Green card holders, treaty elections, and exit tax
(This is the weekly Expatriation Only email that went out on July 22, 2014 to the subscribers. Every week I answer a technical question–usually tax–in great depth about expatriation. Subscribe to the list here, or if you want to ask a question send in your questions here. I answer these either in the email newsletter or by blog posts.)
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This Week's Question
This week's question is going to be a mini case study. This one's long, but I hope it is useful–not only for green card holders who contemplate expatriation, but for green card holders living abroad who are considering electing to be treated as nonresidents of the United States for income tax purposes.
The question comes from an accountant in another country–someone who handles cross-border clients. Thanks, S.C., for the email. Rather than quote the email (it is long!) I will summarize the key points of S.C.'s email conversation with me.
She has a citizen of that country who happens to hold a U.S. green card. The green card was issued in February, 2009. This, of course, makes the client a U.S. taxpayer for income tax purposes, taxable on his worldwide income.
The individual lived in the United States on the green card for a year or two, but has been
living in his home country more-or-less full time for the last couple of years. I'm not sure, but it sounds like the green card holder probably does not want to live permanently in the United States in the future. He has family in the United States (children and grandchildren) so visits will happen, but in terms of "where do I live?" the answer is not the United States anymore.
Because of differences in the tax laws, a particular item of income that is tax-free in that country will be taxable to her client on his U.S. income tax return.
She is thinking of having her client make an election to be a nonresident of the United States for income tax purposes for 2013. What are the consequences of making that election?
Treaty elections to be an income tax nonresident
The United States imposes income tax on U.S. citizens and green card holders regardless of where they actually live. In other words, the precise location of your corporeal being on Planet Earth is irrelevant–you must pay U.S. income tax on all of your income, no matter where it came from.
A green card holder can make a special election and get out of this tax situation–if and only if he or she is living in a country that has an income tax treaty with the United States.
All income tax treaties have a set of rules called "tie-breaker" rules. If a person can be considered a resident of the United States (under its normal tax laws) and also a resident of another country (under its normal tax laws), then in order to prevent agony and double taxation to that person, you look at the tie-breaker rules. Apply them in sequence and sooner or later you will come to a rule that definitively says you are a resident (for tax purposes) of one country and a nonresident of the other.
These provisions are typically in Article 4 of income tax treaties. A few old treaties have the tie-breaker provisions in Article 3.
You are not required to use the treaty tie-breaker rules if you are a U.S. taxpayer. The treaty is like a trump card that you can play to defeat the Internal Revenue Code. The government cannot play the trump card against you–the IRS cannot force you to make an election to apply the treaty to your situation. Only you can play the trump card.
This means that the taxpayer gets to choose the better of the two alternatives: if the tax results are better by applying the plain old Internal Revenue Code, do that; if the tax results are better by making an election to apply the income tax treaty rules, do that.
How the treaty election works
If you make the election under an income tax treaty to be a resident of the other country (where you live) and a nonresident of the United States (where you have a green card), the results are as follows:
- You compute your income tax liability to the United States as if you are a nonresident of the United States; but
- For all other tax filing purposes, you are a resident.
Interpreted, this simply means you can reduce or eliminate the amount of income tax you pay to the IRS, but you still have to do all of the ridiculous paperwork. Form 8938. Form 5471. Etc. All of the intrusive and privacy-destroying paperwork you can imagine will still apply to you. All of the insane penalties that the IRS throws at you? They still apply.
How to make a treaty election
The interesting thing (for tax nerds, at least) is how the treaty election is made. You simply file a tax return that is consistent with calculating your tax according to how the income tax treaty says you should calculate it. That is how you take a tax reporting position based on the treaty.
There is a form to file, of course. Form 8833. Interestingly, if you do not file Form 8833, your treaty election is not defeated. You still are allowed to compute your income tax according to the treaty rules. The worst that can happen to you is that you pay a $1,000 penalty. Cheap!
This is not to say that I recommend blowing off Form 8833. By all means file it. It prevents problems.
Questions to ask yourself
Now we get to the considerations that S.C. must analyze before filing a 2013 income tax return for her clients with a claim of nonresident status under the income tax treaty:
- Will the election to be a U.S. nonresident under the income tax treaty actually save tax?
- Will the client happily and eagerly do all of the rest of the tax paperwork demanded from him by the IRS for the 2013 tax year?
- Will making the election to be a nonresident for income tax purposes create any immigration risks that could trigger revocation of the green card by the U.S. government? And does the green card holder care?
- Will making the election to be a nonresident for income tax purposes create any exit tax problems for the green card holder?
- Are there State income tax questions to consider?
I'm going to talk about the exit tax implications. The other issues must be addressed and considered carefully before filing the 2013 tax returns, but . . . well, life's tooshort for me to exhaustively analyze everything in public. Especially for free.
Exit tax implications of the treaty election
Let's talk about the exit tax implications of the treaty election by this green card holder to be treated as a nonresident of the United States for income tax purposes.
Green card holders are subjected to the exit tax rules when they abandon their green card status (by filing Form I-407) with the U.S. government, or when the U.S. government revokes their visa status. Green card holders are also subjected to the exit tax rules when they make an election under an income tax treaty to be treated as a nonresident of the United States.
That second point is the one we care about–when will an election under an income tax treaty cause a green card holder to be subjected to the exit tax rules?
The answer is simple: when the green card holder has been the proud owner of a green card for a long time. This type of person is called a "long-term resident" in the Internal Revenue Code.
How long is a "long time"? It simply means that the person has held a green card "in" at least 8 of the last 15 years (including the current year).
If the person has held a green card for fewer than that magic number, then the person is not a long-term resident and the exit tax rules do not apply at all.
For the tax nerds among you, "long-term resident" is defined in Internal Revenue Code Section 877(e)(2).
For how a long-term resident is subjected to the current exit tax rules, go look at Internal Revenue Code Section 877A(g)(2)(B). This defines who is an "expatriate" or not as a long-term resident who ceases to be a lawful permanent resident of the United States within the meaning of Internal Revenue Code Section 7701(b)(6). And ceasing to be a lawful permanent resident of the United States within the meaning of Internal Revenue Code Section 7701(b)(6) is the same as making an election under an income tax treaty to be a nonresident for U.S. income tax purposes.
If you are not a "long-term resident" you cannot be an "expatriate". If you are not an "expatriate" then Internal Revenue Code Section 877A–the exit tax rules–cannot apply to you. Section 877A only applies to "expatriates" and specifically to a particular variety of expatriates–covered expatriates.
Applying facts to the law
Let's go back to S.C.'s client. He received his green card in 2009. We are now in 2014. This means he has held a green card in the calendar years 2009, 2010, 2011, 2012, 2013, and 2014.
That's six years. Six is less than eight. I had to use an extra set of fingers in order to do the math.
Since S.C.'s client has not held the green card in at least 8 taxable years out of the last 15, he does not have an exit tax risk if he makes the treaty election to be a nonresident of the United States and a resident of his home country. S.C. can file Form 8833 and cause him to make the treaty election for tax year 2013 without triggering the big Section 877A tax.
The other issues
Exit tax is not a problem. The other issues are worth a quick mention, however. S.C. will need to go deep in analyzing these before choosing to file a Form 8833 treaty election for her client.
- Will this save actual income tax? In this situation it is pretty clear that the client will save income tax. A particular type of capital gain was recognized on sale of an asset in 2013. That capital gain is tax-free in the home country but taxable in the United States. By electing nonresident status in the United States, the taxpayer will eliminate the possibility of income tax on that capital gain.
- The other tax filings. S.C. will need to have a heart-to-heart with the taxpayer to advise him that all of his other tax paperwork is still required. In other words, he is still going to file a big brick of a tax return with the IRS. It will still be expensive to prepare that tax return. The only good news is that he will pay less tax overall in 2013.
- Immigration problems. Filing a nonresident income tax return as a green card holder is a definite bad thing for visa purposes. Every immigration lawyer I have ever spoken to has said "this is a bad mark and is not good to do if you want to keep the green card". S.C.'s client should be OK if he drops the green card visa status. For him, it will be no problem to enter and exit the United States as a tourist since he comes from a country that has good diplomatic relationships with the USA. It's one of the Five Eyes countries. Hello, NSA!
- State income tax. I assume (based on the amount of time that the taxpayer has been outside the United States) that no State assumes he is a resident for State income tax purposes.
My suggestion for people in a situation like this is to drop the green card. Get rid of that visa status, because as soon as you hit that magic "in at least 8 taxable years during the period of 15 taxable years ending with [this year]" you will be subjected to the exit tax.
As a general principle it is a good idea to dump the green card unless you really, truly intend to remain a physical resident of the United States forever and ever, amen. If you harbor an intention to possibly return to your home country to live (e.g., upon retirement), staying too long in the United States might become extremely costly. The exit tax rules create a perverse economic incentive that drives successful immigrants away.
For this gentleman, it sounds like he will remain a resident of his home country and make visits to the United States to see the grandchildren. He just needs a tourist visa for that.
Dump the green card. File Form I-407 at your favorite Consulate or Embassy and be done with the IRS. This will make 2014 the last year that you have the IRS burrowed deep inside you.
Not Legal Advice
Now of course is a prudent moment to remind you that this is not legal advice. I'm probably wrong, and anyway this information is outdated ever since it was written with a quill pen while I was sailing on a clipper ship from Southhampton to Sydney, by the light of a coal oil lamp. And who knows–Congress will undoubtedly pull some election-year stunt in a shameless pandering for votes and you–an American abroad or worse yet an American giving up citizenship or resident–simply don't matter at all to a random politician in the United States.
Next Tuesday there will be another expatriation-related question and answer. Send yours in.
International Tax Lunch: Expatriation and Covered Expatriate Status: What It Is and How to Avoid It
What: International Tax Lunch: Expatriation and Covered Expatriate Status: What It Is and How to Avoid It
When: Friday, August 8, 2014 at Noon (Pacific Time)
Who: Debra Rudd, CPA
This month’s International Tax Lunch will be a detailed guide on how to determine whether your client who is expatriating is a covered expatriate and how to pass the certification test. Debra has prepared dozens of tax returns for expatriates. She will talk about the different ways an individual can become a covered expatriate. Special attention will be paid to the certification test, which is the least-understood and most problematic of the three ways to become a covered expatriate.
To register for conference-call participation, click here.
Expatriation between age 18 and 18-1/2
We get questions. Some of them are answered on the weekly Expatriation Only email list (subscribe!). Here is one that I’ll just answer here as a blog post. It is a followup to an earlier question from reader N.
This is for parents of wealthy children–how do you ensure that your children can give up their U.S. passports without paying a massive exit tax? Here is one method.
If you are a “covered expatriate” when you renounce your U.S. citizenship, then the possibility of a massive tax bill exists. You are treated as if you sold all of your assets. Special tax rules apply to beneficial interests in trusts and other things. Other Bad Stuff Happens.
For the purpose of this blog post, just assume that “massive tax liability” is the result.
You want to avoid covered expatriate status if you can.
Minor children with wealth
Let’s consider the expatriation choices for minor children with wealth. It is difficult for a minor to renounce U.S. citizenship. Our usual recommendation is to not bother. Wait until the child turns age 18.
When a minor child has wealth it is almost always because he or she is a beneficiary of a trust. Let’s assume that the value of a child’s beneficial interest in a trust exceeds the $2,000,000 threshold, making the child a potential covered expatriate when he/she renounces U.S. citizenship.
Avoid covered expatriate status
If the child renounces citizenship between age 18 and 18 1/2, the amount of wealth held by the child (directly or in a trust) is irrelevant–he or she will not be a covered expatriate. [Warning: some conditions apply.]
The rules are in Internal Revenue Code Section 877A(g)(1)(B)(ii), which says that an individual is not a covered expatriate if both of these conditions are true:
(I) the individual’s relinquishment of United States citizenship occurs before such individual attains age 18 1/2, and
(II) the individual has been a resident of the United States (as so defined) for not more than 10 taxable years before the date of relinquishment.
The first requirement is easy to understand–just make sure the renunciation date is before age 18 1/2. If you are successful in having a renunciation before age 18 (I applaud your tenacity) you’ve met the test. If you wait until age 18 (now the State Department cannot reject your application because you are a minor), you are OK too.
The second requirement is a bit non-obvious. What you do is look at the “substantial presence test”, which is the day-counting rule that applies to determine whether a nonresident is a resident of the United States. Find this stuff at Internal Revenue Code Section 7701(b)(1)(A)(ii) and Section 7701(b)(3).
If you can show that the child was not in the United States for a sufficient number of days to qualify as a resident under the substantial presence test, then that is a taxable year that is NOT counted toward your 10 years before the renunciation date.
For a child who has lived outside the United States for most of his or her life, this is easy. It is likely that the child has spent only holiday-style quantities of days in the United States.
If the child has spent up to and including 10 years of his or her life in the United States as a resident under the “too many days” test, then it is possible at any time to exit the United States without covered expatriate status.
“Some conditions apply”
Yes, tax law always comes with conditions. The child who renounces citizenship with substantial wealth will not be a covered expatriate–as long as the renunciation occurs before age 18 1/2.
However, the child must still satisfy the certification test–on Form 8854 he or she must certify that the previous five years of U.S. tax obligations are neatly squared away. All forms filed, all tax bills paid. And the child must file correctly and on time for the year of renunciation. This means the final tax return and Form 8854.
In other words, don’t ^@!$!#@& up the paperwork.
When to file Form 8854
We get questions. Some of them are answered on the weekly Expatriation Only email list (subscribe!). Here is one that I’ll just answer here as a blog post. It is from reader R.T.:
Hi, I am planning on abandoning my green card this July, 2014. The latest dates of expatriation in Part 1, #4 are from January 1, 2013 – December 31, 2013. Should I just check this box?
Thanks, R.T.–I always appreciate questions and comments.
R.T. is referring to Form 8854. He is looking at the 2013 version of Form 8854. On Form 8854 you are supposed to tell the IRS when you renounced citizenship or abandoned your green card. The 2013 form doesn’t have a place for this person to answer the question accurately. What does he do?
The answer: wait until next year
R.T., you’re too eager. You don’t have to file Form 8854 yet. Wait until 2015.
When someone expatriates (renounces U.S. citizenship or abandons a green card after holding it for a long time), there is one eternal truth:
You still have to file a U.S. income tax return for the final year that you were a citizen or a green card holder, even if it is only for part of the year. This is usually (but not always) a dual-status tax return. See IRS Publication 519, Chapter 6.
The Form 8854 is filed along with that final tax return. From the Instructions to the 2013 Form 8854, at page 3, in the right hand column:
When To File
If you expatriated after June 16, 2008, attach Form 8854 to your income tax return (Form 1040 or Form 1040NR) for the year that includes your expatriation date, and file your return by the due date of your tax return (including extensions). Also send a copy of your Form 8854 to the address in Where To File, later. If you are not required to file Form 1040NR or Form 1040, send your Form 8854 to the address in Where To File, later, by the date your Form 1040NR (or Form 1040) would have been due (including extensions) if you had been required to file. (See Resident Alien or Nonresident Alien in the Instructions for Form 1040NR.)
Emphasis in original.
For someone who expatriates in 2014, that final tax return will be due in 2015. The filing deadline will either be April 15, 2015 or June 15, 2015, depending on circumstances. An extension request can be made, giving you until October 15, 2015. A further extension request is possible to December 15, 2015.
This means that R.T. will not have to file his final (2014) income tax return and his Form 8854 until sometime in 2015. By then the IRS will have published the 2014 version of Form 8854 and there will be a box to check for R.T. to tell the IRS that he expatriated in 2014.
This is a common question. People who expatriate often assume that they must handle their tax filings immediately after their expatriation date. Not so. The final year’s tax filings are done in the following year.
Careful: Form W-8CE
There is one exception to this rule: Form W-8CE.
If you are a covered expatriate and you have deferred compensation plans (think “pension” in plain English), you must file Form W-8CE with the compensation plan administrator within 30 days of your expatriation date.
If you do this, your U.S. income tax on pension distributions will be 30%, as the payments
are made to you. If you miss the 30 day deadline, you are treated as if you received a giant lump sum distribution of your entire lifetime’s worth of pension payments. This will create a Godzilla-sized income tax payment that the IRS will be keenly interested in receiving promptly.
The problem is a cash flow problem. If you are receiving dribbly-drabbly payments every month for the rest of your life, you probably don’t have the cash available to pay some hundreds of thousands of dollars in income tax today.
Expatriation by minors–possible but difficult
We get questions. Some of them are answered on the weekly Expatriation Only email list (subscribe!). Here is one that I’ll just answer here as a blog post. It is from reader N.
Hi Phil, I have an expatriation-related question for you:
I am a US citizen (naturalized at age 13) who moved to Canada as an adult, married a Canadian, and had two children in Canada. [Stuff removed from the question by me].
If I decide to expatriate myself (still deciding… my entire family and many friends are still in the US, and I visit regularly), should I expatriate my children as well, to make a clean break and keep them free of US tax reporting obligations as they get older and collect enough assets (RESPs, etc) to require the FinCEN (FBAR) reporting? Both are under 10 at the moment.
What are the pitfalls to be expected when expatriating children?
Sorry for the wordiness. I boldfaced the actual questions above.
Man, this is a difficult decision. Thanks very much for organizing this list – I am learning a lot.
The answer we give–and this question comes up a lot–is to wait until the kids turn age 18. You might be able to have your kids expatriate before that, but you and they will incur a lot of brain damage in dealing with the U.S. government.
State Department: we’ll make it really hard
The State Department has its Foreign Affairs Manual. The relevant portion is 7 FAM Section 1292 (PDF). I will reproduce the full provisions here:
i. Renunciation of U.S. citizenship and minors:
(1) Consult CA/OCS/ACS: Whenever you receive a request to renounce from a minor you immediately must contact CA/OCS/ACS. CA/OCS/ACS will not approve a Certificate of Loss of U.S. Nationality (CLN) for a minor without the concurrence of CA/OCS/L, and appropriate consultation with L/CA;
(2) Voluntariness and intent: Minors who seek to renounce citizenship often do so at the behest of or under pressure from one or more parent. If such pressure is so overwhelming as to negate the free will of the minor, it cannot be said that the statutory act of expatriation was committed voluntarily. The younger the minor is at the time of renunciation, the more influence the parent is assumed to have. Even in the absence of any evidence of parental inducements or pressure, you and CA must make a judgment whether the individual minor manifested the requisite maturity to appreciate the irrevocable nature of expatriation. Absent that maturity, it cannot be said that the individual acted voluntarily. Moreover, it must be determined if the minor lacked intent, because he or she did fully understand what he or she was doing. Children under 16 are presumed not to have the requisite maturity and knowing intent;
(3) Interviewing a minor: When conducting the initial interview with a minor and during the renunciation procedure, you should have at least one other person present. The parents and guardians should not be present. As noted, the interview should take place in the presence of the consular officer and a witness, preferably another consular officer, another Foreign Service officer (nonconsular) or locally employed staff (LE staff). You should also explain that upon reaching the age of 18, the minor has a six- month opportunity to reclaim U.S. nationality. See 7 FAM Exhibit 1292, A Sample Letter to Accompany CLN for Minor Renunciants, which should be provided to minor renunciants together with an approved CLN;
(4) Consular officer’s opinion: You should fully document every interaction with the minor and explain in your consular officer’s opinion the reasons you believe that the minor is, or is not, mature enough and sufficiently knowing to renounce.
State Department: minor’s renunciation isn’t final
There is also an important paragraph–encapsulated in a box to tell you how important it is–right above Section 1292(i). A minor who renounces citizenship can reclaim citizenship after turning age 18.
Renunciation is an expatriating act under INA Section 349(a)(5). The Foreign Affairs Manual says:
NOTE: INA 351(b) (8 U.S.C. 1483) provides that a national who within six months after attaining the age of eighteen years asserts his claim to U.S. nationality, in such manner as the Secretary of State shall by regulation prescribe, shall not be deemed to have lost United States nationality by the commission, prior to his eighteenth birthday, of any of the acts specified in paragraphs (3) and (5) of Section 349(a) of this title.”
A kid younger than age 16 is unlikely in the extreme to get a favorable result. The government presumes that such a person is too young to know the full impact of renouncing U.S. citizenship. I wouldn’t even bother going to the Consulate or Embassy in this situation. The time and brain damage cost to the parents is too high.
For any child who is older than 16, I wouldn’t bother with renouncing U.S. citizenship. My experience is that children have few assets and therefore few tax problems. It is easier to deal with the tax filings for a couple of years–until the child turns 18–than it is to bang heads with the State Department.
There might be situations where there is some pressing tax need to have the child expatriate. This might be where the child has significant net worth via inheritance or being named as a beneficiary of a trust. There are some circumstances where that child’s later renunciation might trigger the exit tax.
Bottom line: unless there is a lot of potential income tax at stake, wait until the child is age 18 and can freely renounce U.S. citizenship using the normal procedures. For situations like reader N’s, where the assets are normal RESPs and the like, I don’t see any real benefit to early renunciation. And in her case, the kids are under age 10 so it’s basically impossible right now, anyways.