An Overview of the Covered Expatriate Gift Regulations and Potential Planning Opportunities

Under Section 877A of the Internal Revenue Code, a “covered expatriate” is required to recognize gain on their worldwide assets as part of a deemed sale the day before the expatriation date. However, gain of up to $890,000 (for the 2025 calendar year) is not subject to the deemed sale provisions of Section 877A. A “covered expatriate” is an individual who: 1) relinquishes his or her U.S. citizenship or permanent residence (but only if the expatriate was a U.S. resident during 8 out of the last 15 years), and 2) meet one of the following tests: i) he or she had a net worth of over $2 million when they expatriated; ii) he or she had an average annual income tax burden of more than $206,000 (for the 2025 calendar year) during the five preceding years; or iii) he or she failed to certify compliance with U.S. tax obligations over the last five years.

Introduction to the Section 2801 Inheritance Tax

The Internal Revenue Service (“IRS”) and Department of Treasury recently finalized regulations that added a new “inheritance tax” or “gift tax” on certain gifts or bequests made by “covered expatriates” to U.S. recipients. Section 877A imposes the highest applicable gift or estate tax rate (40 percent) on U.S. citizens or residents who receive a so-called “covered gift or bequest” from an expatriating individual.

The term covered gift means any property acquired by a gift directly or indirectly from an individual who is a covered expatriate at the time the gift is received by the U.S. recipient, regardless of the situs of the gift. A gift generally includes any property transferred during the donor’s lifetime for less than adequate consideration. See IRC Section 2511. Adequate consideration generally means the fair market value of transferred property. The fair market value of the property is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell, and both having knowledge of relevant facts. Thus, if Mom sells Blackacre to Child for $100, and Blackacre is actually worth $250, Mom has made a gift to Child of $150. See Treas. Reg. Section 25.2518-8.

The tax is payable by the recipient of the gift or bequest, not the expatriate. There is no expiration of the potential applicability of Section 2801. Thus, a gift or bequest made by a covered expatriate several years (or longer) after expatriation could trigger the tax. The Inheritance Tax is imposed in addition to the mark-to-market tax paid by the covered expatriate upon exit. Currently, the tax rate imposed by Section 2801 is 40 percent of the value of the gift or bequest. Section 2801 taxes U.S. citizens or residents who receive gifts and bequests from covered expatriates, which would otherwise have escaped U.S. transfer taxes (as a consequence of the donor’s expatriation). Transfers by covered expatriates are subject to a tax similar to the gift and estate tax but saddle the donee with the Inheritance Tax. The term “gift” for expatriation tax purposes has the same meaning that would ordinarily apply under U.S. gift tax laws. A gift or bequest received from an expatriating individual is known as a “covered gift.” The new regulations define a “covered gift” received from a covered expatriate on or after June 17, 2008 regardless of the situs of the property and whether or not the property was acquired by the covered expatriate before or after expatriation.

A U.S. beneficiary who receives a covered gift could be required to report the gift to the IRS on Form 708. An IRS Form 708 must be filed for each calendar year in which a U.S. beneficiary received a covered gift. The due date for the filing of the Form 708 is the 15th day of the 18th month following the close of the calendar year in which the covered gift was received by the U.S. recipient. In certain cases, U.S. beneficiaries may also be required to disclose a covered gift on an IRS Form 3520. The gift tax is determined by multiplying the by multiplying the covered gift or gifts by the greater of the highest gift or estate tax provided in the Internal Revenue Code.

The recipient’s basis for figuring gain for income tax purposes is the same as the donor’s adjusted basis. Any gift tax owed to the IRS does not increase the basis in the covered gift. See IRC Section 1015(d). Thus, an individual that received a covered gift may be required to pay a gift tax and income tax on any gain recognized on the gifted property.

In addition to reporting a covered gift on a Form 708, a U.S. beneficiary may also need to disclose a covered gift to the IRS on a Form 3520.  In general, a U.S. person’s Form 3520 is due on the 15th of the 4th month following the end of such a person’s tax year for income tax purposes, which, for individuals, is April 15th.

Three Year Clawback

Under Section 2035(a) of the Internal Revenue Code, certain gifts made within three years of the donor’s death are included in the donor’s taxable estate for estate tax purposes. This rule minimizes the incentive for a decedent to transfer property shortly before death and thereby reduce federal estate tax. The covered regulations provide a three year clawback for covered expatriates. Consequently, if a expatriating individual gifts assets or property to a U.S. person within three years prior to expatriating, a covered gift tax may apply to the gift.

Transfer to a Foreign Trust, Foreign Corporation, or Foreign Partnership Will Not Avoid the Gift Tax

Some may believe a gift can be transferred through a foreign trust, foreign corporation, or a partnership to avoid the gift tax. This is not the case. To prevent avoidance of the gift tax rules, Section 672(f)(4) broadly authorized the IRS and the Department of Treasury to recharacterize gifts or bequests from a number of entities to avoid gift tax. The regulations under Section 672(f)(4) provide that if a U.S. donee receives a purported gift from entities such as foreign trusts, foreign corporations, and partnerships, the gift will be included in the U.S. donee’s income as taxable ordinary income.

Potential Exclusion for Spouses

Property gifted from a covered expatriate to his or her spouse may potentially avoid gift tax to the extent a martial deduction is available pursuant to a marital deduction available under Sections 2523 or 2056 of the Internal Revenue Code. In certain cases, as long as only one spouse expatriates, gifting between spouses could be an effective tool to reduce or eliminate the exit tax and taxes on covered gifts. In certain cases, this strategy can even be used if one or both spouses are not U.S. citizens if an estate and gift tax treaty can be utilized. Some estate and gift tax treaties provide an unlimited or partial martial deduction. It remains an open question if a provision in an estate or gift tax treaty regarding a marital deduction can be utilized to avoid a gift tax from a covered expatriate.

Expatriation and Treaties

The Denmark, Germany, Austria, and France treaties with the United States all contain provisions similar to the Section 2107 expatriation provisions. In these cases, the term “citizen” includes a person who renounced his or her citizenship, having as a principal purpose the avoidance of tax, for a period of ten years after citizenship was lost. If an applicable tax treaty does not contain a specific expatriation clause, a former U.S. citizen who expatriates to a treaty country may claim that he or she is not a U.S. citizen” for treaty purposes whenever relevant under the treaty. Crow v. Commissioner, 85 T.C. 376 (1985) involved a similar situation for purposes of the U.S.-Canada income tax treaty. See Estate and Gift Taxation of Nonresident Aliens in the United States, (2016)  Michael Rosenberg. Currently, no income tax or estate treaty takes into consideration Sections 877A and 2801 of the Internal Revenue Code (the provisions of the Internal Revenue code that govern expatriation and covered gifts). The IRS and Department of Treaty have yet to decide whether a tax treaty or estate and gift tax treaty may in effect override a covered gift tax or covered inheritance tax. See Freda, Treaties May Protect Expatriations’ Gifts from U.S. tax, 205 DTR G-1 (Oct. 23, 2015).

Conclusion

Under current and developing law, expatriation can be costly for both those expatriating and for those who may receive gifts or bequests from those who have expatriated. However, in certain cases, there are planning opportunities to reduce these potential tax consequences.advising clients expatriating from the United States. We have significant experience providing planning advice to those expatriating from the U.S. We also assist in providing tax compliance services to individuals expatriating from the United States.

Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.

He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.

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.