United States Expatriation Tax Reform
After several false starts, legislation has been enacted to implement proposals to reform the way in which the United States taxes expatriating citizens and long-term residents. Generally, the tax legislation enacted as the primary revenue raiser of the P.S. 110-245: Heroes Earnings Assistance and Relief Tax Act of 2008 (the “HEART Act“) creates an “exit tax” – that is, assets of the departing citizen or long-term resident are “marked to market” in a deemed sale triggering gain recognition on the day before expatriation or residency termination. Net gain on the deemed sale is recognized if it exceeds
The exit tax applies to tax expatriates (US citizens who relinquish citizenship or long-term residents who terminate residency in the United States) who satisfy any of the following three tests:
(1) average annual net income tax liability for the five years preceding expatriation or residency termination exceeds $139,000 (an adjusted amount for 2008 reflecting a base amount of $124,000 in 2004);
(2) a net worth of $2,000,000 or more on the date of expatriation or residency termination; or
(3) failure to comply with all US federal tax obligations for the preceding five years or fail to file appropriate certification (under penalties of perjury), along with supporting evidence of compliance.
Exceptions to the first and second tests are available for dual citizens who have not been residents in the United States for more than ten taxable years during the fifteen-taxable-year period beginning with the year of expatriation, and for US citizens who relinquish their citizenship before reaching age
eighteen and a half and have not resided in the United States for more than ten taxable years during the fifteen-taxable-year period before the date of relinquishment.
The definition of a long-term resident is consistent with prior law: someone who is a lawful permanent resident of the United States for at least eight of the fifteen taxable years prior to the taxable year in which the individual either ceases to be a lawful permanent resident or is treated as a resident of another
country under a US tax treaty.
Relinquishing US citizenship or long-term residency
Leaving the United States with the intention of never returning is insufficient to relinquish citizenship or terminate residency. For persons who are US citizens, the expatriation day is the earliest of the following four events:
(1) renunciation of US nationality before a diplomatic or consulate officer;
(2) furnishing the US State Department with a signed statement of voluntary relinquishment of US nationality;
(3) issuance by the US State Department of a certificate of loss of US nationality; or
(4) cancellation of a certificate of naturalization by a US Court.
Situations 1 and 2 require confirmation by the US State Department. Although such confirmation is retroactive to the date at which renunciation occurred, the tax expatriate remains subject to US income taxation on worldwide income in the interim.
In the case of a long-term resident, the expatriation date is the earlier of the date on which the tax expatriate loses green card status through revocation or the date on which the loss of their green card status is judicially or administratively determined. Revocation of green card status is
accomplished by filing Form -407: “Abandonment of Lawful Permanent Resident Status.” Absent loss of green card status, expatriation will
not occur until the tax expatriate:
(1) begins to be taxed as a resident of another country under a tax treaty between that country and the United States;
(2) fails to waive the benefits of the treaty applicable to residents of that country; and
(3) notifies the Internal Revenue Service that the tax expatriate has become a resident of another country under
the tax treaty between that country and the US.
In addition to the requirements specific to US citizens and long-term residents, both types of tax expatriates must also file Form 8854 with the Internal Revenue Service to document expatriation. However, unlike under prior US law, tax expatriates are not required to file this form for ten years. Instead, Form 8854 is filed only fort he year in which expatriation occurs. Failure to file Form 8854 subjects the tax expatriate to a $10,000 penalty.
Return to the United States
Prior law re-imposed US income taxation on worldwide income in the case of tax expatriates who returned to the United States for more than thirty days within ten years of renouncing US citizenship or terminating long-term residency. The new law continues these rules, but only for persons who expatriated prior to June 17, 2008.
Current US law allows the US attorney General to deny admittance to any tax expatriate. It is believed this authority has yet to be used. Failure to file Form 8854 may make return to the United States more difficult.
Generally, expatriation triggers gain recognition and income acceleration for the tax expatriate. Assets are deemed to be sold on the day before expatriation, and are fully taxable in the year of expatriation to the extent that the gain realized exceeds $600,000. No opportunity exists to take advantage of deferral rules, such as those provided by Section 1031 of the IRC. The tax expatriate is deemed to own all assets of any trust characterized as a grantor trust
under the rules of Subpart E of the Internal Revenue Code (IRC).
Tax expatriates are also deemed to have received distribution of their entire interest in IRAs and other specified tax deferred accounts on the day before the expatriation date (although the 10% early distribution penalty will not apply). “Specified tax deferred accounts” include IRC Section 529, qualified tuition
plans, IRC Section 530 Coverdale Education Savings Accounts, IRC Section 223 Health Savings Accounts, and IRC Section 220 Archer Medical Savings Accounts.
In addition to an exemption for the first $600,000 of gain realized on the deemed sale of the tax expatriate’s assets, deferred compensation arrangements that satisfy certain conditions, beneficial interests in non-grantor trusts, and certain tax-deferred accounts are also exempt from the acceleration of income
required by the HEART Act.
In the case of green card holders, the basis used to compute gain or loss on the deemed sale of the tax expatriate’s assets is stepped up to the value of the tax expatriate’s property on the date at which the expatriate first became a US resident.
Acceleration of the income attributable to the tax-expatriate’s deferred compensation plans can be avoided if:
(1) the payer of the deferred compensation is a “United States person” as defined by IRC Section 7701(a)(1), or elects to be treated as a United States person for purposes of US tax withholding;
(2) the tax expatriate notifies the payer of the expatriate’s status; and
(3) the tax expatriate executes an irrevocable waiver of any right to treaty benefits that could reduce the withholding tax.
Eligible deferred compensation items remain subject to a 30% US withholding tax that is not subject to treaty relief. Deferral is only available for any contributions made to the deferred compensation plan that are attributable to services the tax expatriate provided while in the United States.
Similarly, distributions from non-grantor trusts are also subject to a 30% withholding tax, and not subject to reduction by tax treaty. Although the withholding requirement is imposed on both US and non-US trusts, it is unclear how the Internal Revenue Service would go about enforcing the withholding requirement against foreign trustees.
In the case of non-cash distributions, the trust is required to recognize gain on property distributed to the tax expatriate as if it had been sold at fair market value.
Tax expatriates may elect to defer payment of the exit tax, but they will be subject to an interest charge equal to that applied to tax underpayments in the United States. The election can be made on a property-by-property basis, but it is irrevocable.
Under the deferral system, tax is paid to the US for the taxable year in which the property is either sold or otherwise subject to disposition. If the property is not sold or disposed of during the tax expatriate’s lifetime, the exit tax is due on or before the due date for the tax return for the year in which they died.
Deferral is subject to a requirement to post bond.
Gifts and bequests from tax expatriates
The HEART Act creates a special transfer tax on any gifts and bequests made by a tax expatriate to US citizens or residents (other than spouses or charities) that are not reported and filed on a US gift or estate tax return in a timely manner. This tax is imposed on the value of the gift or bequest at the highest marginal US federal gift or estate tax rate in effect on the date of receipt by the US citizen or resident. (The rate is currently 45 %.) The transfer tax is imposed on a calendar year basis, and is subject to an annual exclusion of $12,000 USD (adjusted for inflation).
The transfer tax is reduced by any corresponding gift or estate taxes paid to a foreign country. If a marital or charitable deduction would have been available to the tax expatriate had the gift or bequest been made while a US citizen or resident, the gift or bequest will be exempt from the transfer tax
imposed by the HEART Act. Special rules apply for gifts or bequests made to US trusts and foreign trusts with US beneficiaries. In the case of the former, the transfer tax is imposed as distributions are made to the US beneficiaries. If the distribution from the trust or estate is subject to US income tax, the beneficiary will be able to deduct the transfer tax imposed by the HEART Act in computing their US income tax obligation.
The tax expatriation legislation is codified in the new IRC sections 877A and 2801, and is effective for US citizens and long-term residents who expatriate or terminate their residency on or after June 16, 2008, and to gifts and bequests made by such persons after that date.
Robert E. Ward, J.D., LL.M., is the president of Robert E. Ward & Associates, LLC a US-based law firm that recently opened an office in Vancouver and advises Canadian individuals, businesses, and not-for-profits on US legal and tax matters. He specializes in tax laws, business and estate planning, international taxation, and foreign trusts, and teaches law as an adjunct professor at the George Mason University School of Law.