How Dual Citizens Can Escape the U.S. Exit Tax

The taxation of worldwide income that confronts U.S. citizens may entice some to renounce their citizenship and become nonresident aliens. Section 877 of the Internal Revenue Code was designed to dissuade U.S. citizens from renouncing their U.S. citizenship for tax reasons. Section 877 effectively taxes a nonresident on all income from U.S. sources and on gains realized with respect to stock and securities in U.S. corporations and certain other property during the ten years following loss of citizenship. Moreover, if Section 877 applies, the taxpayer is taxed at the graduated tax rates in the Internal Revenue Code applicable to U.S. citizens and resident aliens rather than the rates applicable to nonresident alien individuals in Section 871. Under the original version of the provision, enacted as part of the Foreign Investors Tax Act of 1966, Section 877 applied to such a former U.S. citizen unless he or she could show that the loss of citizenship “did not have for one of its principal purposes the avoidance of taxes.” See Former IRC Section 877(a).

The 1996 Version of Section 877 for Exit Tax Purposes

The application of the original version of Section 877 required a facts-and-circumstances analysis of a taxpayer’s purpose for expatriation before taxation under Section 877 was triggered. Congress was concerned that the original version of Section 877 was difficult for the Internal Revenue Service (“IRS”) to administer and that expatriates were too easily able to avoid its application by arguing that their intent for expatriation was not to avoid tax. Accordingly, in 1996, Congress added former Section 877(a)(2) to the Internal Revenue Code in an attempt to enhance the effectiveness of Section 877 in preventing former U.S. citizens from avoiding their fair share of U.S. taxes. Former Section 877(a)(2) provided that an individual was conclusively presumed to have a principal purpose of tax avoidance for the loss of U.S. citizenship if (i) the individual’s average annual net income tax for the five years before the date of loss of U.S. citizenship was more than $100,000 or (ii) the individual’s net worth on such date was at least $500,000. (The $100,000 and $500,000 threshold were increased by an inflation adjustment for years after 1996).

This presumption did not apply, however, in the case of certain individuals described in former Section 877(c) who, within one year of the loss of U.S. citizenship, submitted a ruling request for the IRS’s determination as to whether tax avoidance was one of the principal purposes for such loss. Individuals who may have qualified for this exception to the presumption included an individual who became a citizen of the United States and another country at birth and continued to be a citizen of the other country after the loss of U.S. citizenship, or an individual who, within a reasonable period after the loss of U.S. citizenship, became a citizen of the country in which the was born, the country in which the individual’s spouse was born or the country in which either of the individual’s parents was born. See Former IRC Section 877(c)(2)(A). Other individuals who may have qualified for the exception were an individual who present in the United States for 30 days or less during each of the ten years before the loss of U.S. citizenship, an individual whose loss of U.S. citizenship occurred before he or she attained the age of 18 ½ and any other individual excepted from the presumption by regulation. See Former IRC Section 877(c)(B) through (D).

Pursuant to a congressional mandate made in 1996, the Treasury Department conducted a study of the effectiveness of the expatriation rules in Section 877. See U.S. Treas. Dep’t, Income Compliance by U.S. Citizens and U.S. Lawful Permanent Residents Residing Outside the United States and Related Issues (May 1998).  In addition, the Staff of the Joint Committee on Taxation, working with the Government Accounting Office, also conducted a study of the revised Section 877 rules and various federal government agencies’ procedures for enforcing those rules and concluded “that there is little or no enforcement of the special tax and immigration rules applicable to tax-motivated citizenship requirement and residency termination.” See Staff of Joint Comm. on Tax’n, 108th Cong., 1st Sess, Review of the Present Law Tax and Immigration Treatment of Relinquishment of Citizenship and Termination of Long-term Residency, at 5 (2003). These studies played a significant part in encouraging Congress to revisit the Section 877 rules as part of its consideration of legislation that was enacted into law as part of the 2004 JOBS Act.

2004 JOBS Act Rules Applicable to the Exit Tax

The 2004 JOBS Act replaced the prior rules of Section 877 (which combined objective standards for determining tax avoidance with a subjective standard for taxpayers who failed to meet the objective standard thresholds) with revised objective standards. Thus, under the revised version of Section 877, the subjective, facts-and-circumstances approach to determining tax-avoidance motive under the prior versions of Section 877 no longer applies, and the prior case law under Section 877 is of relevance only to taxpayers who relinquish U.S. citizenship (or terminated long-term resident alien status) before the effective date of the JOBS Act changes. Under the revised objective standards in Section 877(a)(2), the alternative tax regime in Section 877 will apply to any individual who lost U.S. citizenship within the 10-year period immediately before the close of the tax year, if –

(1) the individual’s average annual net income tax for the period of five years ending before the date of loss of U.S. citizenship is greater than $124,000 (subject to a cost-of-living adjustment for calendar years after 2004);

(2) the individual’s net worth as of such date is at least $2,000,000; or

(3) the individual fails to certify under penalties of perjury that he or she has met the requirements of the income tax title for the five preceding tax years or fails to submit such evidence of compliance as the Treasury Department may require.

The 2004 JOBS Act revised and narrowed the exceptions in Section 877(c) to provide only two basic alternative tax regimes in Section 877 by reason of either the average annual net income tax standard or the $2,000,000 net worth standard in Section 877(a)(2)(A) and (B).

The first of these exceptions, in revised Section 877(c)(2), applies to an individual who (1) became at birth a U.S. citizen and a citizen of another country, and (2) has had no substantial contacts with the United States. To be treated as having had no substantial contacts in the United States, an individual must never have been a U.S. resident (within the meaning of Section 7701(b)), must never have held a U.S. passport and must not have been present in the United States for more than 30 days during any one of the ten calendar years before the individual’s loss of U.S. citizenship.

In other words, the 2004 JOBS Act significantly limited a dual citizen’s ability to avoid being classified as a covered expatriate for purposes of the exit tax. Under the 2004 JOBS Act, a dual citizen can only avoid being treated as a covered expatriate if the dual citizen never held a U.S. passport and was not present in the United States for more than 30 days during any one of the ten years before the individual’s expatriation from the United States.

The JOBS Act also eliminated the ruling request process for seeking exemption from Section 877 treatment that had been enacted in 1996.

Application of Section 877 to Long-Term Residents

The 1996 legislation had extended the reach of Section 877 to encompass certain “long-term residents” of the United States who terminate U.S. residence or who commence to be treated as residents of another country pursuant to a U.S. tax treaty and who do not waive treaty benefits. Under the 2004 JOBS Act, section 877 did not apply to such long-term residents if they met one of the objective triggers for the application of Section 877. A long-term resident for this purpose is an individual who was a lawful permanent resident of the United States for at least eight of the 15 years before termination of U.S. residence.

The Current Status of the Expatriation Tax

Under the current law governing the exit tax, any U.S. citizen or long-term green card holder expatriating from the United States may have to pay an exit or expatriation tax. The U.S. expatriation or exit tax is assessed against individuals that “expatriate” from the United States. The definition of “expatriate” means (A) any United States citizen who relinquishes his or her citizenship, and (B) any long-term resident of the United States who ceases to be a lawful permanent resident of the United States (within the meaning of Internal Revenue Code Section 7701(b)(6)). A long term resident means any individual (other than a citizen of the United States) who is a lawful resident of the United States (i.e., green card holder) in at least 8 of the last 15 taxable years ending with the year that includes the year of the expatriation. It should be understood that the 8 year period counting towards long term residency stops the running of the year count during the year or years “[A]n individual shall not be treated as a lawful permanent resident for any taxable year if such individual is treated as a resident of a foreign country for the taxable year under the provisions of a tax treaty between the United States and the foreign country and does not waive the benefits of such treaty applicable to residents of the foreign country.” See IRC Section 877(e)(2).

The U.S. exit tax is only assessed against individuals that are classified as a “covered expatriate.” A covered expatriate is required to recognize taxable gain on their worldwide assets as part of a deemed sale the day before the expatriation date. An individual is classified as a covered expatriate if his or her average annual net income tax liability for the 5 years before the date of expatriation is more than $206,000 (for 2025). For married couples filing jointly, this liability cannot be divided. In addition, any expatriating individual that falls to certify under penalty of jury that he or she has complied with all federal tax obligations for the 5 preceding taxable years or fails to certify to such compliance will be treated as a covered expatriate. In addition, individuals exiting the U.S. with a net worth of more than $2 million can be classified as covered expatriates and subject to the exit tax.

Current Exception to the Exit Tax Applicable to Dual Citizens

As discussed above, the 2004 JOBS Act significantly limited a dual citizen’s ability to avoid being classified as a covered expatriate for purposes of the exit tax. Under the 2004 JOBS Act, a dual citizen can only avoid being treated as a covered expatriate if never held a U.S. passport and was not present in the United States for more than 30 days during any one of the ten years before the individual’s expatriation from the United States. The current tax law governing the exit tax has carved out a new exception for dual citizens to avoid being classified as a covered expatriate and being subject to the exit tax.

Under Section 877A(g)(1)(B)(i) of the Internal Revenue Code, dual citizens that became at birth a citizen of the United States and a citizen of another country and, as of the expatriation date, continues to be a citizen of, and is taxed as a resident of, such other country; and has been a U.S. resident of the United States (under the substantial presence test) for not more than 10 years during the 15-taxable year period ending with the taxable year during which the expatriation occurs will not be classified as a covered expatriate for U.S. tax purposes.

In order to qualify for the exception discussed in Section 877A(g)(1)(B)(i), a dual citizen must satisfy the following two elements:

1) The expatriating individual must be taxed as a resident of a foreign country; and

2) The expatriating individual must satisfy the substantial presence test discussed in Internal Revenue Code Section 7701(b) for not more than 10 years during the last 15-taxable years prior to the individual’s termination of his or her U.S. citizenship.

The expatriating individual will satisfy the substantial presence test if the individual is present within the United States during a tax year for at least 31 days and the individual was present within the United States for 183 days during the calendar year and the two preceding years, as determined under the following formula:

Current year………………………………………………………one day is one day
First preceding year……………………………………………..one day is ⅓ of a day
Second preceding year…………………………………………one day is ⅙ of a day

The application of the test can be shown with a simple example. Suppose that Sven is present within the United States on 120 days for each of three consecutive years. He will be considered present for purposes of the test for 180 days (120 days for the current year plus 40 days for last year plus 20 days for the prior year). Accordingly, Sven will not satisfy the substantial presence test. However, should Sven be present within the United States for 125 days during the current year he would satisfy the substantial presence test because the formula now yields 185 days.

Conclusion

The dual citizen exception potentially allows some individuals classified as a covered expatriate to escape hundreds of thousands if not millions of dollars in exit tax. If you are considering expatriating from the United States, you should consult with a qualified international tax attorney. We had assisted dozens of U.S. citizens and U.S. residents through the entire expatriation process.

Anthony Diosdi is an international tax attorney 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 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 [email protected].

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.