a non-U.S. jurisdiction,
(c) serving in the armed forces of a non-U.S. jurisdiction, or
(d) accepting employment by the government of a non-U.S. jurisdiction;
(3) the date the U.S. Department of State issues a certificate of loss of nationality to the taxpayer; or
(4) the date a court of the United States cancels a naturalized citizen’s certificate of naturalization.
While Code Section 877A(g)(4) recognizes four ways in which citizenship may be relinquished, in most cases the taxpayer will submit two forms to the U.S. embassy or consulate in the country where the individual resides: A Statement of Understanding Concerning the Consequences and Ramifications of Relinquishment or Renunciation of U.S. Citizenship and Form DS-4079 Questionnaire Information for Determining Possible Loss of U.S. Citizenship along with copies of the taxpayer’s U.S. and foreign passports.
What assets do you own?
The vast majority of individuals who have dual citizenship with the United States and another country will not be subject to the exit tax of Code Section 877A either because they do not satisfy the Tax Liability Test or the Net Worth Test or because their citizenship arises as an accident of birth and the time the individual was present in the United States was less than eleven out of the last fifteen years. However, for individuals who do not satisfy these requirements or those others summarized above which allow expatriation on a tax free basis (a “covered expatriate”), the exit tax under Code Section 877A must be computed in order to determine the tax liability the individual will incur on expatriation.
Generally, the exit tax on expatriation is a tax on the unrealized income inherent in the covered expatriate’s assets. Thus, assets the individual owns are deemed to have been sold on the date of expatriation. Retirement plan assets and other deferred compensation items are deemed to have been paid to the covered expatriate on the date of expatriation.
To determine the extent and value of the expatriate’s assets, U.S. estate tax principles apply. The same revenue laws which determine the extent of a taxpayer’s gross estate under Code Sections 2033 through 2046 will apply to determine the assets included in the covered expatriate’s net worth. The same principles appearing in U.S. Treasury Regulations issued under Code Sections 2031 and 2512 apply to measure the value of the assets the covered expatriate owns or is deemed to own. (In this regard, the alternate valuation date election under Code Section 2032 and special use valuation under Code Section 2032A are not available. (Notice 2009-85 Section 3A.) An expatriate’s beneficial interests in any trusts will be included in the net worth computation. Contractual arrangements, such as options or other transactions involving family members will generally be ignored, if these arrangements have the effect of depressing the value of an asset. (Notice 2009-85 Section 3A.).
Have you ever transferred assets to a trust?
Property previously transferred to a U.S. trust may also fall within the scope of assets the expatriate is deemed to own if the expatriation causes the U.S. trust to be converted to a non-U.S. trust as a result of relinquishment of citizenship and application of the rules of Code Section 7701(a)(31)(b) and Treasury Regulation Section 301.7701-7. (See Notice 2009-85 Section 4.)
Other arrangements which frequently (but not necessarily) involve the use of trusts will also increase a covered expatriate’s net worth. Code Sections 2035-2038 will treat the covered expatriate as owning assets previously transferred by the expatriate but with respect to which the expatriate retained control over the transferred property or the income therefrom, unless the retained control or income was relinquished more than three years prior to expatriation. (See Notice 2009-85 Section 3A.)
Do you own any life insurance or annuity contracts?
Assets such as annuities and life insurance policies are generally valued at their replacement cost. (Notice 2009-85 Section 3A, referring to Treasury Reg. Section 25.2512-6.)
Have you ever transferred assets to a non-U.S. corporation?
Generally, gain is required to be recognized on contribution of appreciated property to a non-U.S. corporation. However, the gain realized may be deferred by entering into a gain recognition agreement satisfying the requirements of U.S. Treasury Regulations issued under Code Section 367(a). These Regulations also provide that if an individual U.S. transferor loses U.S. citizenship or ceases to be a lawful permanent resident of the United States, the individual will be treated as having disposed of all of the stock of the foreign corporation to which the appreciated property was transferred. As a result, the gain that was deferred as a result of the gain recognition agreement will be accelerated and recognized on the date of expatriation.
Do you participate in any individual retirement accounts, employer provided retirement plans, or are eligible for any other form of deferred compensation benefit?
Computation of the exit tax under Code Section 877A begins with analysis of the assets the covered expatriate owns or is deemed to own. Once these assets are identified, special rules apply to determine the income required to be recognized under Code Section 877A. In the case of personal and investment assets owned directly by the expatriate, these assets are marked to market as if they had been sold for fair market value on the date of expatriation. In the case of other assets such as deferred compensation items, income will be realized as if the deferred compensation were received. In each case, the practitioner should ask questions necessary to identify the types of property Section 877A seeks to tax.
Do you participate in any retirement plans?
For those individuals subject to Code Section 877A, expatriation triggers the acceleration of the covered expatriate’s account balance in a wide variety of retirement plans. Not only are employer provided retirement plans such as 401(k) and pension and profit sharing plans subject to acceleration, but also the expatriate’s interest in any individual retirement account, government 403(b) plans, simplified employee pensions described in Code Section 408(k), and simplified retirement accounts described in Code Section 408(p). (Code Section 877A(g)(4)(A) brings within the scope of Code Section 877A “any interest in a plan or arrangement described in Section 219(g)(5)”.) In addition, “any interest in a foreign pension plan or similar retirement arrangement or program” is included within the definition of a “deferred compensation item” for purposes of Code Section 877A(g)(4). This would appear to include RRSPs, as well as other retirement savings arrangements common in Canada. Further, amounts payable under non-qualified deferred compensation arrangements, such as trusts or other arrangements in which the “covered expatriate has a legally binding right as of the expatriation date to such compensation…not…actually or constructively received on or before the expatriation date…” will be deemed to have been paid. (Notice 2009-85, Section 5b(4).)
Finally, deferred compensation items also include “any property, or right to property, which the individual is entitled to receive in connection with the performance of services to the extent not previously taken into account under Section 83 or in accordance with Section 83.” (Code Section 877A(g)(4)(D).) This would include statutory and non statutory stock options, stock appreciation rights, restricted stock units with respect to which income recognition has been deferred because the property is either subject to a substantial risk of forfeiture or non-transferable. However, if the property has been the subject of an election under Code Section 83(b) resulting in its fair market value having been taken into income by the covered expatriate, it will not be treated as a deferred compensation item for purposes of Code Section 877A. (See Notice 2009-85, Section 5B(1)(d).)
Were any of the services giving rise to the deferred compensation benefit performed outside of the United States?
An exception is provided by Code Section 877A(d)(5) for deferred compensation items attributable to services performed outside the United States while the covered expatriate was not a citizen or resident of the United States. These items fall outside the scope of Code Section 877A’s exit tax. This could only arise in the case of an individual who is not a U.S. citizen but became subject to Code Section 877A as a result of satisfying the definition of a Long Term Resident. Notice 2009-85 provides that taxpayers may use “any reasonable method” to determine what portion of a deferred compensation item is attributable to services performed outside the United States while the covered expatriate was not a citizen or resident from that portion attributable services performed while the covered expatriate was a resident of the United States. (See Notice 2009-85 Section 5E.)
When did you become a U.S. resident?
For those individuals who become subject to the exit tax of Code Section 877A as a result of characterization as a Long-Term Resident (that is, a lawful permanent resident of the United States for at least eight taxable years during the fifteen year period ending with the taxable year in which residency ceases), two exceptions to the scope of the exit tax arise. First, gain inherent in the assets owned by the covered expatriate at the time the individual first became a resident of the United States will be ignored. (Code Section 877A(h)(2).) Residency for these purposes is determined by the tests found in Code Section 7701(b). Thus, residency could commence on the date the individual first
(1) became a lawful permanent resident of the United States (that is, a “green card” holder),
(2) satisfied the substantial presence test of Code Section 7701(b)(3), or
(3) elected to be treated as a U.S. resident pursuant to Code Section 7701(b)(4).
Property owned by the covered expatriate on the residency starting date is deemed to have a basis for purposes of computing gain or loss under Code Section 877A equal to the fair market value of the property on that date. Code Section 877A(h)(2). This basis adjustment is automatic unless the covered expatriate elects out of these rules. Such an election may be appropriate in the case of a covered expatriate whose gain recognition is sufficiently limited so as to be sheltered by the $600,000 exclusion provided by Code Section 877A(a)(3)(A) or who owns a U.S. real property interest with respect to which the individual prefers to recognize gain otherwise excluded as a result of Code Section 877A(h)(2), perhaps because of lower capital gain rates applicable to the year of expatriation. Notice 2009-85 provides that the basis step-up allowed by Code Section 877A(h)(2) will not be available in the case of a U.S. real property interest held in connection with the conduct of a U.S. trade or business on the date the covered expatriate first became a resident of the United States unless the U.S. trade or business was not carried on through a permanent establishment in the United States as a result of a tax treaty between the United States and the country in which the covered expatriate resided prior to U.S. residency. (Notice 2009-85 Section 3D.)
Do you wish to incur the exit tax in the year of expatriation or take advantage of opportunities for its deferral?
Computation of the exit tax. In order to intelligently determine whether the exit tax should be deferred, it is necessary to first compute the covered expatriate’s tax exposure under Code Section 877A. Unless the expatriate’s expatriation date is January 1, the covered expatriate will file a “dual status return” for the year in which expatriation occurs. (Notice 2009-85 Section 8B.) The dual status return requires preparation of both Form 1040NR and Form 1040 attached as a schedule. (The Notice refers taxpayers to Treasury Reg. Section 1.6012-1(b)(2)(ii)(b), Treasury Reg. Section 1.871-13, and chapter 6 of IRS publication 519 for the requirements for filing a dual status return.) With the dual status return, the covered expatriate must provide a statement which includes the information required by Code Section 6039G: generally, the covered expatriate’s income, assets, and liabilities. This information will be used to compute the gain realized as a result of the deemed sale of the covered expatriate’s assets and the income realized as a result the deemed payment of the covered expatriate’s deferred compensation items. Notice 2009-85 provides examples illustrating how the $600,000 exclusion provided by Code Section 877A(a)(3)(A) will be allocated among the assets with respect to which the gain is realized. The Notice resolves two unanswered questions or ambiguities present in the language of the statute. First, loss as realized as a result of the marking-to- market of the covered expatriate’s assets will be applied to offset gains. Second, the resulting basis adjustment will take into account gain sheltered as a result of the $600,000 exclusion.
Example. Mr. Smythe owns one asset with a basis of $200,000 and a fair market value of $2 million. As a result of his expatriation, the asset is marked to market and deemed to be sold for $2 million. Of the $1.8 million of deemed realized gain, $600,000 is sheltered as a result of the exclusion provided by Code Section 877A(a)(3)(A). Mr. Smythe will pay a tax on the remaining $1.2 million of unsheltered gain. Notice 2009-85 makes clear that the basis which Mr. Smythe takes in his U.S. real property interest is $2 million, despite the $600,000 exclusion. (See Notice 2009-85, Section 3C.)
Deferral of income recognition from deemed sales. There are two opportunities to defer the exit tax. First, in the case of any asset subject to the mark-to-market regime a deferral election is available under Code Section 877A(b). Elective deferral is available on an asset-by-asset basis. Notice 2009-85 Section 3E. As a result of the deferral election, the exit tax will be deferred until the asset is sold. In the interim, interest will accrue on the deferred tax liability at the underpayment rate established under Code Section 6621 from the due date of the covered expatriate’s U.S. income tax return determined without extensions for the taxable year that includes the day before the expatriation date. (Notice 2009-85 Section 3E.) That is, April 15 of the year after the year in which the expatriation date occurs, unless the expatriation date occurs on January 1, in which case interest will accrue starting on April 15 of the year in which the expatriation date occurs.
In order to qualify for the deferral election, the covered expatriate must
(1) waive any treaty benefits which would preclude assessment or collection of the exit tax by filing form 8854 with the covered expatriate’s U.S. income tax return for the taxable year that includes the day before the expatriation date;
(2) provide adequate security described by the Notice as either
(a) a bond meeting the requirements of Code Section 6325 or
(b) another form of security acceptable to the U.S. Secretary of the Treasury such as a letter of credit;
(3) enter into a tax deferral agreement with the Internal Revenue Service (conforming to the template provided as Appendix A to Notice 2009-85); and
(4) appoint a U.S. person to act as the covered expatriate’s agent for purposes of receiving correspondence from the IRS relating to the tax deferral agreement by entering into a binding agreement (substantially similar to the form of the agreement provided as Appendix B to Notice 2009-85)
The deferral request the covered expatriate is required to provide in order to elect to defer the exit tax must include
(1) two signed copies of the tax deferral agreement,
(2) a description of the assets with respect to which elective referral applies,
(3) an attachment showing the calculation of the tax attributable to each of the assets computed in the manner required by Notice 2009-85,
(4) documentation of the security offered by the covered expatriate for the deferral of the tax,
(5) a copy of the agreement with the U.S. agent, and
(6) a copy of the covered expatriate’s U.S. income tax return for the taxable year that includes the day before the expatriation date.
In addition, the covered expatriate must include a copy of the deferral request with his tax return for the taxable year that includes the day before the expatriation date. The Notice makes clear that the covered expatriate may file the deferral request simultaneously with this tax return.
Deferral of income recognition from deemed payment of deferred compensation items. Deferral is also available with respect to deferred compensation items which satisfy the definition of an eligible deferred compensation item under Code Section 877A(g)(3). In order to satisfy the requirements of the statute, the deferred compensation must be payable by a United States person or a person who elects to be treated as a United States person for purposes of the statute. The covered expatriate must notify the payor of the taxpayer’s status as a covered expatriate and waive reduced withholding provided by any applicable tax treaty. (Notice 2009-85 Section 5B(2).) The Notice requirement is satisfied by filing form W-8CE with the payor within thirty days of the expatriation date or prior to the first distribution on or after the expatriation date if less than thirty days. (Notice 2009-85 Section 8D.) As a result of the treaty waiver, payment of the deferred compensation to the covered expatriate will be subject to 30% withholding under Code Section 877A(d)(1).
Anything that is not an eligible deferred compensation item is characterized by the Notice as an “ineligible deferred compensation item.” (See Notice 2009-85 Section 5B(3).) These items will be fully taxable in the taxable year of the covered expatriate which includes the day before the expatriation date. The Notice requires the covered expatriate to provide Form W-8CE to the payor of the deferred compensation item. Within sixty days of receipt of Form W-8CE “the payor must provide a written statement to the covered expatriate setting forth the present value of the covered expatriate’s accrued benefit on the day before the expatriation date.” (Notice 2009-85 Section 8D.)
Generally in the case of ineligible deferred compensation items, the amount included in income is the covered expatriate’s account balance on the day before the expatriation date. (Notice 2009-85 Section 5D.) However, in the case of a defined benefit plan, the present value of the covered expatriate’s accrued benefit will be determined using the methodology set forth in Section 4.02 of Revenue Procedure 2004-37, 2004-1C.B.1099. In the case of ineligible deferred compensation items which represent interests in foreign pension plans or similar retirement arrangements or items of deferred compensation payable by a non-U.S. employer, (such as non-qualified deferred compensation), the present value of the covered expatriate’s accrued benefit will be determined by applying the principles set forth in proposed Treasury Reg. Section 1.409A-4. In the case of an ineligible deferred compensation item which takes the form of property subject to Code Section 83, the fair market value of the property interest will be determined as of the day before the expatriation date without regard to any risk of forfeiture as if the item were fully transferrable by the covered expatriate (reduced by the amount, if any, paid by the covered expatriate for the property). ( Notice 2009-85 Section 5D.) With respect to stock appreciation rights or restricted stock units, the Notice provides that these interests will be treated as substantially vested as of the day before the expatriation date and valued by reference to the “cash equivalency doctrine.” (Id., referring to Cowden vs. Commissioner, 289 F.2d 20 (5th Cir. 1961).)
Early distribution taxes and penalties will not apply in computing the tax liability for ineligible deferred compensation items subject to the exit tax. Code Section 877A(d)(2)(B).
Do you own any interest in an IRA, 529 plan, Coverdell saving account, health savings account, or Archer medical savings account?
Although not explicitly stated in Notice 2009-85, accounts of the covered expatriate that fall within the definition of “specified tax deferred accounts” under Code Section 877A(e)(2) are not eligible for deferral. Although no early distribution penalties or taxes will apply to the account balance in the specified tax deferred account, the entire account balance on the day before the expatriation date will be treated as distributed to the covered expatriate. Specified tax deferred accounts are defined by the statute to include any individual retirement plan as defined by Code Section 7701(a)(37) (that is, individual retirement accounts and individual retirement annuities, other than simplified employee pension plans described in Code Section 408(k) and simple retirement accounts described in Code Section 408(p), qualified tuition programs described in Code Section 529, Coverdell education savings accounts described in Code Section 530, health savings accounts described in Code Section 223, and Archer medical savings accounts described in Code Section 220).