- 1 Expatriation Tax and US Expatriates
- 2 Understanding the US Exit Tax
- 3 Citizens and Legal Permanent Residents (Long-Term) Only
- 4 Only Covered Expatriates are Subject to Expatriate Tax
- 5 Covered Expatriate does NOT Mean Exit Tax
- 6 Expatriation Tax at Exit is More than Mark-to-Market
- 7 Ready, Aim, Fire – Not Ready, Fire, Aim
- 8 Golding & Golding: About our International Tax Law Firm
Expatriation Tax and US Expatriates
Expatriation Tax and US Expatriates: With the way 2020 and 2021 turned out, it’s no wonder so many US taxpayers have decided to give up their US person status and expatriate. Common questions include:
What is expatriation?
Who is subject to Exit Tax?
What are the tax consequences of relinquishing Permanent Residence or renouncing US Citizenship?
For many taxpayers, the main catalysts in giving up their US person status are the tax and reporting consequences of the US worldwide income and global reporting. Unfortunately, if an expatriate is deemed a Covered Expatriate, it may not place them in any better tax position once they leave their US Person status behind them.
Therefore, it is important to understand what is involved with expatriation tax (before performing the expatriating act).
Understanding the US Exit Tax
To put you in the mindset of what the US Exit Tax is, picture yourself going on an imaginary trip to a bubble gum moon with your kids. Your children may think you’re actually on a spaceship traveling to a bubble gum moon — but in reality, you are crouched together on an old bean bag they found in the garage as you all work your way towards a worn-out disco ball with an even older piece of gum stuck on it.
Exit tax calculations are the IRS’s version of taking a tax trip to the bubblegum moon. When it comes to exit taxes, you are calculating unrealized gains for sales of stock that have not happened yet. You also calculate imaginary distributions for transactions (such as pension distributions) for income that has not even been distributed yet — and may never occur. In other words, you are not actually selling or receiving anything.
Stated another way, when calculating the exit tax — while you don’t actually sell your assets, you still have to take a make-believe trip to the bubble gum moon to pretend you are selling your assets and receiving distributions from deferred compensation and other tax-deferred products.
The idea of the expatriation tax is the concept that if a US person falls into one of the two categories of being a Long-Term Resident or US Citizen and (1) they have assets that have accrued in value and/or (2) they have amassed certain deferred income or tax-deferred investments — then when it’s time for this person to leave the United States, the IRS wants their fair share of that unrealized gain — even if it was never to materialize at a future date.
The way the IRS accomplishes its goal is by having the taxpayer calculate the perceived gains and deemed distributions on these monies.
- Important: Just being an expatriate does not mean you are “covered,” and just being a Covered Expatriate does not mean you owe any exit tax.
Unrealized Capital Gain Example
Let’s say for example that you purchased a stock for $1, 10 years ago as a Permanent Resident and now it’s worth $3,000 a share (nice job!). Well, the IRS wants to calculate the FMV value of the shares on the day before you expatriate, subtract that from the basis you paid — and now you will pay tax on what the perceived gain is.
This is all despite the fact that you may have no plans to sell the stock. When you do actually decide to sell in the future, perhaps the stock drops significantly in value but that is of no consequence to the IRS.
Citizens and Legal Permanent Residents (Long-Term) Only
Expatriation was previously only an absurdity that US citizens had to deal with, but about 25 years ago, the US government expanded the definition to include Legal Permanent Residents who qualify as a Long-Term Resident or LTR. A Long-Term Resident is a Legal Permanent Resident who has had the status of a Legal Permanent Resident in eight of the last 15 years.
This brings us to our first important point, which is that these are the only two types of individuals who may even be subject to exit tax.
Even if you have been on an H1B, EB-5, or L-1 visa for a hundred years, you are not subject to the exit tax.
Only Covered Expatriates are Subject to Expatriate Tax
Even if you may be considered a Long-Term Resident or US Citizen, that does not mean you will be subject to exit tax. Rather, in order to become subject to the exit tax you must be a covered expatriate. There are three (3) tests a taxpayer can use to determine whether or not they fall into the category of covered expatriate:
Net Income Tax Liability Test; or (not “and”)
Failure to Certify under Penalty of Perjury of Five Years of Tax Compliance Test.
In order to be considered a covered expatriate, the taxpayer only has to meet one of these tests —
The goal of the taxpayer is not to meet any one of these tests.
There are further safeguards in place so that even if a person is considered a Covered Expatriate under one of the tests, they may still be exempt from covered expatriate status if they meet any of the exceptions.
Covered Expatriate does NOT Mean Exit Tax
Just because a person is a Covered Expatriate does not mean they will owe any exit tax.
Here is an Example
David is a US Citizen who is worth $4,000,000. He bought $4,000 worth of stock 25 years ago, which is now worth $4,000,000. Chances are that absent some exit tax planning, David will have to pay tax on a portion of the gain minus the exclusion amount.
Conversely, Dean is a US Citizen who is worth $25,000,000 — but it’s all in cash. Dean will not owe any exit tax when he expatriates, because there is no mark-to-market gain or deemed distribution on cash in a bank account.
Stated another way, the idea behind the exit tax is that the US government wants a portion of the tax that they would have received on unrealized gain. The nearly $4,000,000 of unrealized gain in David’s stock is subject to capital gains tax when he sells it. Therefore, if he expatriates, then the US will consider the day before he expatriates as the date of the sale based on whatever the fair market value is at that time — noting that David really has no plans to sell the stock.
With Dean, the US government is not entitled to any tax on his cash because there is no unrealized gain in the cash.
Expatriation Tax at Exit is More than Mark-to-Market
While the most common phrase you will hear in your exit tax research is mark-to-market for unrealized gain of certain stocks and securities — there is more to exit tax than mark-to-market.
There is something called deemed distributions, which applies primarily to tax-deferred accounts (such as certain IRAs) and other ineligible deferred compensation. Most foreign deferred compensation will be considered ineligible, which is in contrast to eligible deferred compensation such as a 401K which is not subject to the deemed distribution rules unless the expatriate makes a mistake and does not update the administrator within 30 days.
Foreign Retirement Plan Trap
One common situation that occurs often is when a person has a high-net-worth because they have deferred investments.
When a person has foreign retirement, it is usually categorized as “ineligible deferred compensation.” As a result of the ineligible deferred compensation, a taxpayer may have a significant tax consequence because that money will be deemed distributed on the day before expatriation. Even though there is no mark-to-market on the deferred foreign compensation, it is deemed distributed on the day before expatriation.
This may result in a significant tax liability which may be difficult for the taxpayer to pay since they have not actually distributed any money from their foreign retirement.
*There may be a step-up basis depending on what the value of that foreign retirement was before the person became a US person if it was earned outside of the United States.
Beware of Estate Tax Traps
Do NOT perform the expatriating act (such as I-407 or DS-4079-DS-4083) until you have planned for exiting the US. You cannot go back and unwind the act. This is very important for high-net-worth individuals planning to give future gifts to US-person children.
Under Internal Revenue Code 2801, a Covered Expatriate is typically going to be hit with a 40% tax on gifts given to US persons (absent the exclusion rules for charities and spouses).
In a common scenario, a parent who is now a Covered Expatriate — but has children who are considered US persons — may impute an immediate tax consequence to their US person child by gifting them money or assets.
Ready, Aim, Fire – Not Ready, Fire, Aim
When a person is considered a Covered Expatriate, they may have significant tax consequences when they exit the United States, along with future tax consequences in the future. With expatriation, taxpayers should be sure to plan before exiting — since unwinding the expatriating act can be nearly impossible and the future tax consequences of being a Covered Expatriate can be costly for the expatriate and US person family members.
Golding & Golding: About our International Tax Law Firm
Golding & Golding specializes exclusively in international tax, and specifically IRS offshore disclosure.
Contact our firm today for assistance.