The following is a guest blog post by Jacob Stein, a partner with Klueger & Stein, LLP in Los Angeles. Mr. Stein practices international taxation and structures cross-border business transactions.
An increasing number of Americans are opting for an expatriate life. In fact, as MSN reports, more Americans than ever have renounced their U.S. citizenship in the first quarter of 2015. Moving abroad and getting a new citizenship may cut off the U.S. government’s ability to recover taxes from the expat because the U.S. will no longer have personal jurisdiction over that person. That’s where the “exit tax” comes into play—the expatriation rules of the Internal Revenue Code seek to extract a tax while the U.S. still has jurisdiction.
Expatriation, which refers not simply to leaving the U.S. and living abroad, but rather to surrendering U.S. citizenship or permanent residency, can result in a long-term income tax advantage, because nonresident aliens (individuals who are neither U.S. citizens nor U.S. residents) are subject to tax only on their U.S.-source income.
The Heroes Earnings Assistance and Relief Tax Act of 2008 (HEART Act) (Pub L 110–245, 122 Stat 1624) has tried to address this issue by taxing the expat on all of the accrued appreciation in his or her property on the date of the expatriation. See IRC §877A.
Covered expats include those who relinquish his or her U.S. citizenship or permanent resident status (held for at least 8 of the prior 15 years) and who
- have an average annual net income tax liability for the preceding 5 years of $157,000 (for 2014),
- have a net worth of $2 million or more, or
- fail to certify compliance with U.S. tax obligations for the prior 5 years.
Covered expats are taxed on the unrecognized gain in their property to the extent that such gain exceeds $680,000 (for 2014). IRC §877A(a)(3). Effectively, the covered expat is treated as if he or she sold all of his or her assets, worldwide, for their fair market value on the day before expatriation. See IRS Notice 2009–85. The difference between value and tax basis is taxed at capital gain rates.
If the covered expatriate owns tax-deferred accounts (e.g., a 401(k) plan), he or she must file IRS Form W-8CE with the plan to notify the plan that all payments from the plan to the covered expatriate are subject to income tax withholding at the rate of 30 percent. IRAs and certain other specific plans are subject to an immediate exit tax. See IRC §877A(e).
In addition, the HEART Act introduces a new set of rules for taxing gifts made by covered expatriates to U.S. citizens and residents (other than to a spouse or a charity). See IRC §2801.
There are ways a would-be expat can plan for the exit tax. For example,
- Sell the expat’s home before expatriation. Because the exit tax applies to the extent that all assets owned by the expat have a built-in gain in excess of $680,000, and the expat can’t increase that threshold by the IRC §121 gain-exclusion amount, the expat should sell the residence before expatriation and take advantage of the §121 gain exclusion.
- Make assets separate property of non-expatriating spouse. When only one spouse expatriates and the other remains a U.S. citizen, California spouses may enter in a transmutation agreement that makes certain assets the separate property of the spouse that will remain a U.S. citizen and thus reducing the assets of the expatriating spouse.
- Move to liquid assets. Only assets with a built-in gain present a problem in the mark-to-market regime. Slowly converting property into liquid form may solve that problem.
- Own less in the U.S. and more outside. It’s generally desirable to position the expat to own fewer assets in the U.S. and more assets outside the U.S.
Get much more useful information on international tax issues in Mr. Stein’s articles A Lawyer’s Guide to International Taxation, Parts I and II, in the Winter 2014 and Spring 2015 issues of CEB’s California Business Law Practitioner.
Other CEBblog™ posts you may find useful:
- Tax Tip for California Resident Trustee with Nonresident Beneficiaries
- Second Bite at the Apple: How Unregistered Domestic Partners (and Other Cotenants) Can Still Avoid Property Tax Reassessment
- Opening a Law Practice? Pay Attention to Tax Issues
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