Expatriation: Exit Tax, Planning Options, New Citizenship
Expatriation refers to not simply leaving the U.S. and living abroad, but also to surrendering U.S. citizenship or permanent residency. If someone does surrender U.S. citizenship, moves abroad and picks up a new citizenship, the U.S. government may be unable to recover taxes due to it by the expat (no more jurisdiction). Consequently, the expatriation rules of the Code look to extract a tax from the expat while the U.S. still has jurisdiction. This is commonly referred to as the "exit tax."
Expatriation may present a long-term income tax advantage. U.S. taxpayers are subject to federal income taxes on their worldwide income, whereas nonresident aliens (individuals who are neither citizens nor residents) are subject to tax only their U.S.-source income.
The current expatriation rules are governed by the so-called Reed Amendment passed in 19961 and by the Heart Act.2 The Reed Amendment allows the U.S. Attorney General to deny reentry of a former citizen to the U.S. if the AG determines that expatriation was for the purpose of tax avoidance. To date, the Reed Amendment has not been invoked in any case.
The Heart Act introduces a mark-to-market regime for expatriates, by taxing the expatriate on all of the accrued appreciation in his property on the date of the expatriation. Expatriation is reported by filing Form 8854. This is a one-time filing requirement and it replaces the 10-year filing requirement that existed prior to the Heart Act.
The new Code Sections 877A and 2801 introduced by the Heart Act apply to a "covered expatriate." A covered expatriate is defined in Section 877A(g) (with reference to Section 877(a)(2) as a person who relinquishes his U.S. citizenship or his permanent resident status (held for 8 out prior 15 years), and who has (i) an average annual net income tax liability for the preceding five years of $124,000 (indexed for inflation), (ii) has a net worth of $2 million or more, or (iii) failed to certify compliance with U.S. tax obligations for the prior five years.
Individuals who were born citizens of the U.S. and another country, and still retain their citizenship and residency in the other country will not be subject to the exit tax if they were not resident in the U.S. for more than 10 of the preceding 15 years. This covers dual citizens who spend the majority of their time living in the other country they have a citizenship in.
The mark-to-market rules of the Heart Act subject covered expatriates to a tax on the unrecognized gain in their property to the extent that such gain exceeds $600,000 (adjusted for inflation). Effectively, the covered expatriate is treated as if he sold all of his assets, worldwide, for their fair market value on the day before expatriation.
The payment of tax may be deferred if the covered expatriate posts a bond to secure the payment of tax. The election to defer may be made on a property by property basis. The deferred tax liability accrues interest at the underpayment rate.
The Service has published Notice 2009-85 to provide substantive guidance on these rules. For example, the Notice provides that when determining what assets to include in the tax base of the exit tax, use the estate tax rules - the assets that would have been included in the expatriate's estate if he died on the day before the expatriation, will be subject to the mark-to-market rules, using the valuation principles used in the estate tax arena.
If the covered expat owns tax deferred accounts (like a 401k plan), he must file Form W-8CE with the plan. Filing of the form notifies the plan that all payments from the plan to the covered expat are subject to income tax withholding at the rate of 30%. IRAs and certain other specific plans are subject to an immediate exit tax.
If the expat is a beneficiary of a nongrantor trust, he will either be subject to the 30% withholding on the distributions, or must include the value of his beneficial interest in computing the exit tax (the Service must agree to the value in a PLR). Note that the withholding applies only to a nongrantor trust, because if the trust is grantor, its assets are included in calculating the exit tax and withholding is not necessary.
A new set of rules has been introduced to tax gifts made by covered expatriates to U.S. citizens and residents (other than a spouse or charity).3 This gift tax liability is imposed on the recipient of the gift. Whereas the old rules applied for only 10 years following expatriation, the new rules apply without a limitation. The new gift tax rules apply whether the gift was made directly or through a trust.
Planning to Expatriate
Expatriation planning is all about planning in advance. For example, the exit tax applies to the extent all assets owned by the expat have a built in gain in excess of $600,000. If the expat owns a residence, he does not get to increase that threshold by the Section 121 exclusion amount. A personal residence should be sold prior to expatriation, taking advantage of the Section 121 gain exclusion and the $600,000 gain threshold.
Only assets with a built-in gain present a problem in the mark-to-market regime. Slowly converting property into liquid form may solve that problem. Using valuation rules applicable in the estate tax arena speaks to the value of using FLP structures to obtain a valuation discount for the purposes of the exit tax.
It is also generally desirable to position the expatriate to own fewer assets in the U.S. and more assets outside the U.S.
Picking Your New Home
Many nations have implemented laws to allow foreigners to easily obtain citizenship. Most commonly this is done through the concept of economic citizenship. For example, a country may require the prospective citizen to place a sum of money on a time deposit with a local bank for a period of 12 months. Once the deposit is in place, the application for citizenship may commence. Many Caribbean, Central and South American and E.U. nations allows for economic citizenship. Even the U.S. has such a program.
Other nations do not have legislation allowing for economic citizenship but have a de facto equivalent program. For example, on my recent visit to St. Vincent and the Grenadines I learned that a foreigner may buy a home in St. Vincent (which can be quite inexpensive) and then apply for permanent residence. Once residence is approved, citizenship can be applied for. The entire process is fairly simple and inexpensive.
One of the most important issues to consider when picking the country of new citizenship is your ability to travel with the new passport. For example, travelling on an Uruguay passport will require visas for many nations, including U.S. and E.U. Travelling on a Nevis passport will allow no visa travel to any member of the British Commonwealth, and easy to obtain visas for the U.S. and Schengen nations.
We have assisted many clients with their expatriation planning and research into new citizenship. We welcome your comments and inquiries.
1 Section 1182(a)(10(E) of the Immigration and Nationality Act.
2 The Heroes Earnings Assistance and Relief Tax Act of 2008
3 Code Section 2801
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