By Anthony Diosdi
A record number of individuals have expatriated from the United States in 2020. For federal tax purposes, expatriation means 1) any United States citizen who relinquishes his or her citizenship or 2) any long-term resident of the United States who ceases to be a lawful permanent resident of the United States. The abandonment of citizenship or long-term residence may result in the assessment of the expatriation tax. This tax consists of the “exit tax” and the inheritance tax. This article will focus on the inheritance tax.
An Overview of the Exit Tax
The Heroes Earnings Assistance and Relief Tax Act of 2008 (“HEART Act”) added Section 877A to the Internal Revenue Code. This code section imposes an exit tax on individuals who expatriate on or after June 17, 2008. Section 877A(a) imposes a “mark-to-market” tax regime on “covered expatriates.” Under Section 877A(a)(1), all property of a covered expatriate is treated as being sold on the day before or her expatriation date for its fair market value. The exit tax is an income tax on 1) unrealized gain from a deemed sale of worldwide assets on the day prior to expiration; and 2) the deemed distribution of IRAs, 529 plans, and health savings accounts (taxed at ordinary income rates).
A covered expatriate is deemed to have sold any interest in property held worldwide, other than property described in Section 877A(c) (deferred compensation, specified tax-deferred accounts, specified tax-deferred accounts, and interest in a nongrantor trust, as of the day before expatriation. The mark-to-market regime imposes an income tax on the unrealized gain (on the covered expatriate’s worldwide assets), but only to the extent the deemed gain (as of the day before expatriation date) exceeds an inflation adjusted safe harbor ($744,000 for 2021). The rates of tax differ with the type of asset involved. Long-term capital gain assets and qualified dividends receive the applicable preferential rates. However, the unrealized gain in a life insurance contract is generally taxed at ordinary income rates. The exit tax is generally payable immediately (i.e., April 15 following the close of the tax year in which expatriation occurs).
An expatriated green card holder is subject to Section 877A as a covered expatriate only if a long-term permanent resident prior to expatriation. a long-term lawful permanent resident is a person who has been a green card holder during eight of the previous 15 years prior to expatriation. If a green card holder expatriates before this eight-of-15-year test is met, Section 877A does not apply.
Section 877A applies to only covered expatriates who meet any one of the three tests, set out in Section 877(a)(2)(A)-(C).
1) The Net Worth Test: Having a net worth of $2 million or more on the date of expatriation. The $2 million threshold considers all assets worldwide. The expatriate is considered to own any interest in property that would be taxable as a gift under Chapter 12 of the Internal Revenue Code (i,e., the gift tax provisions) if the individual was a citizen who transferred that interest immediately prior to expatriation.
2) The Average Annual Income Tax LiabilityTest: Earning an average annual net income for the five years ending before the date of expatriation of more than a specified amount, adjusted for inflation ($172,000 for 2021),
3) Failure to Certify Tax Compliance: Failure to certify satisfaction of federal tax compliance to the Secretary of Treasury for the five preceding taxable years or failure to submit such evidence of compliance as “may be required.”
Under Section 877A(a)(3), if a departing taxpayer’s deemed gain is less than $600,000 (adjusted for inflation, $744,000 for the 2021 calendar year), there is no tax due. If the covered expatriate’s gain exceeds this amount, he or she must allocate the gain pro rata among all appreciated property. Such allocation generally involves allocating the exclusion amount of each gain asset over the total built-in gain on all gain assets.
The Inheritance Tax
In addition to the above discussed exit tax, the HEART Act imposes an inheritance tax on expatriating individuals. The tax is calculated at the highest tax rate specified in the estate and gift tax tables in effect as of the date the gift is received. Currently, this rate is 40 percent.
The term covered gift is defined as any property acquired by gift directly or indirectly from a “covered expatriate.” Direct gifts are easily identified: A transfers some stock to B; X deeds some land to Y; P gives child C an expensive car. Some examples of indirect gifts include transfers in trust, transfers to private corporations, gifts by controlled corporations, discharge of indebtedness, and below-market interest rate loans.
For purposes of the inheritance tax, gift has the same meaning as per the Internal Revenue Code. (Under Internal Revenue Code Section 2511, a gift generally includes any property transferred during the donor’s lifetime for less than adequate consideration). However, exclusions differ. The following gifts are excluded from the inheritance tax: 1) property shown as a taxable gift by the covered expatriate on a timely filed gift tax return; 2) the property included in the gross estate of the covered expatriate on a timely filed estate tax return; 3) transfers that would have qualified for a charitable deduction if made by a U.S. citizen or resident; 4) a transfer from a covered expatriate to his or her spouse; and 5) a transfer made pursuant to a qualified disclaimer made by a covered expatriate that is not considered a gift or bequest. The following gifts are not excluded from the inheritance tax: 1) gifts that do not exceed the annual exclusion amount for the calendar year; 2) tuition or medical expenses paid directly to a medical or educational institution for another person; and 3) gifts to a political organization for its use.
The inheritance tax is also imposed on “covered bequests.” A “covered bequest” is the conveying of assets through the provisions of a will or an estate plan from a “covered expatriate.”
Treatment of Covered Gifts and Bequests
The inheritance tax is imposed on the recipient of the gift instead of the donor. As a result, the U.S. recipient of the gift or bequest has responsibility for determining whether the donor or decedent is a covered expatriate and whether the gift or bequest received is a covered gift or bequest. For purposes of determining the inheritance tax, the U.S. recipient must add together all the net covered gifts and covered bequests received during the calendar year. The sum of this total is the amount subject to the inheritance tax less any pre-donee exclusions discussed in Section 2503(b) of the Internal Revenue Code. The inheritance tax may be further reduced by estate and gift taxes paid to another country.
How is the Inheritance Tax Reported to the IRS?
The inheritance will ultimately need to be disclosed on Form 708. A Form 708 will need to be filed for each calendar year in which the U.S. person receives a covered gift or bequest. As of the date of this article, the IRS has yet to release the Form 708 or provide any instructions as to how the form must be completed. However, the IRS issued Announcement 2009-57. In Announcement 2009-57, the IRS announced that the due date for the Form 708 would be contained in future guidance, and that such guidance would provide a reasonable period of time between the date of issuance and the date prescribed for the filing of the return and the payment of the tax.
The Proposed Regulations further guidance regarding the filing of Form 708 and the payment of the inheritance tax. For example, Prop Reg. Section 28.6071-1(a), provides that the due date for the initial Form 708, subsequent Forms 708 will be due on the 15th of the 18th month following the close of the calendar year in which the covered gift or bequest was received. For example, the Form 708 for covered gifts and bequests received in 2020 would be June 15, 2022. In cases of covered bequests which are not received when a decedent dies, a Form 708 must be filed by the later of: 1) the 15th day of the 18th month following the close of the calendar year in which the covered expatriate died; or 2) the 15th day of the 6th month following the close of the calendar year in which the covered bequest was received. See Prop. Reg. Sections 28.6071-1(a)(1)(i); 28.6071-1(a)(1)(ii). Prop Reg. Section 28.6071-1(b) states that an automatic six-month extension will be available to file the Form 708.
In today’s fast paced global economy, highly skilled individuals will continue to make the United States their temporary home for economic opportunities. Many of these individuals will eventually leave the United States to either return to their home countries or for other opportunities. The expatriation tax was designed to penalize Americans who renounced their citizenship to avoid paying taxes. The expatriation tax does not take into consideration highly skilled individuals who come to America on a temporary basis. They typically do not renounce their citizenships or green cards for tax reasons. However, the expatriation tax penalizes these individuals as if they were renouncing citizenship or resident for tax avoidance purposes. Not only are these expatriating individuals subject to punitive exit tax, their beneficiaries of estate or gift plans are severely punished under the expatriation laws.
To make matters worse, the IRS has yet to promulgate the necessary forms needed to comply with the inheritance tax. Thus, U.S. recipients of a “covered gift” or “covered bequest” have no way of reporting these gifts and paying the inheritance tax. This will certainly cause serious hardships to many unsuspecting beneficiaries of so-called “covered gifts” or “covered bequests.” It is not too difficult to imagine a scenario in which a beneficiary of a “covered gift” or “covered bequest” does not disclose the gift on a Form 708 because one is not available. This same individual risks a surprise inheritance tax assessment along with all applicable penalties and interest. Hopefully the IRS issues more guidance in this area in the very near future.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. As a domestic and international tax attorney, Anthony Diosdi provides international tax advice to individuals, closely held entities, and publicly traded corporations. Anthony Diosdi also has substantial experience in expatriation tax and treaty planning. Diosdi Ching & Liu, LLP has offices in San Francisco, California, Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in international tax matters throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: firstname.lastname@example.org.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.