By Anthony Diosdi
Introduction
Seems like whenever there is an election a number of people threaten to leave the United States and move to another country if their candidate doesn’t win. I’m not sure how many of these individuals make good on their threats. This article is designed to provide an overview of the U.S. tax consequences associated with renouncing one’s U.S. citizenship and discuss potential strategies to mitigate the taxes associated with expatriating. Anyone considering abandoning their U.S. citizenship or ending a long-term U.S. residency must understand that they may be assessed an “expatriation tax.” An “expatriation tax” consists of two components: the “exit tax” and the “inheritance tax.” Both may be triggered upon abandonment of citizenship or abandonment of a green card. We will discuss both these taxes in more detail below.
History of the Expatriation Tax
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 (“HEART”) changed the expatriation rules and established Internal Revenue Code Section 877A. Section 877A established the term “covered expatriate.” Under this new 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 $737,000 (for the 2020 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 $171,000 (indexed annually. For 2020, this amount is $171,000) during the five preceding years; or iii) he or she failed to certify compliance with U.S. tax obligations over the last five years. 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.
Form 8854 and Calculating the Exit Tax
Now since we discussed the general general tax consequences of expatriating, we will need to discuss the compliance aspect of expatriating. Anyone expatriating from the U.S. must complete Internal Revenue Service (“IRS”) Form 8854. Form 8854 is filed with the IRS and calculates any required exit tax. As of the writing of this article, the Form 8854 is in draft format and has yet to be finalized by the IRS. Also the Form 8854 is currently in draft form and has yet to be finalized, we believe that once the Form 8854 is finalized, it will consist of three parts. We will now briefly review each of the three parts of the Form 8854.
Part I. General Information
Part I of Form 8854 will require that the expatriating individual disclose general information such as their address, list of countries (other than the United States) which he or she is a citizen and how the expatriating individual became a U.S. citizen or permanent resident.
Part II. Initial Expatriation Statement for Persons Who Expatriated
Part II will be required to be completed by all individuals who expatriate. Part II of Form 8854 is designed to determine whether or not an expatriating individual can be classified as a “covered expatriate.” Part II is broken down into three subcategories; Section A, Section B, and Section C.
Section A.
The questions in Section A of Part II is designed to determine if an individual is a “covered expatriate” as the result of having an average annual income tax burden of more than $171,000 (for 2020) during the five proceeding years.
Line 1.
Line 1 will require the expatriating individual to enter his or her U.S. tax liability (after foreign tax credits) for the five tax years before the date of expatriation.
Line 2.
Line 2 will require that the expatriating individual enter his or her net worth.
Line 3.
Line 3 will require that the expatriating individual to check the “Yes” box if he or she became at birth a U.S. citizen and a citizen of another country and, as of the expatriation date, he or she continues to be a citizen of, and taxed as a resident of another country.
Line 4.
Line 4 will be required to be completed by individuals that answered “Yes” to question 3. Line 4 will ask whether or not the expatriating individual has been a resident of the United States for not more than 10 of the last 15 years.
Line 5.
Line 5 will ask the expatriating individual to check “Yes” if he or she was under age 18 1/2 on the date of expatriation and if he or she was a U.S. resident for not more than 10 years.
Line 6.
Line 6 will ask the expatriating individual to check the “Yes” box if he or she complied with their tax obligations for the five years ending before the date on which he or she expatriated. Checking “Yes” to this question will result in an automatic “covered expatriate” classification. Anyone considering expatriating must make certain that they are in compliance with all U.S. tax and filing obligations.
Section B.
Section B of Part II of Form 8854 will require that the expatriating individual complete a balance sheet stating the fair market value and adjusted basis of their global assets and liabilities as of the expatriation date. When completing Section B of Part II to Form 8854, the expatriating individual must keep in mind that he or she can be classified as a “covered expatriate” if his or her global net worth is $2 million or more on the date of expatriation. The $2 million threshold considers all assets worldwide.
Section C.
Section C of Part II of Form 8854 will only be required to be prepared by “covered expatriates.” Lines 1a through 1d requires that the expatriating individual disclose to the IRS if they had any eligible deferred compensation items, ineligible deferred compensation items, specified tax deferred aunts, or interests in grantor trusts. Line 2 will ask the expatriating individual to calculate any taxable gains for the above mentioned items. A mark-to-market method is utilized to determine the tax consequences of the assets included in Line 2. If however, the expatriating individual’s deemed gain is less than $737,000 (for 2020), there is no exit tax due.
Section D.
Section D of Part II will be completed by those expatriating individuals who elect to enter into a tax deferral agreement with the IRS with respect to any exit tax. As discussed above, the expatriation or exit tax is calculated as if the expatriating individual sold his or her assets on the date of expatriation. In certain cases, the tax of a mark-to-market deemed sale may be deferred until the property is sold or the expatriate dies. In order to make the deferral election, the covered expatriate must provide “adequate security” to the IRS and agree to pay the statutory interest on the deferred tax.
Expatriation is Not Free
There are a number of non-tax matters that an expatriating individual must consider. First, individuals considering expatriating from the United States must understand that not only will they be required to pay an exit tax, they also be required to pay $2,350 to the State Department for the privilege of expatriating.
An Expatriating Individual Must Appear in Person for an Interview
An expatriating individual must also be prepared to attend an interview at a U.S. embassy or consulate before an expatriation can be finalized. The expatriating expatriate must bring the following documents and information to the interview:
1. U.S. Passport;
2. Certification of citizenship of at least one other country than the United States;
3. Evidence of any name changes.
4. A completed Form DS-4079.
Anyone seeking to expatriate from the U.S. must understand that the expatriation interview is just one step in the expatriation process. The interviewer at the embassy or consulate does not have the authority to revoke an expatriating individual’s U.S. citizenship or residency. The final decision to revoke an expatriating citizen’s citizenship or residency is made by the Department of Homeland Security. The Department of Homeland Security will advise the individual seeking to expatriate from the U.S. in writing whether or not the request to expatriate was granted.
Form DS-4079 Must be Properly Completed
Finally, anyone considering expatriating must understand that renouching a U.S. citizenship or residency is not automatic. The individual seeking to expatriate must establish by a preponderance of evidence that he or she is a U.S. citizen or green card holder who performed an expatriation act voluntarily and with the intent to relinquish U.S. citizenship or permanent residency. An individual may establish by a preponderance of evidence that the expatriation act is voluntary and with the intent to relinquish U.S. citizenship or permanent residency by completing Form DS-4079. Completing the Form DS-4079 is extremely important because if it is not correctly completed the Department of Homeland Security may reject the request to expatriate. However, if the Department of Homeland Security arbitrarily rejects an expatriation request, it may be possible to bring suit in a United States district court to compel the Department of Homeland Security to reverse its position.
Potential Planning Strategies to Mitigate the Consequences of the Exit Tax
The exit tax is an income tax on 1) unrealized gain from a deemed sale of worldwide assets on the day prior to expatriation; and 2) the deemed distribution of deferred compensation plans. A covered expatriate is deemed to have sold on most property held worldwide on the day before expatriation. A mark-to-market method imposes an income tax on unrealized gains. In some cases, the exit tax can be substantial. However, with proper planning, the exit tax can be significantly reduced or even eliminated.
One way an individual that plans to expatriate the U.S. can reduce his or her exit tax liability is to outright gift his or her assets to others. Although the HEART Act has imposed an “inheritance tax” on the gross value of a “covered gift,” in some cases, the “inheritance tax” can be avoided if a gift is made at least three years prior to expatriation. Regardless when made, an expatriating individual may also make unlimited tax-free gifts to a spouse that is a U.S. citizen. Another strategy would be to establish a self-settled “expatriation trust.” The trust should be formed as an irrevocable non grantor discretionary domestic trust in a state that permits such a trust. If established properly and at least three years before expatriation, an “expatriation trust” could significantly reduce or eliminate the exit 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. We have assisted many individuals through the expatriation process.
Anthony Diosdi is one of several international tax attorneys at Diosdi Ching & 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 Ching & 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.