Section 877 of the Internal Revenue Code (Code) establishes 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 United States for more than 30 days.[i]
The principal income tax effect of Section 877 is to impose income tax on otherwise tax-exempt U.S.-source income (of a non-resident alien). For example, the expatriate may not avoid income tax on (a) bank account interest, (b) “portfolio interest” or (c) capital gains earned from trading in U.S. stocks and bonds.
The Exit Tax under Section 877A
The Heroes Earnings Assistance and Relief Tax Act of 2008 (the HEART Act) added Section 877A. Section 877A(a) imposes a mark-to-market exit tax on “covered expatriates.” Under Section 877A(a)(1), all property owned by a “covered expatriate” is treated as being sold on the day before expatriation for its fair market value.[ii] The exit tax is an income tax on (a) unrealized gain from a deemed sale of worldwide assets on the day prior to expatriation and (b) the deemed distribution of IRAs, section 529 plans, and health savings accounts (taxed at ordinary income rates).
The mark-to-market regime taxes unrealized gain on the covered expatriate’s worldwide assets.[iii] The rates of tax differ according to asset involved. Long-term capital gain assets and qualified dividends receive the applicable preferential rates. The exit tax is generally payable immediately (i.e., April 15, 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.
Long-Term Permanent Resident (Green Card Holder)
An expatriated green card holder is subject to §877A as a “covered” expatriate only if he or she is a “long-term permanent resident” prior to expatriation. A long-term lawful permanent resident is a green card holder during 8 of the previous 15 years prior to expatriation. If a green card holder expatriates before this “8 of 15” test is met, Section 877A does not apply. A U.S. resident alien (under the U.S. substantial presence income tax test)[iv] is not subject to the expatriation tax if the resident has no green card.[v]
Section 877A applies to only covered expatriates who meet any one of the three tests, set out in Section 877(a)(2)(A)–(C).[vi]
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 ($190,000 for 2023).[vii] An individual who files a joint tax return must take into account the net income tax reflected on the joint return.[viii]
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.”[ix] Individuals without considerable assets or income may be covered expatriates by failing to certify tax compliance.
Exemption Amount – $821,000 (adjusted for inflation)
Under Section 877A(a)(3), if a taxpayer’s deemed gain is less than $821,000 (adjusted for inflation), there is no tax due.[x] If the covered expatriate’s gain exceeds the exemption, the gain must be calculated pro rata among appreciated property.[xi]
Special Deferral Rules of Section 877A(b)
The Exit Tax deemed sale may strain liquidity to cover the tax, as no actual sales proceeds are available. Payment may be 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.[xii]
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.[xiii] 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 United States) are not eligible for the step-up.[xiv]
Potential Planning Strategies
Outright Gifts – To Spouse and Others
The proposed expatriate may gift assets sufficient to reduce his or her net worth below the $2 million net worth test, for characterization as a covered expatriate. For example, before expatriation, an expatriate may use the Section 2503(b) annual exclusion (currently $17,000 per done) to make nontaxable gifts, or alternatively make larger gifts by utilizing his or her unified estate and gift tax credit.
A potential expatriate may also make unlimited tax-free gifts to a U.S. citizen spouse (prior to expatriation).[xv] 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 United States) may take advantage of a full unified estate and gift tax credit ($12,920,000 in 2023) by implementing general U.S. transfer tax avoidance strategies before expatriation. These include utilizing lack of marketability and lack of control valuation discounts for potential transfers, gifts to domestic irrevocable trusts (e.g., grantor retained annuity trusts, qualified personal residence trusts, intentionally defective grantor trusts, charitable lead trusts, charitable remainder trusts).
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).
Use of Domicile Planning
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 United States. 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 United States. There is no 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 United States based on the intent of the taxpayer to leave permanently.[xvi] 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 United States. This strategy may permit the potential expatriate to completely avoid the Exit Tax (if transfer brings net worth below $2 million). [xvii]
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.[xviii] 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.
Abandonment of U.S. citizenship or long-term residency may trigger the Exit Tax and the Inheritance Tax. The Exit Tax deems the expatriate to have sold all assets held worldwide. Tax may be potentially avoided by limiting income and net worth through gifts and transfer tax avoidance strategies. We explain the Inheritance Tax in our next article.
Gary Forster is managing partner and co-founder at the law firm of ForsterBoughman. Orlando, Fla.st.
[i] IRC §877(g)(1)
[ii] Topsnik v. Commissioner of Internal Revenue, 146 T.C. 1, 121 (2016)
[iii] Confronting the New Expatriation Tax: Advice for the U.S. Green Card Holder, John L. Campbell and Michael J. Stegman, ACTEC Journal 266 (2009).
[iv] IRC §7701(b)(3); See Treas. Reg. §301.7701(b)-1(b)(3).
[v] 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 15 years in the U.S.; and (2) who have relinquished U.S. citizenship before attaining the age of 18 ½ , and have not lived in the U.S. for more than 10 years before the expatriation date.
[vi] 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 ½ 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.
[vii] IRC § 877(a)(2)(A); Rev. Proc. 2019-44
[viii] Section 2(B) of Notice 2009-85, referencing § III of Notice 97-19.
[ix] 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.[ix] 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).
[x] 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
[xii] IRS Notice 2009-85 contains detailed rules on the deferral election.
[xiii] IRC § 877A(a), (h)(2)
[xiv] Notice 2009-85 at Section 3.D.
[xv] IRC §2523
[xvi] See discussion regarding the establishment of domicile; See Treas. Reg. §25.2501-1(b)
[xvii] IRC §2501; Treas. Reg. §25.2501-1(a)
[xviii] 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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