The number of individuals expatriating from the U.S. is at an all-time high. In 2014, nearly 3,500 individuals surrendered their U.S. citizenship or green cards. Fifteen years ago, in 1998, there were fewer than 400 such individuals. Why are so many more Americans expatriating now? The decision to expatriate is a complicated and personal one, but there are several factors that may be resulting in increasing expatriation, particularly for U.S. citizens residing abroad. U.S. citizens and green card holders are subject to taxation on their worldwide income, which often will require advisors and accountants who are well versed in foreign tax credits and potential treaty benefits. There is also well-publicized reporting required for U.S. taxpayers with foreign bank accounts and ownership interests in foreign entities. In addition, U.S. citizens and green cardholders are finding it increasingly difficult to open foreign bank accounts, and may also be subject to new, onerous reporting obligations associated with their foreign bank or financial accounts because of the Foreign Account Tax Compliance Act (commonly known as “FATCA”). U.S. citizens and green card holders who wish to expatriate should keep in mind that under a current law known as the Reed Amendment, re-entry into the U.S. by that expatriate could be denied if the U.S. attorney general determines that the expatriate surrendered citizenship or green card for tax avoidance purposes.
A U.S. citizen or green card holder who is deciding whether to relinquish his or her status should consider the income tax and transfer tax consequences of that decision, and whether there may be planning opportunities to avoid or minimize any tax burden. This article will describe what it means to be a “covered expatriate” and the tax effects of that status, as well as some of the techniques that an expatriate may wish to consider when planning for future expatriation.
Covered Expatriate Status
Those individuals who would have income tax and transfer tax consequences to expatriations are known as “covered expatriates.” In order to be a “covered expatriate,” an individual must first be an “expatriate.” An expatriate is a U.S. citizen who surrenders his U.S. citizenship or a person who relinquishes a green card that has been held for 8 of the last 15 calendar years. Individuals who are U.S. taxpayers by election1 or because of their substantial presence2 within the U.S. are not considered expatriates.
Green card holders should be aware that possession of a green card for even one day of a calendar year will constitute a full calendar year. Therefore, a person who receives his green card on December 31, 2001, and relinquishes it on January 1, 2008, is an expatriate under these rules. Accordingly, a green card holder should evaluate, well in advance of his eighth year of holding the green card, whether or not to surrender it.
Not all expatriates are covered expatriates. A covered expatriate is generally an expatriate who satisfies one of the following three tests:3 (i) the Certification Test, (ii) the Net Income Tax Test, and (iii) the Net Worth Test. Accordingly, an expatriate must fail all three tests in order to not be a covered expatriate so as to avoid expatriation-related U.S. tax penalties.
Under the Certification Test, an expatriate will be a covered expatriate if he fails to certify under penalties of perjury that he is compliant with all U.S. federal tax obligations under the Internal Revenue Code (“Code”) for the five taxable years preceding expatriation, or if he fails to submit evidence of compliance as may be requested. Federal tax compliance for purposes of the Certification Test means not only income tax compliance, but also compliance in all other areas of the Code, such as employment taxes, gift taxes, and information returns. Individuals who otherwise would not be covered expatriates should be careful to come into full tax compliance prior to expatriating, as there does not appear to be a “de minimis” exception to the rule.
For individuals who have been diligently filing their U.S. tax returns annually, it is particularly important to thoroughly review compliance with all U.S. information returns and disclosure obligations. Some of the disclosure requirements are difficult to comply with absent proper professional advice, such as the obligations to disclose foreign bank/financial accounts and the new disclosure obligations under FATCA. Individuals who may have unreported or omitted income in previous years should consider taking advantage of one of the IRS voluntary disclosure programs.
Net Income Tax Test
The Net Income Tax Test provides that expatriates who have an average annual net income tax liability in excess of a certain threshold for the five taxable years preceding expatriation are covered expatriates. The income tax liability threshold is indexed for inflation and is $160,000 for 2015. Individuals may be able to plan to reduce their income tax liability on a prospective basis in many ways, such as reducing wage income, adjusting investments to dividends, and realizing losses. In addition, it may be possible to reduce income taxes on a retroactive basis for married couples who have filed jointly by amending tax returns for prior years using a “married filing separately” status. While this may result in an increase in total income tax liability, it may reduce each individual’s overall tax liability to fall below the Net Income Tax Test threshold.
Net Worth Test
Under the Net Worth Test, an expatriate is a covered expatriate if his net worth as of the date of expatriation is $2 million or more. Unlike the threshold for the Net Income Tax Test, this $2 million threshold is not indexed for inflation. An individual will be considered to own any interest in property (including trusts) that would be taxable as a gift if he gave it away prior to expatriation. The property of an expatriate for purposes of the net worth test would generally be valued in the same manner as assets are valued for federal gift tax purposes; i.e., “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.”
Accordingly, there are several ways in which a taxpayer may be able to plan in order to fall under the $2 million net worth threshold. The individual may wish to make completed gifts to others by giving annual exclusion gifts, making payments for educational or medical expenses, or making use of his or her $5.43 million federal gift tax exemption. If the taxpayer has interests in trusts, he may consider disclaiming or renouncing that interest, or the trustee of the trust may consider eliminating the taxpayer’s interest in the trust by decanting. Finally, the individual may consider structuring his assets in a manner so that he could take advantage of potential valuation discounts, such as a discount for lack of control or a discount for lack of marketability on the gift of a minority interest in an illiquid security.4 By reducing the expatriate’s net worth through gifts, disclaimers, and valuation discounts, the taxpayer is potentially able to avoid covered expatriate status.
Tax Consequences of the Expatriation of Covered Expatriates
Perhaps the most widely known consequence of the expatriation of a covered expatriate is the exit tax upon expatriation. In general, all of the worldwide property of the covered expatriate5 will be treated as if it were sold on the day before expatriation at Fair Market Value. The covered expatriate will owe a one-time income tax on the amount of gain (offset by any losses) that exceeds the exemption amount, which is currently $690,000 and is indexed for inflation. The property owned by a covered expatriate would be valued in the same manner as assets are valued under the Code for federal estate tax purposes, which is the same “willing buyer, willing seller” standard discussed above. Importantly, valuation discounts would be available to potentially reduce the exit tax paid by a covered expatriate. Because the value of assets under the Net Worth Test is determined in a similar manner as the basis for the mark-to-market exit tax, potential planning by an expatriate to fall under the $2 million threshold would also serve the dual purpose of reducing the tax base for the exit tax.
Transfer Tax Consequences
A covered expatriate will have lasting U.S. transfer tax consequences if he gives property by gift or bequest to U.S. citizens or residents or to a U.S. domestic trust (which are generally known as “covered gifts” or “covered bequests”). In general, a transfer tax will be due not only with respect to covered gifts and bequests, but also to distributions from a foreign trust attributable to a covered gift or bequest. Unlike the application of gift taxes to U.S. citizens and residents, the transfer tax on covered gifts and bequests is paid by the recipient. The result is a gift that is “tax inclusive” like the U.S. estate tax, and is thus more expensive than the gift tax that is regularly imposed on U.S. citizens and residents. In addition, while the exit tax is a one-time tax, the transfer tax consequences of expatriation taint the covered expatriate for life (or potentially even longer, if the covered expatriate funded a foreign trust). The tax will apply to covered gifts and bequests even if the assets were acquired after expatriation and even if the recipient of the covered gift or bequest was not a U.S. person at the time of expatriation.
For all of these reasons, it would be more efficient for the covered expatriate to make gifts to U.S. beneficiaries or trusts prior to expatriation. And if the covered expatriate would like to make further gifts after having expatriated, there are helpful exceptions to the rule that he may take advantage of. First, the transfer tax does not apply to covered gifts or bequests that are made for Fair Market Value or that are already subject to U.S. gift tax (such as gifts of U.S. situs property or gifts that occur while the covered expatriate is a U.S. domiciliary). To determine the Fair Market Value of hard-to-value assets, it would be necessary to obtain a qualified appraisal.
Second, transfers by a covered expatriate that are under the annual exclusion amount will not be subject to a transfer tax. It should be noted that there is no exception to this transfer tax for the payment of medical or educational expenses by a covered expatriate for the benefit of a U.S. person.
Third, in general, transfers by a covered expatriate that would have qualified for the gift tax or estate tax marital deduction or charitable deduction would not be subject to a transfer tax. This means that a covered expatriate could establish and fund a lifetime marital trust for his spouse without the imposition of a transfer tax. However, caution should be exercised if the covered expatriate’s spouse is not a U.S. citizen, because qualified domestic trusts do not appear to be exempt from the transfer tax. Thus the establishment of a qualified domestic trust for the spouse of a covered expatriate may be subject to double transfer tax.
Finally, there does not appear to be a generation-skipping transfer (“GST”) tax imposed on covered gifts or bequests. Accordingly, a covered expatriate should be able to make transfers to U.S. grandchildren or more remote descendants without the imposition of an extra GST tax.
The U.S. transfer tax imposed by covered gifts and bequests by covered expatriates is onerous, but if the covered expatriate makes transfers to U.S. persons or trusts prior to expatriating, and limits his transfers to U.S. persons to annual exclusion gifts, transfers to grandchildren, and transfers that qualify for the marital or charitable deduction, the covered expatriate will be in no worse position from a transfer tax perspective than he would have been if he had stayed a U.S. citizen or green card holder.
Chi-Yu Liang, Esq. is a Partner at Withers Bergman LLP. She can be reached at +1.212.848.9814 or Chi-Yu.Liang@withersworldwide.com.
Individuals considering expatriation should plan well in advance in order not to pay a heavy U.S. tax penalty. In addition, they should review their U.S. tax compliance history and remedy any deficiencies. Valuation techniques will be important in many aspects of the expatriation planning.
1 For example, someone who is neither a citizen nor resident of the US could elect to file US tax returns jointly with her US spouse.
2 If someone otherwise is not subject to US tax but for her physical presence in the US, then this person is considered as meeting the so called “substantial presence test.” Very broadly speaking, if this person physically stays in the US for at least 122 days every year, the substantial presence test is met.
3 There are some exceptions to covered expatriate status, most notably certain individuals who were dual citizens at birth and certain individuals who expatriate before age 18½.
4 Other examples of applicable valuation discounts may include a blockage discount on the gift of large blocks of publicly traded domestic or foreign stocks, or a fractional interest discount on the gift of partial interests in assets such as real estate or artwork.
5 Property is included for purposes of the exit tax if the property would be includible in the covered expatriate’s taxable estate if he had died immediately prior to expatriating. Certain property is excluded from the mark-to-market tax, such as certain eligible deferred compensation and interests in non-grantor trusts. Planning opportunities may be available to minimize taxes by analyzing any deferred compensation plans and considering the restructuring of grantor trusts as non-grantor trusts prior to expatriation.