Expatriation: Look Before You Leap!
Because the United States subjects its residents to income tax on their worldwide income, and subjects those who are domiciled in the U.S. to estate tax on their worldwide assets, many such individuals actively look for ways to reduce or eliminate their U.S. tax obligations. Off-shore tax havens are plentiful, and provided accounts or activities taking place in these jurisdictions are properly reported to the IRS, they are legal. However, there are taxpayers who wish to cease paying U.S. tax altogether. The purpose of this article is to explain how such taxpayers can legally eliminate their U.S. tax obligations and the consequences of pursuing this course of action.
Expatriation is defined as the “voluntary departure from the nation of one’s birth for permanent or prolonged residence in another nation.” For purposes of U.S. taxation, however, the concept of expatriation is defined much more broadly. Whether you are a U.S. citizen or a long-term U.S. resident (i.e., green card holder), the same tax rules apply should you desire to abandon any and all rights afforded to you under U.S. law (these persons will be referred to as “expats” in this article). While there is a formal process that must be followed in order to successfully expatriate, expats will be subject to an alternate U.S. tax regime for 10 years following the date of expatriation. Certain U.S. residents are subject to the alternate U.S. tax regime even though they are not able to expatriate.
The manner in which the expatriation rules apply, as well as exceptions to those rules, differ based upon the identity of the expat (i.e., whether they are a citizen or green card holder who expatriated). Notwithstanding, Congress continues to introduce legislation amending the expatriation rules. The year 2007 marked the third consecutive year in which such legislation was introduced in two different congressional bills. While it is impossible to predict if the legislation will become law, one constant exists through all permutations of the legislation – an exit tax – to which all expats will be subject.
This article will summarize the following:
- who is impacted by the expatriation rules
- exceptions to the expatriation rules
- the proper process for expatriating
- the manner in which expats are taxed
It will conclude with a brief summary of the proposed regulations that would impose an exit tax on all expats, as they leave.
Who Is Impacted by the Expatriation Rules
Citizens. While the expatriation rules apply equally to U.S. citizens and long-term permanent residents, only certain of these individuals will actually be impacted. This is because the expatriation rules only reach those U.S. citizens seeking to expatriate who have (i) a net worth of at least $2 million on the date of expatriation, or (ii) an average annual net income tax for the five tax years prior to expatriation greater than $136,000 (this amount increases annually as it is tied to an index). Notwithstanding these criteria, even if the U.S. citizen does not have such a net worth or income tax liability, if he fails to certify under penalties of perjury that he has been compliant with the U.S. tax laws for the five-year period prior to expatriation, he will also be subject to the rules. Therefore, even if the individual seeking to expatriate does not have significant wealth which meets or exceeds the net worth or income tax thresholds, the expatriation will still apply absent a certification under penalties of perjury.
Green Card Holders. As stated above, the expatriation rules also apply to those persons in possession of a green card. However, green card holders are only subject to the expatriation rules if they have been permanent U.S. residents for at least eight of the 15 years prior to expatriating. Consequently, the expatriation rules may not apply to green card holders who have a residence or domicile in a country with which the U.S. has an income tax treaty. This result may occur because even though the individual may have a green card, if they can be classified as a resident of a foreign country for any year during the 15-year period through a treaty tie-breaking provision, then such individual would be deemed not to be a U.S. resident for that year. Furthermore, if an individual were to expatriate prior to residing in the U.S. for eight years, the expatriation rules would not apply unless that individual were to return to the U.S. within the remaining 15-year period.
Resident Aliens (Non Green Card Holders). Individuals who qualify as U.S. resident aliens under the substantial presence test of Internal Revenue Code (IRC) Section 7701, regardless of whether such aliens possess a green card, may also be subject to the same alternate tax system to which expats are subject. The tax would apply to all individuals who (i) were U.S. residents for three consecutive years; (ii) during such three-year period were physically present in the U.S. for at least 183 days each year; (iii) became non-resident aliens following the third consecutive year in which they were a U.S. alien, even if such non-resident status was obtained through an income tax treaty tie-breaker provision; and (iv) became U.S. residents within the three-year period following the year such aliens ceased to be so classified. Consequently, those persons becoming U.S. residents under the three-year rolling average test of IRC §7701 need not worry about IRC §877 and the alternate tax system.
Exceptions to the Expatriation Rules
There are two types of U.S. citizens who, if they expatriate, are exempt from the expatriation rules. The first such exempt citizens are children who were born in the U.S., but who have had no real contact with the U.S. since birth. In order to qualify for such exemption, (i) the child’s parents must not have been U.S. citizens; (ii) the child must expatriate before turning 18-1/2 years of age; and (iii) the child must not have been in the U.S. for more than 30 days in any of the 10 years preceding the expatriation. Children with dual citizenship may also qualify for exemption from the expatriation rules. To be eligible, the child must have (i) obtained U.S. citizenship solely by reason of birth; (ii) obtained citizenship of another country at birth; (iii) remained a citizen of such other country; and (iv) had no substantial contact with the U.S.
A child with dual citizenship will be deemed to have had substantial contact with the U.S. if such child (i) ever qualified as a U.S. resident under the substantial presence test; (ii) had a U.S. passport; or (iii) was physically present in the U.S. for more than 30 days in any of the 10 years before expatriating. If a child with U.S. citizenship meets either of these exceptions, upon expatriating the child will not be subject to the expatriation tax. However, there is no exception for children who were long-term residents; if the child with a green card was in the U.S. at least eight out of the 15 years prior to expatriating and fails any of the requirements (i.e., income tax, net worth, or certification), he will be subject to the expatriation rules and the alternate tax system.
The Proper Process for Expatriating
Simply leaving the U.S. even with the stated intent of never returning is not sufficient to expatriate. There is a two-step process that must be followed in order to properly expatriate, which differs based upon whether the expat is a citizen or long-term resident. The first step consists of terminating one’s U.S. status for immigration purposes, while the second step consists of terminating one’s U.S. status for tax purposes. Failure to follow these steps will cause the individual to remain subject to U.S. tax. Additionally, even after an individual properly expatriates, the expat may become subject to U.S. income tax if the expat spends in excess of 30 days in the U.S. during the subsequent 10-year period (hereinafter “subsequent 10 years”).
Renouncing U.S. Status for Immigration Purposes. For U.S. citizens to expatriate, the first step is satisfied by giving notice of expatriation. Such notice is established by (i) renouncing one’s U.S. citizenship outside the U.S. before a diplomatic or consular officer under the Immigration and Nationality Act (INA), or (ii) submitting to a U.S. embassy or consulate a signed statement affirming the individual’s voluntary intentional relinquishment of U.S. citizenship accompanied by documentation confirming the performance of an act defined as potentially expatriating under the INA. A Certificate of Loss of Nationality is prepared by the diplomatic or consular officer and submitted to the Department of State. Unless and until the Department of State approves the expatriation, the expat will remain a U.S. citizen, and will be subject to U.S. tax on worldwide assets. However, at such time as the expatriation is accepted, the effective date of the certificate is the date on which the individual renounced such citizenship in front of the consular or director officer. For a long-term resident, the notification of expatriation consists of filing Form I-407, Abandonment of Lawful Permanent Resident Status, before the Secretary of Homeland Security. Such notice is equivalent to surrendering the green card and having it administratively terminated.
Renouncing U.S. Status for Tax Purposes. Individuals seeking to expatriate must file Form 8854 to notify the IRS of the expatriation. There is no due date for the filing of the initial Form 8854, however, the expat will remain subject to U.S. income tax on the expat’s worldwide income until such form is filed. Consequently, it is more than likely that an individual will become an expatriate for U.S. immigration purposes before he becomes an expatriate for U.S. tax purposes.
While Form 8854 must be filed to indicate that an expat has expatriated or terminated their green card status, it also must be filed in each of the subsequent 10 years. The annual forms, which require detailed income, asset and liability information, are due on the date the person’s U.S. tax return would have been due. As a general rule, the expat should also file Form 1040-C, the United States Departing Alien Income Tax Return, commonly known as the “Sailing Permit.” This will confirm the absence of U.S. income tax liability.
Persons failing to file the Form 8854 or filing an incomplete form are subject to a penalty in the amount of $10,000. While the penalty may be waived for reasonable cause, the real consequence of failing to file Form 8854 indicating the individual’s expatriation is that such individual remains subject to the U.S. tax laws. Thus, even if an expat leaves the U.S. to become a resident of a foreign country, the expat will remain subject to the U.S. tax laws until he files the initial Form 8854.
Both the Department of State and Department of Homeland Security are required to notify the IRS when they approve a Certificate of Loss of Naturalization or revoke a person’s lawful permanent residency. Additionally, within 30 days of the close of each calendar quarter, the IRS is required to publish the names of all persons who have expatriated within the Federal Register. Interestingly, even if the governmental bodies administratively approve the expatriation, if the individual fails to file the initial Form 8854, the expat will remain subject to U.S. tax.
Restriction on U.S. Presence Following Expatriation. For U.S. citizens and green card holders, if the expatriate returns to the United States within the subsequent 10 years, and remains in the U.S. for more than 30 days, the expat will once again be subject to U.S. tax on worldwide income. Essentially, the expatriation will be ignored and such classification as a U.S. resident will be on a year-to-year basis. Consequently, if the expat leaves the U.S. the year following this return to the U.S., the expat will once again be subject to the expat tax system and the original 10-year period. In other words, the 10-year period does not begin anew. The 30-day rule is relatively straightforward: any day of U.S. presence is counted and the exceptions that are generally available to non-resident aliens for counting days of presence under Section §7701 are not available.
If the expat is in the U.S. for more than 30 days, but that time is spent exclusively working for an employer who is not related to the expat, then up to 30 additional days of presence will be exempt. Thus, eligible expats may in essence spend up to 60 days in the U.S. provided that the 30 additional days are spent actually performing services in furtherance of the employment. Days not working such as weekends and holidays are counted as days of U.S. presence and if there are more than 30 of these days, the expat will be subject to U.S. income tax on worldwide income. Additionally, the expat must not have been physically present in the U.S. for more than 30 days in any one of the 10 years prior to the date of expatriation or the expat must be a citizen or resident of a country in which he, his spouse or either of his parents was born and fully subject to income tax in such country.
It is interesting to note that the U.S. attorney general has the right to deny reentrance to the U.S. to any expat. This rule is known as the Reed Amendment, and while it has yet to be used as grounds to deny readmission, it is a significant concern to expats. While the Reed Amendment is generally applicable to any expat who expatriated for purposes of avoiding federal tax, there is no system in place for the IRS or the federal government to make such decisions, and perhaps this is the reason that the attorney general has yet to use this authority. Notwithstanding, if an expat fails to file Form 8854 or pay the required tax under the alternate tax system for the subsequent 10 years, it would appear that the attorney general would have sufficient grounds to deny such expat readmission to the U.S.
The Manner in Which Expats Are Taxed
Income Tax. U.S. citizens and green card holders are subject to U.S. income tax on worldwide income. Non-resident aliens are subject to U.S. income tax at graduated rates for income effectively connected to a U.S. trade or business, and to a 30 percent or lower treaty rate on U.S. source passive income. Capital gains earned by a non-resident alien, except for those attributable to the sale of U.S. real property, are not subject to U.S. income tax. During the subsequent 10 years, the expat will be subject to tax in a manner similar to that which a non-resident alien is taxed, unless the tax liability under an alternate tax system is greater. The alternate tax system is essentially the same as that under which a non-resident alien is taxed, except for the expanded definition of U.S. source income. Under the alternate system, U.S. source includes the following: (i) capital gains on the sale of U.S. stock or debt obligations; (ii) income earned from a Controlled Foreign Corporation (CFC); (iii) gain that would have been earned on the sale of a U.S. asset that was transferred to a foreign jurisdiction within the five years prior to expatriation; (iii) gain on what would have otherwise been a tax-free exchange of property; and (iv) gain on the sale of a principal home in the U.S.. Expats are denied capital loss carryover and are only eligible to take deductions on expenses that were directly connected with the gross income earned.
Estate Tax. While U.S. citizens and green card holders are subject to U.S. estate tax on worldwide holdings, these individuals are able to exempt the first $2 million of assets. This contrasts with non-resident aliens who are subject to U.S. estate tax on U.S. situs assets, and who are provided an exemption from U.S. estate tax on the first $60,000 of U.S. situs assets. The stock of a foreign corporation, even if it holds U.S. situs assets, owned by a non-resident alien will not be deemed to be a U.S. situs asset.
Similar to non-resident aliens, expats who die within the subsequent 10 years are subject to U.S. estate tax on U.S. situs property and provided an exemption on the first $60,000 of U.S. situs assets. However, for purposes of U.S. estate tax, the stock of a foreign corporation owned by an expat, whether directly or indirectly, may be treated as U.S. situs property. If the foreign corporation holds U.S. situs assets, a portion of the stock of such corporation will be treated as U.S. situs property so long as the deceased expat owned directly, or indirectly: (i) 10 percent or more of the voting power of all class of stock, or (ii) more than 50 percent of the total voting stock or more than 50 percent of the total value of the foreign corporation. Because non-resident aliens are not subject to U.S. estate tax on the stock in a foreign corporation, but for this rule an expat could transfer ownership of U.S. situs assets to a CFC prior to expatriation in order to avoid U.S. estate tax. Additionally, an expat must be careful not to spend more than 30 days in the U.S. during the subsequent 10 years, otherwise, instead of being subject to estate tax on U.S. situs assets and CFCs, the expat will instead be subject to estate tax on worldwide assets.
Green card holders who are able to qualify as residents of an income tax treaty country such that they do not qualify as U.S. residents for income tax purposes and who maintain a domicile in the treaty country are not subject to U.S. estate tax on U.S. situs assets owned through a CFC. Therefore, any such individuals who own U.S. situs assets through a CFC may wish to consider not expatriating because then the CFC stock will be subject to estate tax should the individual die within the subsequent 10 years.
Gift Tax. While U.S. citizens and green card holders are subject to U.S. gift tax on the gratuitous transfer of property, wherever located, for less than full and adequate consideration, such individuals are able to exempt the first $1 million of taxable gifts. Non-resident aliens, on the other hand, are only subject to gift tax on the gratuitous transfer of U.S. situs tangible property; intangible property is not subject to the gift tax. Additionally, all individuals, whether U.S. citizens, green card holders, or non-resident aliens, are able to make unlimited tax-free annual gifts of $12,000 provided such gifts are made to different recipients.
Expats are also entitled to make annual exclusion gifts of $12,000. However, gifts in excess of $12,000 made by an expat during the subsequent 10 years may be subject to gift tax. Expats similar to non-resident aliens are subject to gift tax on the transfer of U.S. situs tangible property. However, the rules are broadened to also subject the transfer of stock in a U.S. corporation as well as a portion of the stock of a CFC to gift tax. Of course, if the expat spends more than 30 days in the U.S. during the subsequent 10 years, all gifts of property, regardless of where it is located or the character of the property, will be subject to gift tax.
Congress has introduced legislation over the past several years seeking to change the expatriation rules. Thus far the legislation has failed to proceed, but it continues to be introduced in one form or another. The most recent legislation passed through the House of Representatives on November 9, 2007. While the legislation would provide expats with an exemption of $600,000, there would be an immediate tax due on the value of the expats worldwide assets in excess of the exemption. The legislation was attached to an alternative minimum tax (AMT) reform bill (H.R. 3996, Temporary Tax Relief Act of 2007). Because any exit tax bill enacted by the House would need to be reconciled with the Senate version, and vice versa, which could then be subject to a presidential veto, the prospects for passage of the exit tax remain uncertain. However, given that Congress is currently looking for revenue-raising measures to cover the costs of the Iraq war, AMT relief and other expense items, individuals who are considering expatriating are generally encouraged to take steps to complete their expatriation as soon as possible.
Under the most recent House version of the proposed exit tax legislation, eligible deferred compensation plans (i.e., having a U.S. payor) would generally be exempt from the mark-to-market rules. Instead, the payor would be required to deduct and withhold a tax equal to 30 percent of any taxable distribution to the expats. With regard to non-eligible deferred compensation plans, an amount equal to the present value of the accrued benefit in the plan would generally be treated as having been received as a distribution by the expat on the day before the expatriation date. No early distribution penalty tax would apply. Appropriate adjustments would be made to subsequent distributions to reflect such treatment. The exit tax rules would not apply to any deferred compensation plan which is attributable to services performed outside of the U.S. while the expat was not a citizen or resident of the U.S. With regard to IRAs and other tax-deferred accounts, the expat would be treated as receiving a distribution of his entire interest in the account on the day before the expatriation date (no early distribution penalty tax would apply), and appropriate adjustments would be made to subsequent distributions from the account to reflect such treatment.
In the case of distributions (directly or indirectly) to the expat from a non-grantor trust of which the expat is a beneficiary on the day before the expatriation date, the trustee would generally be required to deduct and withhold a 30 percent tax on the amount of the distribution. In addition, gain would be required to be recognized by the trust as if the property were sold to the expat at its fair market value.
The current House exit tax bill also provides that gifts and inheritances in excess of $10,000 that are received by a U.S. person from an expatriating individual after the expatriation date would generally be taxed to the recipient at the highest estate tax rate (unless the gift or bequest is otherwise subject to U.S. estate or gift tax and is reported by the expatriating individual on a timely filed estate or gift tax return).
With regard to the effective date of the current House bill, the mark-to-market tax would apply to an expat whose expatriation date is on or after the date of enactment. The tax on gifts and bequests from expats would apply to property received on or after the date of enactment, regardless of when the transferor expatriated. It is important to note that these new rules would apply in addition to the current alternative tax regime under IRC §877.
In conclusion, the existing process for expatriation is complex and the proposed reforms will only make the process and the consequences of expatriation more involved. Before giving serious consideration to expatriation, it is best to consult with legal, financial and accounting professionals who are highly experienced in this area.