By Anthony Diosdi
This article discusses how U.S. retirement accounts (i.e., IRA and 401(k) plans) are treated for expatriation tax purposes. Before discussing how a U.S. retirement account is treated for expatriation tax purposes, this article will provide an overview regarding the expatriation tax.
Section 877A and the “Exit” Tax
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 $767,000 (for the 2022 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 $178,000 (indexed annually. For 2022, this amount is $178,000) during the five preceding years; or iii) he or she failed to certify compliance with U.S. tax obligations over the last five years.
For a U.S. citizen, the expatriation date takes place on the earliest of the following:
1) The day the U.S. citizen renounces his or her nationality before a diplomatic or consular of the United States (assuming the renunciation was approved by the U.S. Department of State);
2) The day the U.S. citizen furnishes the U.S. Department of State a signed statement of voluntary relinquishment of United States nationality confirming the act of expatriation;
3) The day the U.S. Department of State issues to the individual a certificate of loss of nationality;
4) The date a U.S. court with proper jurisdiction cancels a naturalized citizen’s certificate of naturalization.
For permanent residents or green card holders, the expatriation date is when either of the following takes place:
1) resident status is considered to be rescinded if final administrative or judicial order of exclusion or deportation is issued regarding the individual;
2) When a permanent resident abandons residency status before a consular officer or a judicial determination is made regarding the abandonment of residency.
3) In certain cases, if a residency position is claimed under a treaty.
All U.S. citizens who relinquish their U.S. citizenship and all long-term residents who cease to be lawful permanent residents of the United States must file Form 8854 in order to certify, under penalties of perjury, that they have been in compliance with all federal tax laws during the five years preceding the year of expatriation.
Expatriation Tax and U.S. 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.
Treatment of Individual Retirement Accounts or IRA for Purposes of the Expatriation Tax
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 j60 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.
Treatment of 401(k) Plans for Purposes of the Expatriation Tax
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.
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.
We have substantial experience advising clients ranging from small entrepreneurs to major multinational corporations in foreign tax planning and compliance. We have also provided assistance to many accounting and law firms (both large and small) in all areas of international taxation.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & 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 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.