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October 23, 2013 - Phil Hodgen

Chapter 1 – A Quick Overview of the Exit Tax

[This is Chapter 1 of the Student Edition of my Exit Tax book.]

This chapter contains a quick summary of how the exit tax system works:  who is affected and what happens to them.

Section 1.  What is the Exit Tax?

The exit tax is a Federal tax provision that–in its current incarnation–was put into place in June, 2008.

The phrase “exit tax” is not used in the Internal Revenue Code, but is a shorthand that everyone seems to use. I will use it here.

Exit

It is an “exit” tax because it applies to someone who is leaving the United States in a specified way—by termination of citizenship or permanent resident status.

Tax #1

It is a “tax” because it imposes an income tax on someone who has made his or her exit from the United States. The defining feature is that all assets are treated as if they are sold on the day before citizenship or resident status is terminated. If there is any profit from that “pretend” sale, it is taxed immediately. This is the “mark-to-market” feature of the exit tax rules.

There are other income tax provisions of the exit tax rules. The basic idea is to completely settle up all income tax obligations with the United States as you leave.

Tax #2

There is a second tax aspect to the exit tax rules. This aspect applies to gifts by or inheritances from persons who meet a special definition in the exit tax rules. If you are a Covered Expatriate then any U.S. person who receives a gift from you or an inheritance at the time of your death will pay a tax.

This is upside down from the normal U.S. gift and estate tax system. The normal procedure is to impose a gift tax on the person making a gift, or impose the estate tax on the assets of the deceased person. The recipient of gifts or inheritances receives everything tax-free.

Paperwork

Because it is a tax law, there is a truckload of paperwork required. Doing it right and doing it on time is essential to making your exit from the United States with a minimum of tax pain.

The Law

The exit tax law is found in Section 877A of the Internal Revenue Code (for the income tax provisions) and Section 2801 (for the estate and gift tax provisions).

Apart from the law itself, the only other significant piece of information from the government about how the exit tax works is found in Notice 2009-85. It discusses income tax matters only. There is conspicuous silence from the government on the estate and gift tax aspects of renouncing citizenship or permanent resident status.

Section 2.  Who Cares About the Exit Tax?

If you have the correct status (citizen or long term resident) and an expatriation event occurs, the exit tax rules described in this book will apply to you.

Status Generally

The exit tax applies to two categories of people:

  • U.S. citizens who terminate their citizenship; and
  • Permanent residents of the United States (holders of a “green card” visa) who terminate their permanent resident status after holding it for many years.

People who fall into those two categories need to walk warily through the tax landscape.  If you do not fall into one of those categories, you do not need to worry further about the exit tax rules.

Status:  Citizens

Someone who is a U.S. citizen can terminate citizenship voluntarily. In infrequent situations, the government terminates the citizenship of an individual. Dual citizenship does not matter. Holding another passport in addition to a U.S. passport will not affect the tax results discussed in this book.

Many people acquire U.S. citizenship status unknowingly—a parent is a U.S. citizen, for instance. If you are a U.S. citizen in this way, even if you never travelled to the United States–the exit tax applies to you.

Status:  Long Term Residents

The second category of people who care about the exit tax are “long term residents.” These are people who have permanent resident status in the United States. Most people refer to this as a “green card” visa. So will I.

Just having a green card will not be enough to subject you to the exit tax. You must have held the green card visa for a sufficiently long time. The length of time is curiously defined as “in at least 8 of the last 15 years”. This is harder to figure out than you would think. Which years count and which do not? This will be discussed later in this book.

Expatriation Event:  Citizens

You are not subjected to the exit tax just because you are a citizen or a Long Term Resident. There is another critical requirement: an “expatriation event” must occur.

An expatriation event for a citizen is simple. You were a U.S. citizen, and now you are not. Usually this is an action taken by the individual, rather than the government.  There are two ways this can happen, called “renunciation” and “relinquishment” of citizenship.  If you are worried about the difference between the two, you need a lawyer.

For the typical person, renunciation is the path.  Fill in a number of forms from the Department of State.   Make an appointment at an Embassy or Consulate somewhere, and show up for an exit interview.  Answer some questions, sign some papers, and wait for a confirmation in the mail–a Certificate of Loss of Nationality.  Perhaps you will be told pick it up at the Embassy or Consulate.  Procedures vary by location, and the Department of State changes its procedures periodically.

Expatriation Event:  Green Card Holders

An expatriation event for a Long Term Resident is a bit more complicated.

Like citizenship, you can expatriate by voluntarily terminating your green card visa. In this case, the form to prepare is the I-407 form.

Also like citizenship, you can expatriate by having your green card visa formally revoked by the government, against your will.  If the U.S. government thinks you have been outside the United States too long, this may be taken as evidence that you no longer intend to make the United States your permanent home. Reentry to the United States might trigger an unpleasant episode at the airport for you at the hands of the immigration officers. You may be faced with a “Sign the papers!” demand that will strip you of your visa and put you on a flight out of the United States.  And that unhappy event will trigger an unanticipated U.S. tax problem.

Finally, making a tax election can be an expatriation event for a Long Term Resident. Green card holders living outside the United States may be able to make an election under an income tax treaty between the United States and that country. This action causes the individual to be taxed as a nonresident of the United States, and a resident of the other country. Making this election is done on Form 8833. When done by a Long Term Resident, it is an expatriation event, triggering the exit tax

Section 3.  How the Exit Tax Works

The exit tax works like this:

Are You an Expatriate?

Determine whether you are an “Expatriate.” If you are not an Expatriate, the exit tax rules do not apply to you. If you are an Expatriate, you have some paperwork requirements to satisfy. You may or may not also be required to pay some tax.  The pleasure of tax payments is reserved for you only if you are also a Covered Expatriate.

Are You a Covered Expatriate?

A Covered Expatriate is someone who is an Expatriate and who satisfies (or fails, depending on your point of view) one of three ways.

You are a Covered Expatriate if you are:

  • “too rich” as the Internal Revenue Service defines this (in two different ways), or
  • if you fail on the paperwork required.

Paperwork failures fall into three categories.  You ensure Covered Expatriate status if you are late in filing the required paperwork when you expatriate, you are not up to date for your U.S. tax filings for the previous five years, or . . . how do we say this politely? . . . fail to be less than scrupulously truthful.

Result for Expatriates

Someone who is merely an Expatriate files an income tax return for the year of expatriation. It is a complicated tax return, consisting of a Form 1040NR, Form 1040, and Form 8854.

Result for Covered Expatriates

Covered Expatriates do the same paperwork. But they also pay U.S. income tax in the year of expatriation. The tax calculations are described in later chapters.

Covered Expatriates also have a continuing U.S. tax problem. If they make a gift to a U.S. person, the recipient must pay gift tax on the gift received from the Covered Expatriate. If the Covered Expatriate dies and leaves an inheritance to a U.S. person, the recipient pays the gift tax on the money received.

Expatriation