Expatriation, Inheritance, and another Inheritance
The U.S. exit tax system contains a perverse incentive. Because the United States is in no need of capital inflows, the tax system is designed to punish U.S. citizens who give up their citizenship, then want to make gifts or inheritances to their U.S. heirs.
This blog post discusses one such situation.
Consider Fred. Fred’s parents are U.S. citizens, as are his two adult children. In order to keep things simple, let us assume that Fred is not married.
Fred gives up U.S. citizenship. At the time of giving up citizenship, Fred’s net worth was $2,500,000, all in cash, so he was a covered expatriate under the exit tax definitions.
For the purposes of this example, Fred’s parents then die, and he inherits their entire net worth of $1,500,000 cash.
To compound this sad situation, Fred dies only days after his parents (again, for the purpose of this example only), leaving all of his assets to his two adult children.
What tax must his two adult children pay on their inheritance of $4,000,000 of cash?
Aside–Covered Expatriate Defined
Fred’s status as a “covered expatriate” means one of three things — when he terminated his U.S. citizenship, he had a net worth above $2,000,000; an average Federal tax liability in the previous five years above the exit year’s threshold [$151,000 for 2012, for instance]; or he failed to file Form 8854 on time. In the example, I assumed that his net worth exceeded the threshold.
Section 2801′s Inheritance Haircut
U.S. persons who inherit assets from a covered expatriate must pay tax on whatever they receive. (This rule applies to gifts, too. However, this blog post is all about inheritances, so I am going to keep things simple and ignore gifts).
Section 2801(a) of the Internal Revenue Code is where you find the rules:
(a) In general. If, during any calendar year, any United States citizen or resident receives any covered gift or bequest, there is hereby imposed a tax equal to the product of–
(1) the highest rate of tax specified in the table contained in section 2001(c) [26 USC § 2001(c)] as in effect on the date of such receipt (or, if greater, the highest rate of tax specified in the table applicable under section 2502(a) [26 USC § 2502(a)] as in effect on the date), and
(2) the value of such covered gift or bequest.
This tax applies to everything the recipient gets above the “tax-free gift” amount in Internal Revenue Code Section 2503(b). See Internal Revenue Code Section 2801(c). In 2013, this amount is $14,000. It is indexed for inflation, so future readers of this blog post may have a different number to wrestle with.
Simple math: what you receive from a covered expatriate multiplied by the highest tax rate you can find in Section 2001(c) of the Internal Revenue Code. This is the estate tax. The current rate is 40%.
The recipient pays the tax. See Internal Revenue Code Section 2801(b).
Fred dies and leaves the princely sum of $15,000 to his U.S. citizen son.
Fred’s son must pay a 40% tax on $1,000. The first $14,000 of the inheritance is exempt from tax, but the excess ($1,000, in this example) is taxable at the highest estate tax rate in force.
Untaxable Money Becomes Taxed
Let’s go back to our example again. Fred had $2,500,000 when he expatriated. He inherited all of the money his parents had in the world ($1,500,000) and then died, leaving $2,500,000 to his two children, both U.S. citizens.
The exit tax rules of Section 2801 are remarkably easy to apply here. And they are remarkably harsh. The entire $4,000,000 (minus $28,000) received by Fred’s children will be taxed at 40%. Section 2801(a) makes the entire inheritance taxable, but Section 2801(c) makes the first tranche of $14,000 per recipient exempt from the tax.
The big problem in my example is that Fred’s parents had modest wealth–far beneath the estate tax threshold for them of $5.25 million each. Yet their $1,500,000 of net worth will be taxed at the highest possible estate tax rate. Money that should never have been taxed will now be taxed, simply because it went through the hands of a covered expatriate.
What can the players in this game choose as a tax-minimizing strategy? Well, don’t die, of course. But after that, the options available are limited:
- A covered expatriate should not allow inheritance of assets at death by U.S. taxpayers. In other words, Fred should disinherit his kids.
- A recipient should not be a U.S. citizen. In other words, Fred’s two children should follow their father and renounce their U.S. citizenship.
- A U.S. citizen should not pass wealth to a covered expatriate if the successor inheritor will be a U.S. citizen. In other words, Fred’s parents should have configured their will to skip Fred. They should have left everything to their two U.S. citizen grandchildren. Alternatively, they should have created a trust in which Fred had an income interest for life, with Fred’s two children as the remainder beneficiaries.
Trusts for U.S. Recipients
Trusts won’t work. Congress didn’t fall off the turnip truck yesterday. If Fred left all of his money in trust for his kids, the tax will be imposed anyway.
- If the trust he created is a U.S. trust, then the tax is imposed as the money goes into the trust. Internal Revenue Code Section 2801(e)(4)(A).
- If the trust he created for his two children is a foreign trust, then the tax is imposed as distributions come out of it. Internal Revenue Code Section 2801(e)(4)(B).
Action and Reaction
I see two real-life responses to this law. (Well, three actually. I’m not counting the “Submit and be assimilated” response to the Borg that the Borg really expects from all of us).
The first response is that this law encourages whole families to terminate U.S. citizenship, even if some members do not necessarily want to do so. The financial cost is too high to retain citizenship if you expect to inherit wealth from your covered expatriate parents.
The second is that capital does not flow into the United States. In most families there are U.S. citizen family members and non-citizen members. Wealth simply goes to the non-citizens to the maximum amount that the family can stomach. And sometimes that is all of it.
How to Compute Net Tax Liability for Form 8854
When you give up your U.S. citizenship (or green card), there are tax consequences. The tax consequences are benign (paperwork only) or malignant (paperwork and actual taxes to pay) dependent on whether you are a “covered expatriate” or not.
A “covered expatriate” is someone who is too rich, as far as the IRS is concerned. You’re rich if your net worth is $2,000,000 or more. You’re rich if your Federal income tax liability was high–$151,000 or more in average Federal income tax liability for the prior five years, if you gave up your citizenship/green card in 2012.
This post discusses how you compute your Federal tax liability in order to determine whether you are a covered expatriate.
Use Line 55 from Form 1040.
Form 8854, Part IV
This whole exercise ends up with you filling in five blanks on Form 8854, Part IV, Line 1. There, you report your actual Federal tax liability for the five years before the year in which you terminate your U.S. citizenship or green card. If, for instance, you terminated your U.S. citizenship in 2012, then you would fill in the blanks for 2007 through 2011.
The instructions to Form 8854 have absolutely nothing to tell you how to fill in these blanks. I guess that’s the government’s way of saying GFY. Fortunately, I’m here for you. This post will tell you exactly how to figure out the right numbers.
The Law Says…
Always start with the Internal Revenue Code. Section 877A(g) says:
For purposes of this section . . . [t]he term “covered expatriate” means an expatriate who meets the requirements of subparagraph (A), (B), or (C) of section 877(a)(2).
Section 877(a)(2)(A) says that an individual is a covered expatriate if:
. . . average annual net income tax (as defined in section 38(c)(1)) of such individual for the period of 5 taxable years ending before the date of the loss of United States citizenship [or termination of green card status] is greater than [$151,000.]
OK. We know something. We have to figure out your net income tax by using the rules in Internal Revenue Code Section 38(c)(1). We do this for the five years before the year you expatriated. We take the average of those amounts.
Let’s look at Section 38(c)(1) to see how to calculate “net income tax”. It says:
[T]he term “net income tax” means the sum of the regular tax liability and the tax imposed by section 55, reduced by the credits allowable under subparts A and B of this part. . . .
In summary, you add the regular tax liability and the AMT, then subtract credits allowable under “Subparts A and B of this part”, which mere mortals can find in Sections 21 through 30D of the Internal Revenue Code.
Internal Revenue Code Section 26(b) defines “regular tax liability”:
(b) Regular tax liability. For purposes of this part [26 USC §§ 21 et seq.]–
(1) In general. The term ‘regular tax liability’ means the tax imposed by this chapter [26 USC §§ 1 et seq.] for the taxable year.
(2) Exception for certain taxes. For purposes of paragraph (1), any tax imposed by any of the following provisions shall not be treated as tax imposed by this chapter [26 USC §§ 1 et seq.]:
(A) section 55 [26 USC § 55] (relating to minimum tax),
(B) section 59A [26 USC § 59A] (relating to environmental tax),
(C) subsection (m)(5)(B), (q), (t), or (v) of section 72 [26 USC § 72] (relating to additional taxes on certain distributions),
(D) section 143(m) [26 USC § 143(m)] (relating to recapture of proration of Federal subsidy from use of mortgage bonds and mortgage credit certificates),
(E) section 530(d)(4) [26 USC § 530(d)(4)] (relating to additional tax on certain distributions from Coverdell education savings accounts),
(F) section 531 [26 USC § 531] (relating to accumulated earnings tax),
(G) section 541 [26 USC § 541] (relating to personal holding company tax),
(H) section 1351(d)(1) [26 USC § 1351(d)(1)] (relating to recoveries of foreign expropriation losses),
(I) section 1374 [26 USC § 1374] (relating to tax on certain built-in gains of S corporations),
(J) section 1375 [26 USC § 1375] (relating to tax imposed when passive investment income of corporation having subchapter C earnings and profits exceeds 25 percent of gross receipts),
(K) subparagraph (A) of section 7518(g)(6) [26 USC § 7518(g)(6)] (relating to nonqualified withdrawals from capital construction funds taxed at highest marginal rate),
(L) sections 871(a) and 881 [26 USC §§ 871(a) and 881] (relating to certain income of nonresident aliens and foreign corporations),
(M) section 860E(e) [26 USC § 860E(e)] (relating to taxes with respect to certain residual interests),
(N) section 884 [26 USC § 884] (relating to branch profits tax),
(O) sections 453(l)(3) and 453A(c) [26 USC §§ 453(1)(3) and 453A(c)] (relating to interest on certain deferred tax liabilities,
(P) section 860K [26 USC § 860K] (relating to treatment of transfers of high-yield interests to disqualified holders),
(Q) section 220(f)(4) [26 USC § 220(f)(4)] (relating to additional tax on Archer MSA distributions not used for qualified medical expenses),
(R) section 138(c)(2) [26 USC § 138(c)(2)] (relating to penalty for distributions from Medicare Advantage MSA not used for qualified medical expenses if minimum balance not maintained),
(S) sections 106(e)(3)(A)(ii), 223(b)(8)(B)(i)(II), and 408(d)(9)(D)(i)(II) [26 USC §§ 106(e)(3)(A)(ii), 223(b)(8)(B)(i)(II), and 408(d)(9)(D)(i)(II)] (relating to certain failures to maintain high deductible health plan coverage),
(T) section 170(o)(3)(B) [26 USC § 170(o)(3)(B)] (relating to recapture of certain deductions for fractional gifts),
(U) section 223(f)(4) [26 USC § 223(f)(4)] (relating to additional tax on health savings account distributions not used for qualified medical expenses),
(V) subsections (a)(1)(B)(i) and (b)(4)(A) of section 409A [26 USC § 409A] (relating to interest and additional tax with respect to certain deferred compensation),
(W) section 36(f) [26 USC § 36(f)] (relating to recapture of homebuyer credit), and
(X) section 457A(c)(1)(B) [26 USC § 457A(c)(1)(B)] (relating to determinability of amounts of compensation).
Bwahahahahaha! Read it and weep. Can you say “Tax law is 100% bureaucratic sludge!” with me now?
For you, Ladies and Gentlemen: use Line 44 from your Form 1040.
Section 26(c) defines the term “tentative minimum tax”–needed because Section 38(c)(1) says you need it:
(c) Tentative minimum tax. For purposes of this part [26 USC §§ 21 et seq.], the term ‘tentative minimum tax’ means the amount determined under section 55(b)(1) [26 USC § 55(b)(1)].
Simple. Find this number on Line 45 of your 2012 Form 1040.
The IRS, Bein’ All Helpful ‘n Stuff
As I noted, the instructions to Form 8854 are silent. There’s nothing there. Not even wrong information. Just silence.
Notice 2009-85 tells you this, at Section 2(B):
For guidance on determining whether an individual is a covered expatriate by reason of the tax liability test or the net worth test, see Section III of Notice 97-19, 1997-1 C.B. 394.
We then look at Notice 97-19 [PDF], which tells us this at Section III:
For purposes of the tax liability test, an individual’s net U.S. income tax is determined under section 38(c)(1). An individual who files a joint income tax return must take into account the net income tax that is reflected on the joint income tax return for purposes of the tax liability test.
This is useful, because it tells us to look where we already looked (Section 38 of the Internal Revenue Code). And it is useful because it tells us what to do if you filed a joint tax return with your spouse.
Joint Tax Returns
We come now to the practical part of this blog post: what to do.
The first thing is for those of you who filed joint tax returns with your spouse. When extracting the numbers from your prior year tax returns, do not divide by two. Your net tax liability is calculated using the numbers on the joint tax return, not 50% of the numbers (which would seem logical but nope, you can’t do that).
If you are thinking about expatriating at some point in the future, start filing your tax returns using the status “Married Filing Separately” rather than “Married Filing Jointly”. You may be able to avoid covered expatriate status that way.
For example, if your annual Federal tax liability is $200,000 when you are filing jointly, you are going to be a covered expatriate. If you file separately from your spouse, you will have an annual tax liability of $100,000, which is well under the $151,000 (2012 amount) threshold.
Addition and Subtraction
In order to calculate your net tax liability, you will compute your tax liability for regular income tax and alternative minimum tax. Then you will subtract a bunch of tax credits from the total. What you end up with is the number you need to fill in the blanks on Form 8854, Part IV, Line 1.
I am going to give you the theory and the places to look on your 2012 Form 1040 to find the numbers you need. From year to year the government changes Form 1040, so for other years the Line numbers may/will be different. I’m doing 2012 for you. For other years, you’re on your own.
Start With 2012 Form 1040, Line 46
The top line number is found at Line 46 of your 2012 Form 1040. This is your total regular tax liability (Line 44) plus your alternative minimum tax liability (Line 45). Write this number down. You are going to subtract a bunch of stuff from it. Remember, it does not matter whether you your filing status was “married filing jointly” or “married filing separately”.
Then Subtract Tax Credits (TL;DR Version)
Internal Revenue Code Section 38(c)(1) told us to subtract all of the tax credits found in subparts A and B. This means Internal Revenue Code Sections 21 through 30D. Here are the tax credits you will subtract from your Line 46 amount: take the total on Form 1040, Line 54.
The Scholar’s Explanation
Because you are scholarly, you want to know the reasons behind the math. “Line 46 – Line 54 = Answer” is not enough for you. I’m here to quench your thirst for truth.
Remember that Internal Revenue Code Section 38(c)(1) told us to compute net tax liability by subtracting all of the tax credits in Subparts A and B, meaning Internal Revenue Code Sections 21 through 30D? Here they are:
- Section 21. Credit for dependent and child care. Computed on Form 2441 and reported on 2012 Form 1040, Line 48.
- Section 22. Credit for the elderly and the permanently and totally disabled. Computed on Schedule R and reported on 2012 Form 1040, Line 53.
- Section 23. Adoption credit. Computed on Form 8839 and reported on 2012 Form 1040, Line 53.
- Section 24. Child tax credit. Computed on Form 8812 and reported on 2012 Form 1040, Line 51.
- Section 25. Credit on certain mortgage interest. Computed on Form 8936 and reported on 2012 Form 1040, Line 53.
- Section 25A. Education credits. Computed on Form 8863 and reported on 2012 Form 1040, Line 49.
- Section 25B. Elective deferrals and IRA contributions by certain individuals. Computed on Form 8880 and reported on 2012 Form 1040, Line 50.
- Section 25C. Nonbusiness energy property credit. Computed on Form 5695 and reported on 2012 Form 1040, Line 52.
- Section 25D. Residential energy efficient property credit. Computed on Form 8936 and reported on 2012 Form 1040, Line 52.
- Section 26 is a limitation on how much credit you can take. Nothing to see here; move along.
- Section 27. – Foreign tax credit. Computed on Form 1116 and reported on 2012 Form 1040, Line 47.
- Section 28. Nothing here in the Internal Revenue Code.
- Section 29. Nothing here in the Internal Revenue Code.
- Section 30. Certain plug-in electric vehicles. Computed on Form 8834 and reported on 2012 Form 1040, Line 53.
- Section 30A. USC economic activity credit. Applies to corporations, not humans.
- Section 30B. Alternative motor vehicle credit. Computed on Form 8910 and reported on 2012 Form 1040, Line 53.
- Section 30C. Alternative fuel vehicle refueling property credit. Computed on Form 8910 and reported on 2012 Form 1040, Line 53.
- Section 30D. New qualified plug-in electric drive motor vehicles. Computed on Form 8936 and reported on 2012 Form 1040, Line 53.
The number you need to compute your net tax liability for 2012 is found on 2012 Form 1040, Line 55.
I took you the long way around to show you how the Tax Code is a bunch of interlinked provisions that require you to follow carefully. Something that looks simple (Line 55 on your income tax return) hides a world of complexity beneath it. Now you know.
Where I am now
In the lounge at LAX headed for Beirut via London. Quite a difference from Checkerboard Mesa at Zion National Park.
Beirut and Riyadh, April 2013
I will be in Beirut on April 24-25, flying out on April 26. As usual, I will be staying at the extremely nice Le Gray Hotel. I have a pretty full schedule but email me if you’d like to meet up.
My Riyadh time is limited–Saturday and Sunday, April 27 and 28. As usual (again) I will be staying at the Al Faisaliah Hotel. Again, shoot me an email if you want to meet.
I should be back in the Middle East in late May if we don’t connect on this trip.
Form 1040NR Filing, Tax Payment Deadlines
I received an email from a CPA friend of mine today. She and another person in her office disagreed on a seemingly simple question. They were preparing a Form 1040NR for a nonresident alien and wanted to get an extension of time to file the tax return. They both agreed that Form 4868 should be filed before June 15 to get the extension of time to file a timely tax return. But they disagreed on making the tax payment: is the tax payment due on April 15 or June 15?
I was about to reflexively answer her question when I thought to myself, “Hang on. Let’s look at the Code.” I’m glad I did. My reflexive answer would have been conservative, safe, and wrong. (Hint: I would have said “Pay the tax by April 15, file Form 4868 by June 15. That’s wrong. But it’s safe!)
This blog post will now explain the rules entirely without using IRS Publications, instructions to various forms, or other similar unreliable and lazy crutches. This is totally an Internal Revenue Code plus Treasury Regulations boondoggle. The Board of Accountancy should award you bonus CPE credits for reading this blog post.
Since this post is written in response to a CPA’s question (and she will read this), you should approach it as if you are a CPA. Basic terminology will not be explained.
A nonresident alien who has U.S. taxable income and must file a U.S. income tax return (Form 1040NR) must do so on or before June 15.
The nonresident alien can get an extension of time to file a tax return by filing Form 4868. This will extend the filing deadline to December 15.
If the nonresident alien owes U.S. income tax, the payment deadline is June 15.
The rules are cheerfully and needlessly different for a nonresident alien who has wage income subject to U.S. income tax withholding. For these folks, the filing deadline is April 15. An extension of time will run to October 15. The payment deadline is April 15 for any tax liability.
I am going to ignore nonresident aliens who have wage income subject to U.S. income tax withholding. Let’s just talk about my friend’s client, who has rental income from U.S. real property and must file Form 1040NR to report the income and pay the income tax.
Internal Revenue Code Section 6072(c) contains the rule:
Returns made by nonresident alien individuals (other than those whose wages are subject to withholding under chapter 24) . . . under section 6012 on the basis of a calendar year shall be filed on or before the 15th day of June following the close of the calendar year and such returns made on the basis of a fiscal year shall be filed on or before the 15th day of the 6th month following the close of the fiscal year.
(Section 6012 of the Internal Revenue Code is the basic rule that says humans and other sentient and non-sentient beings must file income tax returns in the United States).
I am going to ignore fiscal year taxpayers. Rare indeed is the nonresident alien who has the presence of mind to claim a fiscal year for a tax year on his or her U.S. income tax return. Plus it is well known that fiscal year accounting (and the accrual method, for that matter) cause brain damage. It’s true! You can look it up.
So the nonresident alien who is using the calendar year as his or her tax year has a filing deadline of June 15.
There are the usual rules for pushing the filing deadline forward if June 15 falls on a weekend or public holiday. In 2013, for instance, June 15 falls on a Saturday, so the actual filing deadline will be the first business day after that, which is Monday, June 17, 2013.
You can find the filing deadline information easily enough in the Instructions to Form 1040NR.
Extension of Time to File Tax Return
A nonresident alien (again we are talking about someone with no wage income subject to U.S. income tax withholding)) who wants more time to file a tax return can apply for an extension. This is done with the normal Form 4868.
A properly and timely-filed Form 4868 extends the filing deadline for our nonresident alien to file his Form 1040NR until December 15. You want to know why? Here you go.
The time prescribed for filing the tax return is June 15. Internal Revenue Code Section 6072(c). The taxpayer can get an automatic six month extension of time from the time prescribed for filng the tax return. Treasury Regulations Section 1.6081-4(a) says:
(a) In general. An individual who is required to file an individual income tax return will be allowed an automatic 6-month extension of time to file the return after the date prescribed for filing the return if the individual files an application under this section in accordance with paragraph (b) of this section. In the case of an individual described in §1.6081-5(a)(5) or (6), the automatic 6-month extension will run concurrently with the extension of time to file granted pursuant to §1.6081-5.
The last sentence does not apply to a nonresident alien. An individual described in Treasury Regulations Section 1.6081-5(a)(5) or 1.6081-5(a)(6) is a U.S. citizen or resident living abroad. A nonresident alien is not that.
The method for getting the automatic six month extension is spelled out in Treasury Regulations Section 1.6081-5(b). In plain English? File Form 4868.
Time to Pay Tax
Now we know when the nonresident alien must file an income tax return that is treated as filed “on time”. What if the taxpayer has a tax liability? What is the payment deadline for the tax payment?
The general rule is that income tax is due and payable at the time and place fixed for filing the tax return. Internal Revenue Code Section 6151(a) says:
Except as otherwise provided in this subchapter, when a return of tax is required under this title or regulations, the person required to make such return shall, without assessment or notice and demand from the Secretary, pay such tax to the internal revenue officer with whom the return is filed, and shall pay such tax at the time and place fixed for filing the return (determined without regard to any extension of time for filing the return).
As is common in the Internal Revenue Code, we are invited to go on a treasure hunt. “Except as otherwise provided in this subchapter” is the magic incantation that sends us on our quest. “This subchapter” refers to Title 26, Subtitle F, Chapter 62, Subchapter A of the United States Code. (Title 26 of the United States Code is colloquially referred to as the “Internal Revenue Code” and it is where Federal tax law lives). Subchapter A includes Sections 6151 through 6159. Trust me. There is no exception lurking in Sections 6151 through 6159 of the Internal Revenue Code that would apply to our nonresident alien.
Therefore, we conclude that a nonresident alien individual who must file Form 1040NR must — if tax is due — pay that tax on or before June 15.
An extension of time to file a tax return does not extend the time for payment of the tax due. Internal Revenue Code Section 6151(a); Treasury Regulations Section 1.6151(a)(1).
Note that the normal rules for estimated payments of tax will apply. If you make a big lump sum payment on June 15 and you should have made quarterly estimated payments, expect a little letter from the IRS asking you to shed some blood in penance.
Nonresidents with Wage Income Tax Withholding
Finally, I will just wave a flag here. My friend the CPA did not have this problem so I did not look at it. But if the nonresident alien taxpayer had received wage income on which withholding was imposed under “Chapter 24″ (i.e., Title 26, Subtitle F, Chapter 24 of the United States Code), then all of this would not apply.