By Anthony Diosdi
Because the United States subjects its citizens and residents to income tax on their worldwide income, and subjects those who are domiciled in the United States to estate and gift tax on their worldwide assets, 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:
Number One- You May be Subject to an Expatriation Tax
Anyone expatriating from the United States may have to pay an exit or expatriation tax.
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.
Number Two- 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.
Number Three- if You are a “Covered Expatriate” or Going to be a “Covered Expatriate,” Think Twice About Gifting Away Your Assets to Avoid the Exit Tax
In order to attempt to mitigate their expatriation tax consequences, many “covered expatriates,” believe they can give away assets both before and after they expatriate to spouses or family members. The proposed regulations define gifts from a covered expatriate to a U.S. person as a “covered gift.” Proposed Regulation Section 28.2801-2(g) defines the term “covered gift” as any property acquired by gift directly or indirectly from an individual who is a covered expatriate at the time the property is received by a U.S. citizen or resident, regardless of its situs and of whether such property was acquired by the covered expatriate before or after expatriation from the United States. The term “covered gift” also includes distributions made by reason of death or from a trust.
According to the Proposed Regulations, the U.S. recipient of a covered gift or bequest is responsible to pay any transfer taxes associated with the “covered gift.” A Form 708 must be filed with the IRS for each calendar year in which a U.S. person receives a “covered gift.” See Prop. Reg. Section 28.2801-4(e).
Number Four- 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.
Number Five- If You are a U.S. Resident, You Must Formally Terminate Your Residency
If you are a U.S. resident (i.e., a green card holder), you will need to abandon your green card to terminate your U.S. residency. There is no such thing as “informally” abandoning a green card. In order for a green card to be abandoned, the U.S. resident terminating his or her U.S. residency must complete Form I-407 and return his or her green card to the U.S. Government.
Number Six- You Will be Required to Appear in Person Before a U.S. Embassy to Relinquish Your U.S. Citizenship or Green Card
A U.S. citizen expatriating from the United States must attend an interview at a U.S. embassy before the expatriation can be finalized. This interview should be scheduled online for the appropriate U.S. embassy in advance. If you are a U.S. citizen and are expatriating from the United States, you will be required to bring the following documents and information to the interview:
1. Your U.S. passport.
2. Certification that you are a citizen of the country you have become a citizen of.
3. Evidence of any name changes, if applicable;
4. A completed Form DS-4079.
These documents can be forwarded to the embassy prior to your scheduled interview. Anyone seeking to expatriate must understand that the expatriation interview is just one step in the expatriation process. The interviewer will not tell the individual seeking to expatriate from the United States of his or her U.S. citizenship or permanent residency status at the conclusion of the interview. Instead, the individual seeking to expatriate will be advised in writing by the Department of Homeland Security of their citizenship or permanent residency status.
Number Seven- Expatriation is Not Automatic
Prior to the expatriation interview, a U.S. citizen seeking to expatriate from the United States will be required to provide an unsigned Form DS-4079 to the interviewer. At the conclusion of the interview, you will be instructed to sign the DS-4079. The DS-4079 will be forwarded to the Department of Homeland Security. The DS-4079 is probably the most important document in the expatriation process. An individual seeking to expatriate from the United States must establish by a preponderance of evidence that he or she was 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. The Department of Homeland Security has rejected requests to expatriate on the grounds that it does not believe the Form DS-4079 was prepared accurately or it does not believe that DS-4079 establishes by a preponderance of evidence the expatriating act was done voluntarily with the intent to relinquish U.S. citizenship or permanent residency. If the Department of Homeland Security rejects a Form DS-4079, it is possible to bring suit in a United States district court to compel the Department of Homeland Security to reverse its position on the theory that it acted arbitrarily in rejecting the DS-4079.
It is extremely important that the DS-4079 be completely accurate and that the form demonstrates that the petitioner establishes with a preponderance of evidence that the expatriating act was done voluntarily with the intent to relinquish U.S. citizenship or permanent residency.
Number Eight- Expatriation is Not Free for U.S. Citizens
U.S. citizens considering expatriating from the United States must understand that it is not free. In order to expatriate from the United States, the U.S. citizen expatriating will be required to pay $2,350 to the State Department. This payment is due at the time of the expatriation interview.
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 but also understands the immigration law governing the expatriation process. 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.