By Anthony Diosdi
Historically, an individual who relinquished his or her U.S. citizenship with “a principal purpose of avoiding U.S. taxes” was subject to a special U.S. income, gift and estate tax for a period of 10 years after the expatriation. When applicable, the expatriate remained subject to U.S. tax on his or her U.S. source income at rates applicable to U.S. citizens and the expatriate could be subject to gift taxes in certain circumstances. In 1996, the Internal Revenue Code substantially expanded the expatriation tax to not only include expatriating U.S. citizens but to certain long-term residents (those having U.S. permanent resident status in 8 of the 15 years preceding termination of residency). Expatriates were also subject to U.S. estate and gift tax during the subsequent ten year period.
Internal Revenue Code Section 877
Section 877 was incorporated into the Internal Revenue Code in 1966. Although Section 877 was revised a number of times since it was enacted, Section 877 remains the principal legal structure for the expatriation tax. Section 877 generally treats expatriates as having lost citizenship or residency with a principal purpose of tax avoidance if either the individual’s average annual U.S. income tax liability for the five taxable years before the date of the loss or termination is greater than $100,000 or the individual’s net worth as of the date of the loss or termination is $500,000 or more, unless the expatriate can establish that the renunciation did not have a principal purpose of tax avoidance and he or she falls within one of five specified categories. The only categories which are likely to be commonly available to a departing U.S. citizen or resident will be either the one that requires the individual to have been present in the United States for no more than 30 days during any year in the ten-year period immediately preceding the date of his or her loss of citizenship or that the individual becomes a citizen of the country in which the individual, the individual’s spouse or one of the individual’s parents’ birth. Under Notice 98-34, expatriating individuals may rebut the presumption of tax avoidance by submitting a completed ruling request that the expatriation was not done for the principal purpose of tax avoidance. Without a substantive ruling, the expatriating individual remains in jeopardy of a later determination that the principal purpose of the expatriation was for tax avoidance.
The American Jobs Creation Act of 2004
The American Jobs Creation Act of 2004 made important revisions to Section 877. Effective for expatriations after June 3, 2004, an expatriate individual automatically is subject to an expatriation tax if he or she has an average annual net income for the five-year period preceding expatriation of $124,000 (to be indexed for inflation) or the individual’s net worth as of the day before expatriation was $2,000,000 or more. In addition, this automatic rule applies if the expatriating individual fails to certify under penalty of perjury that he or she has met the requirements of the Internal Revenue Code for the five preceding tax years, or fails to submit appropriate evidence of compliance.
The Exit Tax Under the HEART Act
The Heroes Earnings Assistance and Relief Act of 2008 or HEART changed the expatriation rules and established Internal Revenue Code Section 877A. Section 877A established the term “covered expatriate.” Under this regime, 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.
Reporting and Calculating the Exit Tax
Under the “exit tax” rules, all property of a covered expatriate must be treated as sold on the day before the expatriation date for its fair market value. The tax liability is determined under a mark-to-market regime. A covered expatriate is considered to own any interest in property that would be taxable as part of his or her gross estate for federal estate tax purposes as if he or she died on the day before the expatriation. An expatriating individual’s basis in each asset is taken into consideration regarding a gain or loss under the mark-to-market rules.
A covered expatriate must file a dual-status tax return as if he or she was a U.S. resident for the portion of the year up until the day before the expatriation date. The dual-status return requires the covered expatriate to file a Form 1040NR with a Form 1040 attached as a schedule unless he or she expatriates on January 1st. In addition, all covered expatriates must file Form 8854 with the Internal Revenue Service or IRS.
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.
Think Twice About Using a Foreign Trust, Foreign Corporation, or a Partnership to 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 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.
Reporting and Computing the new Gift or 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.
On September 10, 2015, the Department of Treasury issued proposed regulations for Internal Revenue Code Section 2801. These proposed regulations apply to U.S. citizens or residents that receive gifts that can be classified as a “covered gift” or covered bequests” until regulations are published in the Federal Register. Although the regulations promulgated by the Department of Treasury under Section 2801 are not final. These regulations provide a good overview as to how the IRS will tax gifts received from individuals who expatriated from the U.S.
We have significant experience in assisting individuals expatriate from the United States.
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.