By: Jerald David August
Chair, International Taxation and Wealth Planning Group
Set of Expatriation Blog Posts
This is the third in a series of blog posts on the US income and wealth tax implications of expatriation. This post sets forth the U.S. approach to the expatriation of a U.S. citizen and long-tern resident prior to the effective date of the Heroes Act of 2008 which applied to expatriations occurring after June 16, 2008. A fourth and final post in this series on expatriation will address the succession tax under Section 2801 which tax, in this author’s experience, is frequently overlooked by those seeking to migrate out of the US to someplace else. Maybe the whole family should leave?
A Warning For Those Who Think Expatriation is Just Filing Out a Few Forms: Think Again and Think Hard!
The expatriation rules are quite complex and pose traps for the unwary. This discussion does not address the full extent of the rules, exceptions, deferral or reporting requirements. It also does not cover in depth the certification rules which must be given serious consideration by counsel working with the client before deciding whether to move forward with the client’s desire to expatriate.
The Current Expatriation Rules: The Heroes Earnings Assistance and Relief Tax Act of 2008 (“Heroes Act”)—Introduction of Mark-toMarket Regime
Wide-sweeping changes were again made to the expatriation provisions, both for income and transfer tax rules under the Heroes Act. The goal of Congress’ acting once more in this area was clear. It was to make the tax impact attendant to expatriation more costly to those leaving.
One scenario that Congress wanted to address was to impose a toll-charge for exiting the U.S. In particular, the impose an income tax on talented individuals who have realized financial success in their endeavors and have much unrealized appreciation in their business assets generated while living in the United States/ Prior to the Heroes Act, such individuals could expatriate and, with careful planning, escape U.S. taxation indefinitely or permanently, both income and wealth tax. Therefore, Congress enacted legislation to combat these perceived weaknesses in our tax system.
Two rules contained in the Heroes Act addressed this concern, to-wit: (i) the mark-to-market income tax under Section 877A; and (ii) the U.S. donee inheritance tax under Section 2801 on transfers of property from a covered expatriate to a U.S. donee. The mark-to-market tax applies to individuals who terminated their citizenship or long-term residency after June 16, 2008, and meet certain tests.
Where the requirements for the tax are met, the individual is treated as having sold all her assets or interests in property in a taxable disposition for fair market value on the day prior to the actual date of expatriation. Unlike the 10-year phase out rule under former Section 877, expatriation status of a covered expatriate individual is permanent.
The United States’ broadening the impact of expatriation spurred the enactment of expatriation tax provisions in a number of other countries, including France, Germany and the Netherlands. A covered expatriate, as such term is defined, is generally entitled to have to report only gain in excess of the exclusion amount (as adjusted for inflation), which is $725,000 for 2019. The exclusion amount is allocated among all built-in gain property that is subject to the mark-to-market regime, pro-rata, based on the relative amount of unrealized gain for each built-in gain asset. The characterization of gain or loss under Section 877A is based on the nature of the asset held. Each individual is allowed only one lifetime exclusion amount, with the result that an exclusion amount is no longer available upon a later expatriation to the extent that it has been used up in an earlier expatriation. The tax-free exchange rules or income exclusion provisions are ignored. Covered Expatriate Under Section 877A(g)(1)(A), a covered expatriate is defined based on the requirements contained in Section 877(a)(2)(A)–(C), with exceptions set forth in Section 877A(g)(1)(B).
Thus, the ACJA amendments defining an expatriate remain in place with respect to the: (i) average annual net income tax liability (as adjusted for inflation, which is $168,000 for 2019) for the prior five taxable years; or (ii) the $2,000,000 net worth test, which is not adjusted for inflation; or (iii) the individual fails to certify under penalty of perjury that she has met the requirements of the Code for the preceding five taxable years or fails to submit such evidence of such compliance in the manner required.
The Section 877A test is met when an individual “ceases to be a lawful permanent resident of the United States” (i.e., loses his or her green card status through revocation or has been administratively or judicially determined to have abandoned such status). The HEART Act amended Section 7701(b)(6) to provide that an ex-green card holder will no longer be treated as a permanent resident for tax purposes if: (i) he begins to be treated as a taxable resident of another country “under a tax treaty between the United States and such foreign country”; (ii) chooses not to waive the benefits for which he would otherwise qualify as resident of the foreign country under the treaty; and (iii) notifies the Secretary of the Internal Revenue Service “of the commencement of such treatment.” These “requirements” include filing all required income tax, employment tax, gift tax, and information returns and paying all tax liabilities, interest, and penalties.
A taxpayer must make this certification on Form 8854, which must be filed by the due date of the taxpayer’s income tax return for the taxable year that includes the day before the expatriation date. The five year look-back at the taxpayer’s income tax returns and required filings, including FBAR filings, may reveal that corrections are required. The client may indeed be non-compliant perhaps for issues that are manageable and can be corrected or others, more serious in nature that may leave the client with the choice of first making a voluntary disclosure to the Internal Revenue Service, Criminal Investigatory Division or through some other acceptable channel, as part of his or her desired exit from long-term residence or U.S. citizenship. It is imperative that the individual seeking to expatriate first obtain legal and tax counsel on immigration and tax law matters and receive full advises before deciding to exit. In some instances, it may be prudent to simply maintain a foreign residence, even for a “dual citizen” or “dual resident” than it is to renounce citizenship or green-card status and leave.
Exceptions to Covered Expatriate Classification
There are two exceptions to the definition of a covered expatriate.
The first is the “dual citizen” returning home rule. It applies to an individual who was born with citizenship both in the United States and in another country; provided that (1) as of the expatriation date the individual continues to be a citizen of, and is taxed as a resident of, such other country, and (2) the individual has been a resident of the United States (under the substantial presence test of Section 7701(b)(1)(A)(ii)) for not more than 10 taxable years during the 15-year taxable year period ending with the taxable year of expatriation.
The second exception applies to a U.S. citizen who relinquishes U.S. citizenship before reaching age 18 ½, provided that the individual was a resident of the United States (under the substantial presence test of Section 7701(b)(1)(A)(ii)) for no more than 10 taxable years before such relinquishment (Section 877A(g)(1)(B)(ii)).
The Expatriating Long-Term U.S. Resident
The term “long-term resident” means any individual (other than a citizen of the United States) who is a lawful permanent resident of the United States in at least eight taxable years during the period of fifteen taxable years ending with the tax year of expatriation. Cessation of residence occurs where: (i) the individual’s status of having been lawfully accorded the privilege of residing permanently in the United States as an immigrant in accordance with immigration laws has been revoked or has been administratively or judicially determined to have been abandoned, or if (ii) the individual commences to be treated as a resident of a foreign country under the provisions of a tax treaty between the United States and the foreign country, does not waive the benefits of the treaty applicable to residents of the foreign country, and notifies the IRS of such treatment on Forms 8833 and 8854.
Any long-term resident who ceases to be a lawful permanent U.S. resident under the rules described above is treated for the purposes of Section 877 as if the resident were a U.S. citizen who lost her U.S. citizenship on the date of the cessation or commencement. This includes a long-term resident who loses his green card status or gains benefits of a tax treaty as a foreign resident. In the case of a long-term resident, the date that long-term residency is terminated is the “expatriation date” (Section 877A(g)(3)(B)).
In the case of a citizen, the date that the individual relinquishes citizenship is the “expatriation date” (Section 877A(g)(3)(A)). The deemed sale date is the day prior to the expatriation date. As for the relinquishment of U.S. citizen status, such is deemed to occur on the earliest of four possible dates: (i) the date that the individual renounces her U.S. nationality before a diplomatic or consular officer of the United States (provided that the voluntary relinquishment is later confirmed by the issuance of a certificate of loss of nationality); (ii) the date that the individual furnishes to the State Department a signed statement of voluntary relinquishment of U.S. nationality confirming the performance of an expatriating act (again, provided that the voluntary relinquishment is later confirmed by the issuance of a certificate of loss of nationality); (iii) the date that the State Department issues a certificate of loss of nationality; or (iv) the date that a U.S. court cancels a naturalized citizen’s certificate of naturalization.
Where an individual who is a covered expatriate becomes subject to tax as a citizen or resident of the United States for any period beginning after the expatriation date, the individual is not treated as a covered expatriate during that period for purposes of applying the withholding rules relating to deferred compensation items, the rules relating to interests in non-grantor trusts, and the rules relating to gifts and bequests from covered expatriates. Where the individual again relinquishes citizenship or terminates long-term residency (after meeting anew the requirements to become a long-term resident), the mark-to-market tax and other provisions are re-triggered with the new expatriation date. Computing Gain Realized Under Section 877A(a)(1) In determining the asset basis for property subject to Section 877A, a long-term resident is permitted to claim an initial adjusted basis with respect to the property based on the date the individual first becomes a U.S. resident but not for an amount less than the fair market value of the property on such date in accordance with Section 877A(h)(2). A taxpayer may make an irrevocable election for this basis rule not to apply. T
he IRS has announced that the step-up-in-basis rule will not apply to U.S. real property interests under Section 897(c) and with respect to property used or held for use in connection with the conduct of a trade or business within the United States. However, if prior to becoming a U.S. resident, the nonresident alien was a resident of a country with which the United States had an income tax treaty, and the nonresident alien held property used or held for use in connection with the conduct of a U.S. trade or business that was not carried on through a permanent establishment in the United States under the income tax treaty, the property is eligible for a step-up in basis to fair market value.
Election to Defer Under Section 877A(b)(1)
An expatriate individual may elect to defer payment of the mark-to-market tax imposed on the deemed sale of property. This election may be made to delay payment of the exit tax on one or more assets until the tax due-date of the year after those assets are actually sold (Section 877A(b)(1)). To take advantage of those deferrals, she must provide “adequate security” and “irrevocably waive the benefit of any U.S. tax treaty that would preclude assessment of the tax.”
Where deferral of gain is properly elected, interest is charged for the period the tax is deferred at the rate normally applicable to individual underpayments. The election is irrevocable and is made on a property-by-property basis. Under the election, the deferred tax attributable to a particular property is due when the return is due for the taxable year in which the property is disposed (or, if the property is disposed of in a transaction in which gain is not recognized in whole or in part, at such other time as the Secretary may prescribe).80 The deferral of the mark-to-market tax may not be extended beyond the due date of the return for the taxable year which includes the individual’s death. The election is made by entering into a deferral agreement with the IRS and appointing a limited agent in the United States as directed by Notice 2009-85, supra, and related guidance. Under the security or bond requirement in order to elect deferral of the mark-to-market tax, the individual is required to furnish a bond to the Secretary.
The bond must be conditioned upon payment of the amount of tax due, plus interest thereon, and must be in accordance with such requirements relating to terms, conditions, form of the bond, and sureties, as may be specified by regulations and approved by the Secretary. Other security mechanisms, including letters of credit, are permitted provided that they meet such requirements as the Secretary may prescribe. Where the security provided with respect to a particular property subsequently fails to meet the requirements of these rules and the individual fails to correct such failure, the deferred tax and the interest with respect to such property will become due. As a further condition to making the election, the individual is required to consent to the waiver of any treaty rights that would preclude the assessment or collection of the tax.
Application of the Transfers of Appreciated Property to a Foreign Trust
The act of expatriating will convert many U.S. grantor trusts into foreign grantor trusts. This implicates the realization rule in Section 684 for such former U.S. grantors. More specifically, where a U.S. person transfers property to a non-grantor, foreign trust, Section 684 treats the transfer as a sale or exchange of the property for a price equal to its fair market value. Loss is not permitted on the transfer or deemed transfer of loss property.
Because a nonresident alien generally may not be considered owner of a trust under the grantor trust rules, an individual’s expatriation can terminate his or her ownership of a grantor trust, thereby causing Section 684 to apply. Section 684 takes priority over Section 877A.
Withholding Requirement of Non-Grantor Trusts
The Heroes Act imposes a tax withholding requirement on all non-grantor trusts, foreign or domestic, that make taxable distributions to a covered expatriate. This withholding be set at 30% of the required payment. The FACTA provisions may also be applicable as well so careful thought must be given to distributions from non-grantor trusts to covered expatriates as well as to family members of covered expatriates.
The mark-to-market tax, in general, does not apply with respect to any portion of a trust that is not treated as owned (under the grantor trust rules) by the covered expatriate immediately before the expatriation date. Special rules apply to any non-grantor trust with respect to which the covered expatriate is a beneficiary on the day before the expatriation date.
Under Section 877A(f )(3), where there is a subsequent direct or indirect distribution of any property from a non-grantor trust to a covered expatriate, the trustee must deduct and withhold from the distribution an amount equal to 30% of the portion of the distribution which would be includible in the gross income of the covered expatriate if the covered expatriate continued to be subject to tax as a citizen or resident of the United States. Such portion of such distribution that is subject to the 30% withholding requirement is subject to tax under Section 871.
The covered expatriate is treated as having waived any right to claim any reduction in withholding under any treaty with the United States on any distribution to which Section 877A(f)(1)(A) applies, unless the covered expatriate agrees to “such other treatment as the Secretary determines appropriate.” If the non-grantor trust distributes appreciated property to a covered expatriate, the trust must recognize gain as if the property were sold to the covered expatriate at its fair market value.
This post is for informational purposes and may not be relied upon as legal advice issued by Fox Rothschild LLP or Jerald David August. If you have questions on expatriation please seek the advises of your legal counsel, including your lawyer at Fox Rothschild LLP or Mr. August.