Important Taxable Assets when Exiting the US Tax System

Important Taxable Assets when Exiting the US Tax System

When a US person who is considered a US Citizen or Long-Term Lawful Permanent Resident (LTR) decides to formally exit the US tax system through expatriation, they may become subject to exit tax if they are considered a covered expatriate. But, just because a person is considered a covered expatriate does not mean they will become subject to exit tax. In other words, the exit tax is not a wealth tax but rather a tax on the non-recognized gain on certain assets, along with deemed distributions of other assets such as ineligible deferred compensation and specified tax-deferred assets. There is lots of misinformation online regarding expatriation in general — and more specifically, what type of assets may become subject to the exit tax. Let’s take a look at five important taxable assets to consider if you were going to exit the US tax system.

Traditional IRA and Ineligible Roth IRAs

An IRA is considered a specified tax-deferred account. While it is a type of account used for retirement, it is generally not an employee pension and therefore is not treated the same as a 401(k) for expatriation — realizing, that some taxpayers will roll over their 401(k) into an IRA when they start making contributions since it will provide them more latitude in making investments –– and its impact on the exit tax is beyond the scope of this initial introduction. With a traditional IRA, it is considered to be deemed distributed at expatriation, which means that the value is included in the final tax return as part of the taxable income. When it comes to a Roth IRA it will generally escape tax since it is post-tax dollars, but it must meet the requirements are otherwise required for a Roth IRA in the United States — so that if distributions are being taken prematurely, It may still be taxable although premature IRS withdrawal penalties may be avoided.

Mark-to-Market Gain on Securities

When a person has stocks, funds, or other investments, they are subject to the mark-to-market tax regime at the time of expatriation. In general, this means that a person will look at the value of the basis of the assets and subtract it from the Fair Market Value on the day before expatriation to arrive at the amount of phantom income to be included on the final tax return. Step-up basis values may apply, as well as an exclusion amount on the total amount of gain.

RSU Tax Complications

RSUs in general are complicated even outside of the world of exit tax — but even more so when expatriation is involved. That is because unlike an RSA in which the person has already been awarded the asset, with an RSU it may not have vested yet and therefore technically the employee does not have the right to do anything with the RSU. From an exit tax perspective, that does not mean the RSU has no value. Rather, the value of the RSU is included at the time of expatriation and this analysis can be relatively complicated.

Ineligible Deferred Compensation (Step-up)

Unlike a 401(k) which is considered eligible deferred compensation — and therefore is not taxed at the time of expatriation — ineligible deferred compensation is taxable and is grossed up as part of the total income in the final tax return. This can become a major source of tax and headache, especially for US citizens and lawful permanent residents working abroad because they may have accumulated sizeable value in their foreign pension plans, such as an Australian Superannuation “Super” or Singaporean Central Provident Fund “CPF”. These types of assets are taxable as ineligible deferred compensation and the value is grossed up with the other income on a final tax return (step-up basis may apply).

Eligible Deferred Compensation (Later Date)

For illustrative purposes, it is important to understand the distinction between eligible and ineligible deferred compensation. When it comes to eligible deferred compensation such as 401(k), while the value of the 401(k) is used to determine the total value in analyzing whether the person is a covered expatriate under the net worth test, the value is not grossed up at the time of expatriation — unless that is the strategy the taxpayer prefers and/or certain mistakes and timing issues arise with reporting 401K. Instead of being taxed at exit, once the taxpayer receives distributions as a non-resident alien, the United States will withhold 30% as FDAP – unfortunately, the taxpayer irrevocably waives the ability to ake a treaty election to reduce the withholding at the time of exit.

(Proposed Regulation) PFIC

Even if a person is not subject to exit tax because they are not a covered expatriate, they may still become subject to a quasi-exit tax based on proposed regulations involving PFIC. These proposed regulations provide that when a person gives up their US status this is the equivalent of disposing of the PFIC and therefore this may become a taxable event resulting in excess distributions unless certain elections were made – depending on the value of the PFIC may result in a significant tax impact.

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