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Expatriation from the United States, Part 1: The Exit Tax

Dec 17 2021

Article Written for:  Florida CPA Today, a publication by the Florida Institute of CPAs

Abandonment of United States citizenship or long-term residency (by non-citizens) may trigger the United States “expatriation tax”. The expatriation tax consists of the “Exit Tax” and the “Inheritance Tax.” In this first of our two-part series, we explain the Exit Tax.

Tax Expatriation Generally

U.S. citizens may expatriate by renouncing their U.S. citizenship at a U.S. embassy or consulate. Long-term (non-citizen) residents" (“NRA”s) may similarly terminate residency for federal income tax purposes upon formal relinquishment of the green card.

Section 877

Section 877 was added to the Internal Revenue Code (“Code”) in 1966 (Foreign Investors Tax Act) and remains the principal legal structure for the expatriation tax. The original Section 877 treats an expatriate as a U.S. resident for U.S. income, estate, gift, and generation skipping tax purposes for any calendar year during the 10-year period following expatriation (before June 18, 2008), if present in the
U.S. for more than 30 days.

The principal income tax effect of Section 877 is to impose income tax on U.S.-source income that is otherwise tax-exempt in the hands of a non-resident alien. For example, the covered expatriate may not avoid income tax on (i) bank account interest, (ii) “portfolio interest” or (iii) capital gains earned from trading in U.S. stocks and bonds (generally avoided by NRAs).

The “Exit Tax” under Section 877A

The Heroes Earnings Assistance and Relief Tax Act of 2008 (the “HEART Act”) added Section 877A, effective for expatriations on or after June 17, 2008. Section 877A(a) imposes a “mark-to-market” Exit Tax on “covered expatriates”. Under Section 877A(a)(1), all property of a covered expatriate is treated as being sold on the day before expatriation for its fair market value. The Exit Tax is an income tax on (i) unrealized gain from a deemed sale of worldwide assets on the day prior to expatriation and (ii) the deemed distribution of IRAs, section 529 plans, and health savings accounts (taxed at ordinary income rates).

A covered expatriate is deemed to have sold any interest in property held worldwide , other than property described in Section 877A(c) (deferred compensation, specified tax-deferred accounts, and interest in a non-grantor trust (discussed below)), as of the day before expatriation. The property subject to the mark-to-market regime of §877A(a) is of a type whose value would be includible in the value of a decedent’s U.S. gross taxable estate (on the day before expatriation).

The “mark to market” regime imposes an income tax on the unrealized gain on the covered expatriate’s worldwide assets.^' The rates of tax differ with the type of asset involved. Long-term capital gain assets and qualified dividends receive the applicable preferential rates. However, the unrealized gain in a life insurance contract is generally taxed at ordinary income rates. The Exit Tax is generally payable immediately (i.e., April 15th following the close of the tax year in which expatriation occurs).

“THE HEART ACT” also added the “Inheritance Tax”, a 40% flat tax on the gross value of a “covered gift” or “covered bequest” made to a U.S. beneficiary. The Inheritance Tax is imposed on the recipient of the gift or bequest (rather than the donor or decedent). We discuss the Inheritance Tax in our next article.

Covered Expatriate

Long-Term Permanent Resident (Green Card Holder)

An expatriated green card holder is subject to §877A as a “covered expatriate” only if a “long- term permanent resident” prior to expatriation. A long-term lawful permanent resident is a person who has been a green card holder during eight of the previous fifteen years prior to expatriation. If a green card holder expatriates before this “8 of 15” year test is met, Section 877A does not apply. A U.S. resident alien (under the U.S. substantial presence income tax test)°"' is not subject to the Sections 877 or 877A tax if the resident has no green card."

Statutory Tests

Section 877A applies to only “covered expatriates” who meet any one of the three “tests”, set out in Section 877(a)(2)(A) - (C).

The Net Worth Test - Having a worldwide net worth is $2 million or more on the date of expatriation.

The Average Annual Income Tax Liability Test - Earning an average annual net income tax for the five years ending before the date of expatriation of more than a specified amount, adjusted for inflation ($171,000 for 2020). An individual who files a joint tax return must take into account the net income tax reflected on the joint return.

Failure to Certify Tax Compliance - Failure to certify satisfaction of federal tax compliance to the Secretary of Treasury for the five preceding taxable years or failure to submit such evidence of compliance as “may be required”. Individuals without considerable assets or income may nonetheless become covered expatriates by failing to certify tax compliance.

Exemption Amount - $600,000 (adjusted for inflation).

Under Section 877A(a)(3), if a taxpayer’s deemed gain is less than $600,000 (adjusted for inflation), there is no tax due. For 2020, the exemption amount is $737,000. If the covered expatriate’s gain exceeds this amount, he or she must allocate the gain pro rata among all appreciated property. Such allocation generally involves allocating the exclusion amount of each gain asset over the total built-in gain on all gain assets.

Special Deferral Rules of Section 877A(b)

The Exit Tax deemed sale or distribution might leave insufficient liquidity to cover the tax, as no actual sales proceeds are available. Section 877A(b) provides detailed rules permitting a “covered expatriate” to defer payment of the mark-to-market tax (on a property-by-property basis). Payment is tolled until the property is actually sold or exchanged, death, or the security required to make the deferral election fails to meet statutory requirements (whichever is earliest). To make the deferral election, the covered expatriate must provide “adequate security” and agree to pay statutory interest on the deferred tax. If the covered expatriate elects deferral, gains deferred are based on the value of property as of the taxing date (i.e., as of the day prior to expatriation).

Reporting Compliance under Section 877A

Under Section 6039G, IRS Notice 2009-85 requires additional reporting for “covered” expatriates for the years following expatriation. Under the prior tax regime of Section 877, “covered” expatriates were to file annual informational returns on Form 8854 for a 10-year period following their expatriation, regardless of actual income tax liability. Moreover, if a “covered” expatriate realized U.S. source income on which U.S. income tax was recognized, he or she was required to file a Form 1040-NR.

Under the Section 877A mark-to-market regime, a “covered” expatriate with an interest in a nongrantor trust (or certain deferred compensation assets) must annually file Form 8854. Form 8854 reflects distributions from the trust. The filing requirement appears to have no time limit under IRS Notice 2009-85. The Notice also affirms that a “covered” expatriate must file a Form 1040-NR in the event he or she earned taxable income and U.S. income taxes are not fully withheld at the source.” As foreign institutions or persons will likely not withhold at the source (under Section 1441), this requirement usually creates a filing obligation for covered expatriates.

Lastly, Notice 2009-85 affirms that a “covered” expatriate with a beneficial interest in a nongrantor trust (or deferred compensation asset) must file Form W-8CE (which identifies the payor). The filing is required on the earlier of the date of first distribution from the trust (subsequent to expatriation) or 30 days after the date of expatriation.

Tax Basis

Section 877A(a) requires “proper adjustments” for any gain or loss recognized with respect to an asset deemed sold. Basis is adjusted upward ("stepped up") by the amount of gain attributable to the deemed sale, to avoid double taxation upon the later actual sale of the property. Similarly, basis is reduced to the extent of a deemed loss. Certain types of property are ineligible for the step up. Assets that would have been taxed if the individual had never become a permanent resident (e.g., U.S. real property interests or property that was used or held for use in connection with the conduct of a trade or business within the U.S.) are not eligible for the step-up.

Potential Planning Strategies

Outriqht Gifts - To Spouse and Others

The proposed expatriate may gift assets sufficient to reduce his or her net worth below the $2,000,000 net worth test (for characterization as a covered expatriate). For example, before expatriation, an expatriate may use the Section 2503(b) annual exclusion (currently $15,000 per donee) to make non-taxable gifts, or alternatively make larger gifts by utilizing his or her unified estate and gift tax credit.

Gifts should be made at least three years prior to expatriation, to avoid Section 2035. Section 2035 adds the value of gifts made within three years of a decedent’s death (or deemed expatriation “death”) to the deceased’s taxable estate (if the value of such property gifted would have been included in the decedent’s gross estate under section 2036, 2037, 2038, or 2042, had such property been held until death). Unless an exception applies, all gifts made during the three years prior to expatriation are not only included as assets subject to deemed sale, but are also likely included in calculating the Inheritance Tax (discussed in our next article).

A potential expatriate may also make unlimited tax-free gifts to a U.S. citizen spouse (prior to expatriation). Interspousal gifts are not subject to the 3-year “clawback” rule of Section 2035. If, however, the recipient spouse is also expatriating, marital gifting may function only if the recipient spouse avoids “covered expatriate” status. Otherwise, the proposed transfers will subject the spouse to Section 877A.

Gifts to Trusts / General Transfer Tax Strategies

As a permanent legal resident (green card holder), the future “covered” expatriate (domiciled in the U.S.) may take advantage of a full unified estate and gift tax credit ($11,700,000 in 2021) by implementing general U.S. transfer tax avoidance strategies before expatriation (at least three years before expatriation). These include utilizing lack of marketability and lack of control valuation discounts for potential transfers, gifts to domestic irrevocable trusts (such as grantor retained annuity trusts, qualified personal residence trusts, intentionally defective grantor trusts (with a toggle off of grantor trust status), charitable lead trusts, charitable remainder trusts, etc.

Use of an Expatriation Trusts

As an alternative to outright gifts or other general estate tax saving vehicles, a potential expatriate may fund an irrevocable (self-settled) trust for himself, his spouse and descendants. Gifts to a properly structured “Expatriation Trust” may likely be used to lower net worth (to avoid the $2,000,000 net worth threshold).

One strategy is to establish an Expatriation Trust, to reduce the potential expatriate’s net worth below the $2 million net worth test. The Expatriation Trust should be formed as an irrevocable (non- grantor) discretionary U.S. domestic trust. The Expatriation Trust should be drafted to complete the transfer for U.S. transfer tax purposes (harvesting the Settlor’s unified credit). The trust must also qualify as “non-grantor” for U.S. income tax purposes (with trust income taxed to the trust). To avoid potential inclusion under Section 877A, the potential expatriate should also release any powers over trust assets (i.e. powers of appointment). As this vehicle remains a domestic trust under Section 7701, Section 684 (deemed mark to market sale) would not apply to the transfer of assets into the trust. The potential expatriate may retain the ability to remove and replace independent trustees. Following the passage of three years from funding, Section 877A would not apply to the assets held in trust. “ Moreover, future distributions from the Expatriation Trust to U.S. beneficiaries (or the expatriate) would also avoid the Section 2801 “Inheritance Tax” (discussed in our next article).

Use of Domicile Planning

Alternatively, as discussed above, the non-citizen settlor may utilize foreign domicile transfer tax planning before expatriating. For non-citizen “covered” expatriates (long term green card holders), another possible strategy (to avoid U.S. transfer taxes on foreign assets) is to make transfers after permanently departing the U.S. Although an individual may be a U.S. resident (green card holder) for U.S. income tax purposes, domicile (the standard for residence for estate and gift tax purposes) depends on the intent to remain in the U.S. There is no quantitative “substantial presence test” or “green card test” deeming the non-citizen a resident for estate and gift tax purposes. Domicile may therefore be transferred outside the U.S. based on the intent of the taxpayer to leave permanently. Transfers made while a non-domiciliary, non-citizen for estate and gift tax purposes are not subject to U.S. transfer taxes, unless the property gifted is tangible and located in the U.S.

While maintaining U.S. income tax residency, the proposed expatriate establishes domicile outside the United States. Transfers of non-U.S. situs assets are then not subject to U.S. transfer tax. Moreover, the transfer of certain U.S. situs intangible assets avoids U.S. gift tax (including gifts to U.S. donees). For a resident alien with substantial non-U.S. assets and U.S. situs intangibles, U.S. transfer tax may be avoided. Following the passage of three years from such transfers, Section 877A does not apply the deemed sale rule to the assets transferred. This strategy may also permit the potential expatriate to completely avoid the Exit Tax (if transfer brings net worth below $2 million).

Sale of Personal Residence

The sale of the expatriate’s principal residence (prior to expatriation (for cash), removes the value of the home from the $2 million “net worth” test. The actual sale prior to expatriation reduces net worth and avoids taxable gain. Note that, in the event of a deemed sale of the homestead upon expatriation, the popular Section 121 income tax exclusion (excluding gain from the sale of a principal residence) is likely not available to a "covered expatriate".

Conclusion

Expatriation from the U.S. must be carefully planned. Abandonment of U.S. citizenship or long- term residency triggers both the Exit Tax and the Inheritance Tax. The Exit Tax deems sold all assets held worldwide by the expatriate. Tax may be potentially avoided by limiting income and net worth (through gifts, transfer tax avoidance strategies, and sale of the principal residence). We explain the Inheritance Tax in our next article.

i. 8 USC §1481. [Loss of nationality by native-born or naturalized citizen; voluntary action; burden of proof; presumptions]

ii. Under IRC § 877(e)(2), 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 8 taxable years during the period of 15 taxable years ending with the taxable year during which the relinquishment occurs.

iii. IRC §877(g)(1)

iv. Topsnik v. Commissioner of Internal Revenue, 146 T.C. 1, 121 (2016)

v. Deferred compensation specified tax-deferred accounts and interests in non-grantor trusts are taxed independently of the mark-to-market tax, under § 877A(c).

vi. Topsnik at 15.

vii. Confronting the New Expatriation Tax: Advice for the U.S. Green Card Holder, John L. Campbell and Michael J. Stegman, ACTEC Journal 266 (2009).

viii. IRC §7701(b)(3); See Treas. Reg. §301.7701(b)-1(b)(3).

ix. Note that IRC §877A(g)(1)(B) provides two technical exceptions to "covered expatriate" status. The two exceptions exclude individuals (1) born with dual citizenship, taxed as a resident of the other country (as of the expatriation date), and who have not lived more than 10 out of the last 1S years in the U.S.; and (2) who have relinquished U.S. citizenship before attaining the age of 18 , and have not lived in the U.S. for more than 10 years before the expatriation date.

x. Note that statutory exceptions may apply to exclude certain persons from "covered expatriate" status (even if the tests are otherwise satisfied). These statutory exceptions pertain to certain persons who are dual citizens at birth and minors who have relinquished U.S. citizenship prior to reaching age 18 / years old and have been income tax residents of the U.S. for no more than 10 years within the 15-year period ending with the taxable year of the expatriation.

xi. IRC § 877(a)(2)(A); Rev. Proc. 2019-44

xii. Section 2(B) of Notice 2009-85, referencing § III of Notice 97-19.

xiii. Topsnik at 13, quoting IRC §877A(a)(2)(C); The IRS has promulgated guidance regarding 877A in Notice 2009-85 (the “Notice"). Although courts (including the Tax Court) are not legally bound by the Notice which lacks the status of primary authority, it is an official statement of the IRS’ position and may thus serve as persuasive authority a court may consider in interpreting Section 877A. ii The Notice explains that for purposes of certifying tax compliance for the five years before expatriation pursuant to §877(a)(2)(C): All U.S. citizens who relinquish their U.S. citizenship and all long-term residents who cease to be lawful permanent residents of the United States (within the meaning of section 7701(b)(6)) 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. Individuals who fail to make such certification will be treated as covered expatriates within the meaning of section 877A(g).

xiv. IRC §877A(a)(1); Rev. Proc. 2019-44; See also “Expatriating and Its U.S. Tax Impact”, by Robert W. Wood, BNA Daily Tax Report, Vo. 2011, No. 17, dated January 26, 2011

xv. Id.

xvi. Id.

xvii. IRS Notice 2009-85 contains detailed rules on the deferral election.

xviii. Notice 2009-85, 2009-2 C.B. 598 (October 15, 2009)

xix. Treas. Reg. §1.6012-1(b)

xx. IRC § 877A(a), (h)(2)

xxi. Notice 2009-85 at Section 3.D.

xxii. See, e.g. IRC §2035(c)(3)

xxiii. IRC §2523

xxiv. IRC §203S(c)(3).

xxv. IRC § 2035(a); Treas. Reg. § 25.2501-1(b).

xxvi. See discussion regarding the establishment of domicile; See Treas. Reg. §25.2501-1(b)

xxvii. Id.

xxviii. IRC §2501; Treas. Reg. §25.2501-1(a)

xxix. If seller took back an installment note, however, the note would be property subject to the “mark to market” tax regime. Upon expatriation seller (if a “covered expatriate”) would have to recognize gain on the deemed sale of such installment obligation at fair market value. As noted, separate estate tax principles are used to determine what property is subject to the mark-to-market tax. Section 20.2033-1(b) of the Estate Tax Regulations lists examples of property includible in a decedent’s gross estate and provides, in relevant part, that “[n]otes or other claims held by the decedent are likewise included.” See also Topsnik v. Comm’r, 146 T.C. 1 ( 2016) at 16.

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