By Anthony Diosdi
The United States taxes the worldwide income of U.S. citizens and residents, regardless of where they reside or are domiciled. This approach differs markedly from that of the vast majority of other countries that do not tax unrepatriated foreign earnings of citizens residing or domiciled abroad. Because the United States subjects its citizens and residents to income tax on their worldwide income, many U.S. citizens and residents are actively considering expatriating from the United States. For U.S. tax purposes, the concept of expatriation can be very complicated. If you are considering expatriating from the United States, here are eight things to consider:
The Exit or Expatriation Tax
Section 301 of the Heroes Earnings Assistance and Relief Tax Act of 2008 added Section 877A to the Internal Revenue Code. Section 877A has added a mark-to-market “exit tax” to the Internal Revenue Code. The U.S. 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 $821,000 (for 2023). 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. Finally, individuals exiting the U.S. with a net worth of more than $2 million can be classified as covered expatriates.
There is Significant Tax Filing Requirement Associated with the Expatriation Process
A covered expatriate is required to file a dual-status individual federal income tax return if he or she was a U.S. citizen or long -term resident for part of the tax year before he or she expatriated from the United States. A dual-status income tax return must include both a Form 1040 and Form 1040NR. A Form 8854 must also be attached to the expatriating individual’s income tax return for the year of expatriation. All U.S. citizens and long-term residents who cease to be lawful permanent residents of the U.S. 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. The Form 8854 is used to determine if any exit tax is owed to the IRS.
Constitutionality of Section 877A
In Di Portanova v. United States, 690 F.2d 169, 179-80 (Ct.Cl.1982), an expatriating individual argued that the application of Internal Revenue Code Section 877 to him was unconstitutional on the grounds that it represented an invalid exercise of personal jurisdiction and that it was a denial of due process. The court rejected both arguments and offered some interesting observations about the breadth of the authority that Congress may exercise in the creation and development of the income tax system (including the structure of the U.S. tax system to individuals that are not U.S. citizens or residents):
[First, the plaintiff] argues that the provision is an invalid exercise of personal jurisdiction over him. We have held, however, that Section 877(a) is a source-based tax.
The plaintiff recognizes that the United States may tax United States source income at any rate. He contends, however, that Congress cannot base the rate of tax upon the identification of the taxpayer, i.e., expatriates rather than nonresident citizens, and that when it attempts to do that, it is exercising personal jurisdiction over a nonresident alien.
The plaintiff has not shown why this claim of discriminatory treatment *** converts the tax into one based on personal jurisdiction. If the plaintiff contends that Congress may never tax nonresident aliens on the basis of personal characteristics, he brings into question the distinctions between citizens and aliens and between residents, both personal characteristics from which the plaintiff seeks to benefit. It would be possible for Congress to tax nonresident aliens on their United States income at the same rates it taxes citizens and residents, but it has not done so.
Congress constitutionally may treat nonresident aliens as a special class and subject that class to different tax rates. In Barclay & Co. v. Edwards, 267 U.S. 422, 449-50 (1924), the Supreme Court held that foreign corporations “constituted a class all by themselves and could be properly so treated by Congress…The power of Congress in levying taxes is very wide, and where a classification is made of taxpayers that is reasonable, and not merely arbitrary and capricious, the Fifth Amendment can not apply.
The plaintiff has not shown why Congress may not also draw reasonable distinctions between various classes of nonresident aliens.
Section 877 taxes expatriates only on their United States source income. It is therefore a source-based tax. The plaintiff’s complaints about distinctions drawn between expatriates and aliens who were never citizens of this country are judged by the traditional due process and equal protection standards and are dealt with below.
[Second, the] plaintiff argues that Section 877(a) denies him due process because “the means are unnecessary [and] inappropriate to the proposed end are unreasonably harsh or oppressive, when viewed in the light of the expected benefit, … [and] the guarantee of due process is infringed.” * * *
Congress has wide discretion in deciding whom to tax and how much * * * This court has said the test is one of minimum rationality. * * * There is a strong policy against invalidating tax statutes, and any rational basis for a taxing statute will justify it. * * *
The plaintiff contends Section 877 is ill-suited to preventing tax avoidance because it does not cover all instances. Such arguments, however, are better addressed to Congress. Section was not designed to prevent all tax avoidance. It “was enacted to forestall tax-motivated expatriation.” See Kronenberg v. Commissioner, 64 T.C. 428, 434 (1975).
Di Portanova is an older case and the court’s discussion of Section 877 is dated. A number of legal commentators have suggested that Section 877A is invalid on one or more of a different legal bases: 1) Section 877A is an inappropriate exercise of taxing jurisdiction under general principles of international law; 2) Section 877A violates international human rights principles (i.e., the rights to emigrate and expatriate); and 3) Section 877A is unconstitutional as a violation of either or both the Fifth (because it violates due process) or the Sixteenth Amendment (because it taxes unrealized gains in violation of the realization requirement).
On June 26, 2023, the United States Supreme Court granted a petition for a writ of certiorari in Moore v. United States to determine constitutionality of the transition tax. A decision in favor of the Moores could call into question mark-to-market principles of Section 877A. The plaintiffs, Mr. and Mrs. Moore invested in an India-based corporation. In exchange for the Mr. and Mrs. Moores’ investment, they received approximately 13 percent of the India company’s common stock. However, the Moores never received a distribution, dividend, or payment from the foreign company. Even though the Moores never received a distribution from the foreign company, under the transition tax they were subject to U.S. income taxes.
The Moores initiated refund litigation in the Western District of Washington. The Moores claimed that the 965 transition tax is a violation of the Sixteenth Amendment because it imposes an unapportioned direct tax on them rather than an income tax. Article I of the Constitution provides that Congress may institute “direct taxes” (taxes levied directly on persons and property if the revenue from the tax is apportioned among the states according to population). The Supreme Court has held that an income tax is a direct tax and must be apportioned. See Pollock v. Farmers’ Loan and Trust Company, 157 U.S. 429 (1895). The United States ultimately enacted the Sixteenth Amendment which permits Congress “to lay and collect tax on income, from whatever source derived, without apportionment.” The Moores have argued that the Sixteenth Amendment’s exemption from apportionment is limited to taxes on realized gains and that income has to be realized in order for it to be taxed.
It is unclear how the Supreme Court will rule in this case. A broad ruling that invalidates the 965 transition tax could also call into question the mark-to-market principles of Internal Revenue Code Section 877A. This is because the mark-to- market principles of Section 877-A requires prepayment of taxes on unrealized gains.
Conclusion
If you are considering expatriating, it is very important to seek assistance from an international tax attorney who is not only well versed in the tax aspects of expatriation. We have assisted many U.S. residents and U.S. citizens through the expatriation process. We have also advised many clients how to minimize the tax consequences associated with expatriating.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on providing tax planning domestic and international tax planning for multinational companies, closely held businesses, and individuals. In addition to providing tax planning advice, Anthony Diosdi frequently represents taxpayers nationally in controversies before the Internal Revenue Service, United States Tax Court, United States Court of Federal Claims, Federal District Courts, and the Circuit Courts of Appeal. In addition, Anthony Diosdi has written numerous articles on international tax planning and frequently provides continuing educational programs to tax professionals. Anthony Diosdi 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.