How to Plan for the U.S. Exit Tax

The number of U.S. citizens and U.S. residents expatriating from the United States has increased at an annual rate of 20 percent over the past few years. Expatriation is a major life decision with significant tax implications for anyone considering renouncing their citizenship or U.S. residency. This article discusses the exit tax associated with expatriation from the U.S. This article also discusses potential ways an individual expatriating from the U.S. can mitigate or eliminate the exit tax.

What is the Exit Tax and How is it Calculated

The Heroes Earnings Assistance and Relief Act of 2008 (“HEART”) established Internal Revenue Code Section 877A and the term “covered expatriate.” Under HEART, 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 (indexed annually) during the five preceding years; or iii) he or she failed to certify compliance with U.S. tax obligations over the last five years. Section 877A also imposes the highest applicable gift or estate tax rate (40%) on U.S. citizens or residents who receive a so-called “covered gift or bequest” from an expatriating individual. In other words, the HEART Act imposes an “inheritance tax” on the recipient of a gift from a covered expatriate.

In cases of a U.S. resident (green card holder) that is a dual resident, the individual may stop the running of the eight year count by claiming a residency of a foreign country in a tie-breaker provision of a U.S. income tax treaty. However, claiming a residency treaty position after a U.S. resident that has become a long-term resident (the green card holder resided in the U.S. for more than 8 out of the last 15 years) will trigger an automatic expatriation for purposes of the exit tax.

An individual can only be classified as a covered expatriate if his or her net worth is at least $2 million as of the expatriation date. IRC Section 877(a)(2)(B). An individual’s net worth is the fair market value and the adjusted basis of his or her worldwide assets and liabilities as of the expatriation date. In order to determine an expatriating individual’s net worth by taking into consideration the fair market value and basis in cash, marketable securities, nonmarketable securities, pensions and retirement plans, deferred compensation plans, partnership interests, beneficial interests in trusts, intangibles, loans, real property, and business property. However, an expatriating individual’s interest in an irrevocable nongrantor trust may potentially be excluded from the net worth determination.

Application of the Exit Tax

All property of a covered expatriate shall be treated as sold on the day before the expatriation date for its fair market value. For purposes of computing the tax liability under the mark-to-market regime, a covered expatriate is considered to own any interest in property that would be part of his or her gross estate for federal estate tax purposes as if he or she died on the day before the expatriation date as a citizen or resident of the United States. The $890,000 exclusion amount is allocated among all built-in gain property that is subject to mark-to-market regime. An individual only has one lifetime exclusion amount (if expatriates again, only have a remaining unused amount from first expatriation). All gain taken into account notwithstanding any other provisions of the Internal Revenue Code. For example, the Section 121 personal residence exclusion cannot be utilized to reduce the exit tax.

An individual can defer payment of exit tax liability – irrevocable election and made on an asset-by-asset basis. To make election, must provide adequate security and must irrevocably waive any right under any U.S. treaty that would preclude assessment or collection of tax imposed under Section 877A. See IRC Section 877A(b); Notice 2009-85.

Specific Deferred Compensation

Treated as receiving a distribution of his interest in such account on the day before the expatriation date.

1) An individual retirement plan; 2) a qualified tuition plan (as defined in Section 529); 3) a Coverdell education savings account (as defined in Section 530); 4) a health savings account (as defined in Section 223); and 5) an Archer MSA (as defined in Section 220) (tax advantage medical savings plan). See Notice 2009-85.

Interests in Nongrantor Trusts

Mark-to-market rules do not apply to any interests in a nongrantor trust. 30%withholding tax applies instead.

Careful Consideration Must be Given to U.S. Based Retirement Accounts

As indicated above, for purposes of computing the expatriation tax, all property of a covered expatriate is treated as sold in a taxable sale on the day before the expatriation date for its fair market value. These rules become complicated when dealing with deferred compensation items such as IRA and 401(k) plans. We will discuss how these plans are treated for expatriation tax purposes below.

For expatriation tax purposes, covered expatriates must treat an Individual Retirement Account or (“IRA”) as if it were liquidated on the day before expatriation. The IRA must be disclosed on the Form 8854 and any taxable gains from an IRA will be subject to the expatriation tax. It should be noted that an expatriation does not automatically convert an IRA into a regular investment account. Consequently the IRA is liquidated when a covered expatriate terminates his or her U.S. residency, the IRA will retain its deferred tax status. This means that investment earnings will accrue tax-free inside the IRA. As a result, when a covered expatriate takes an IRA distribution after the expatriation, any investment earned in the IRA will still be subject U.S. tax. Unless an applicable income tax treaty applies, the U.S. tax on any investment income withdrawal from the IRS will be subject to a 30 percent withholding tax. In addition, early withdrawal penalties may still apply.

A covered expatriate who has an interest in an IRA should provide the IRA administrator a completed Form W-8CE within 30 days of the expatriation date. The Form-W-8CE will provide notice to the administrator of the IRA that the individual is a covered expatriate. Within 60 days of receipt of the Form W-8CE, the IRA administrator must provide a written statement to the covered expatriate setting forth the present value of the account’s accrued benefits on the date before the expatriation date. The written statement should provide the covered expatriate with the proper information to determine the expatriation tax associated with an IRA.

In regards to 401(k) plans, eligible deferred compensation plans may be deferred from the expatriation tax. An eligible deferred compensation plan is an agreement or arrangement under which the payment of compensation is deferred (whether by salary reduction or by nonelective employer contribution). For expatriation tax purposes. A covered expatriate has two options regarding his or her 401(k) plan. First, a covered expatriate may elect to treat the 401(k) plan as liquidated for tax purposes on the day before expatriation. Any deferred compensation in the 401(k) is taxed at the present value of the covered expatriate’s accrued benefit. The distribution from the 401(k) plan must be included on the covered expatriate’s Form 1040. In some cases, a covered expatriate may utilize an income tax treaty to reduce the tax implications of receiving a distribution from a 401(k) plan. If a treaty position is taken, it must be disclosed on the expatriate’s Form 1040.

In the alternative, a covered expatriate may elect to defer expatriation tax consequences associated with a 401(k) plan. Such an election is made on a Form 8854. If a covered expatriate makes such an election to defer the expatriation tax on the v401(k) plan, he or she will be subject to a 30 percent tax on the plan’s accrued benefit once a distribution is received. Procedurally, a covered expatriate must list any deferred tax attributed to a 401(k) plan on a Form 8854. Making such an election to defer the expatriation tax requires the covered expatriate to waive any right to claim any tax treaty benefits with respect to the eligible deferred compensation item. A covered expatriate must make a separate election for each qualified 401(k) compensation plan. In addition, the covered expatriate must annually file a Form 8854 to certify that no distributions have been received from the relevant deferred compensation plan. Finally, and probably the most important step to defer a 401(k) plan from the expatriation tax is to timely file a W-8CE with the relevant 401(k) plan administrator. A covered expatriate that wishes to elect to defer a qualified 401(k) plan for expatriation tax purposes must accurately and timely file a Form W-8CE within 30 days of expatriation with the 401(k) plan administrator.

Deferral of the expatriation tax is not available for ineligible deferred compensation plans. Internal Revenue Code Section 457 defines ineligible deferred compensation plans. Section 457 plans are nonqualified, unfunded deferred compensation plans established by state, local government, and tax-exempt employers.

Introduction to the Section 2801 Inheritance Tax

In addition to the exit tax discussed above, HEART added a new “Inheritance 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. In other words, the HEART Act imposes an “inheritance tax” on the recipient of a gift from a covered expatriate.

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 Inheritance 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. However, Prop. Reg. Section 28.2801-2(g) do not apply the the following exceptions to the gift tax that may typically apply:

1. The transfer of intangible property by an individual not domiciled in the U.S.;
2. The transfer of property to a political organization;
3. The transfer of stock in a foreign corporation by an individual not domiciled in the U.S.;
4. Annual transfer exclusions;
5. Transfers for educational and medical expenses; and
6. Transfers that occur as the result of a waiver of a pension right.

The Internal Revenue Code and the Proposed Regulations provide limited exclusions from the gift tax. The exclusions are as follows:

1. Gifts disclosed on a timely filed gift tax return by the covered expatriate. The covered expatriate must also timely satisfy any applicable gift taxes.
2. Gifts disclosed on a timely filed estate tax return by the covered expatriate’s estate. The covered expatriate’s estate must also timely satisfy any applicable gift taxes.
3. Gifts from a covered expatriate to a qualified U.S. charity.
4. A gift from a covered expatriate to his or her spouse to the extent of a marital deduction under Internal Revenue Code Section 2523 or Section 2056 would have been permitted if the individual was a U.S. citizen or resident at the time of transfer.
5. A transfer by a covered expatriate pursuant to a qualified disclaimer is not considered a gift subject to the inheritance tax.

A U.S. beneficiary who receives a covered gift is subject to the inheritance tax. The inheritance 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. 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. 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.

Although HEART provides for a gift or inheritance tax, the IRS has yet to finalize regulations regarding these rules and as of this date, the IRS has yet to enforce the HEART gift or inheritance tax. As of this date, the IRS has yet to even finalize the Form 708 which would permit covered expatriates to report gifts to third parties.

Pre-Expatriation Planning

An individual expatriating from the United States can consider the following planning options to reduce or eliminate the exit tax:

1. The expatriating individual may gift or transfer assets prior to expatriating to reduce his or her net worth below $2 million.
2. U.S. citizens and domicilities could make use of gift/estate tax exemption of $13.9 million to gift assets to family members or third parties to bring their net worth below $2 million.
3. U.S. citizens expatriating can gift unlimited assets to a U.S. citizen spouse or $190,000 annually (in 2025) who is not expatriating to bring his or her net worth below $2 million.
4. Individuals expatriating from the U.S. that cannot bring their net worth below $2 million should consider gifting highly appreciated assets with low basis to family members to minimize the exit tax.
5. Individuals expatriating from the U.S. may consider funding a nongrantor irrevocable U.S. trust.
6. Expatriating individuals should consider selling their primary residents prior to expatriation to utilize the Section 121 exclusion to potentially shelter up to $500,000 of taxable gains from U.S. tax.

Conclusion

Anyone considering expatriating from the U.S. must begin tax planning as early as possible to avoid the exit and inheritance tax. If you are considering expatriating, it is very important to seek the assistance of an international tax attorney who is not only well versed in the tax aspects of expatriation, but also understands the immigration law governing the expatriation process. Diosdi & Liu, LLP have assisted many individuals through the expatriation process.

Anthony Diosdi is one of several international tax attorneys at Diosdi & Liu, LLP. As an international tax attorney, Anthony Diosdi provides international tax advice to closely held entities and publicly traded corporations. Anthony Diosdi also represents closely held entities and publicly traded corporations in IRS examinations. Diosdi & Liu, LLP has offices in 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: 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.