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January 8, 2015 - Phil Hodgen

Covered Expatriates and Their IRAs After Expatriation

This Week’s Expatriation Question

I made up this week’s question because this topic occurred to me as I was writing last week’s episode.

Last week we talked about covered expatriates and their Roth IRAs–how are they taxed when a person renounces U.S. citizenship?

This week we look at covered expatriates and IRAs after expatriation. How do IRAs behave after expatriation? How are distributions taxed? What is the strategically best choice–keep your money in the IRA or close it, take the money, and run?

To keep things relatively short, I am only going to talk about regular IRAs.

The TL;DR

The “too long, didn’t read” this week:

  • Covered expatriates are treated as if they received a full distribution of the entire IRA balance on the day before expatriation, even though they didn’t receive any cash.
  • The IRA will continue to be treated as an IRA for U.S. income tax purposes, even after expatriation. It will not convert into a regular taxable investment account.
  • This means that investment earnings will accrue tax-free inside the IRA for a covered expatriate.
  • When the covered expatriate takes an IRA distribution, only the investment earnings generated after expatriation will be taxable. The U.S. income tax rate will be 30% unless an income tax treaty makes the U.S. tax rate lower.
  • When the covered expatriate takes a real cash-money IRA distribution after expatriation, the value of the IRA on the day
    before expatriation will be nontaxable when eventually distributed to the covered expatriate.
  • Strategy? I think the economic value of tax-free investment income growth and deferral of tax liability until withdrawal is LESS than the brain damage and cost of dealing with the U.S. tax system. Run the numbers if you like, but my suggestion is that you close out your IRA as soon after expatriation as possible.

Starting Point: Covered Expatriates with IRAs = “As
If” Distribution

A covered expatriate with an IRA is treated as having received a full distribution on the day before the expatriation date:

In the case of any interest in a specified tax deferred account held by a covered expatriate on the day before the expatriation date
… the covered expatriate shall be treated as receiving a distribution of his entire interest in such account on the day before the expatriation date[.]1

The only published information from the IRS (so far) is Notice 2009-85. The discussion of specified tax deferred accounts (an IRA is one of these) is found in Notice 2009-85, Section 6:

The mark-to-market regime does not apply to specified tax deferred accounts. Instead, section 877A(e)(1)(A) provides that if a covered
expatriate holds any interest in a specified tax deferred account (defined below) on the day before the expatriation date, such covered expatriate is treated as having received a distribution of his or her entire interest in such account on the day before the expatriation date. Within 60 days of receipt of a properly completed Form W-8CE, the custodian of a specified tax deferred account must advise the covered expatriate of the amount of the covered expatriate’s entire interest in his or her account on the day before his or her expatriation date. See section 8 of this notice for more information concerning Form W-8CE. (Emphasis added).

That is pretty easy to understand. Figure out the value of your IRA on the day before the expatriation date, and report that number as taxable income. Phantom income. You’re paying tax on something that is not “I got cash in my pocket!” income.

This Spawns Two Questions

Even though you wrote down a number on a tax return–and paid income tax–when you expatriated, you did not get cash. The cash never left the IRA. Some day, however, you will take cash out of the IRA and you need to know how it will be taxed.

The idea that you received a distribution–but you really didn’t–creates two spin-off questions.

  • Is It Still an IRA? You have some money in an account that says “IRA” on it. From the perspective of the IRS, that account is either still an IRA or it is a regular taxable account. Did your expatriation and the fictional “distribution” of all of the IRA’s assets change the character of the account from an IRA to a regular taxable account?
  • Money Was Distributed But It’s Still There. If it is still an IRA, how do we explain the fact that money (fictionally) came out of and then (fictionally) immediately went back into the IRA? There is a whole set of rules limiting contributions to IRAs, with penalties for excess contributions. If the money came out as a fictional distribution, doesn’t it make sense that it went back in as a fictional contribution? How do we get around the excess contribution penalties?

Still An IRA After Expatriation

I think we can divine the answer to this one. Where a covered expatriate has an IRA, on the day after expatriation that account is still an IRA.

Here is my logic. Tell me if you agree or disagree.

– Inference From What Congress Did Not Do

When a judge tries to figure out what a law means, the starting assumption is that Congress knows what it is doing when it writes a law. (Heh.) If Congress is silent, we assume that the law writer considered the action and decided against it.

The exit tax rules say a covered expatriate has a “pretend” distribution of the IRA balance on the day before expatriation. There is only one another area of IRA law that I know of where we can find a “pretend” distribution occurring: prohibited transactions.

If you do a prohibited transaction with your IRA (e.g., you borrow money from your IRA), the entire IRA ceases to be an IRA as of the first day of the year, whether you took money out or not, and you are taxed as receiving the entire balance of the IRA on January 1 of the year when the prohibited transaction occurred. The “bad thing” that happened causes the account to stop being an IRA, and because the account is no longer an IRA, you are treated as receiving a distribution of the entire balance.

Example

You have $20,000 in your IRA on January 1, 2014. On April 1, 2014, you borrow $5,000 from your IRA. This is a prohibited transaction.

Your entire IRA is treated as terminated as of January 1, 2014. The account is no longer an IRA, and the conversion of the account from
IRA to regular taxable account is a constructive distribution to you on January 1, 2014 of the entire IRA balance of $20,000.

This shows that Congress knows damn well how to write a rule that converts an IRA into a regular ordinary financial account when a “bad” event occurs. Congress did not write a rule like that into the tax laws for expatriation. Therefore it is reasonable to say that Congress did not intend for a covered expatriate’s IRA to be converted involuntarily from an IRA into a regular taxable account–because if Congress intended that result, the relevant exit tax law2 would be different.

After expatriation, the covered expatriate still has an IRA.

– Inference From What the IRS Did

We can infer from Notice 2009-85 that Congress intended a covered expatriate’s IRA to remain taxable as an IRA after expatriation.

After the constructive distribution triggered by expatriation,3 there is to be an adjustment to the tax attributes of the IRA. This recognizes that
tax has already been paid on the money inside the IRA, so a second income tax should not be imposed when the cash is actually, really, truly distributed to the IRA owner:

[A]ppropriate adjustments shall be made to subsequent distributions from the account to reflect such treatment.4

That is vague. Notice 2009-85 helps us understand the hand-wavy “appropriate adjustments” phrase a little better:

Section 877A(e)(1)© provides that appropriate adjustments must be made to subsequent distributions to take into account the previously taxed amount under section 877A. Thus, in the case of distributions that are taxable under the rules of section 72, the amount that the covered expatriate includes in gross income pursuant to section 877A(e)(1) will be treated as investment in the contract for purposes of section 72.5

The first sentence assumes there will be “subsequent distributions”. Take this as meaning the same thing it would mean with any pension plan or IRA. A “distribution” is a specific event, when cash leaves a “qualified plan”. An IRA is a qualified plan. So, by using the phrasing that implies the existence of future “distributions”, I think the IRS signals that they expect the IRA to continue being an IRA, even after the covered expatriate … uh … expatriates.

The second sentence refers to Internal Revenue Code Section 72. This is a provision that tells us how to look at a distribution and figure out how much of it is taxable and how much of it is not taxable. Section 72 starts talking about annuities, but applies to distributions from IRAs as well.6

The fact that Section 72 is invoked should not, alone, signal whether the IRS thinks an IRA remains an IRA, post-expatriation, for a covered expatriate. But in using the specific jargon used in IRA rules, and by invoking the specific method for computing taxability of IRA distributions, I think we can reasonably infer that the IRS administratively thinks that a covered expatriate’s IRA remains an IRA after expatriation.

It is possible that the IRS intended to make the IRA status stop as of the expatriation date for a covered expatriate. But I doubt it. Until we get Regulations interpreting Section 877A, I think we can assume that IRA status continues.

– Conclusion: It Is Still An IRA

I think a covered expatriate’s IRA is still an IRA after expatriation. Prove me wrong. Or let’s wait for Moses to descend from Mt. Sinai Treasury Regulations to blossom in Washington DC. Until then, your guess is as good as mine.

Explaining The Money Inside the IRA: A Wave of the Imperial Hand

Let’s go with the assumption that the covered expatriate’s IRA is an IRA after expatriation. How do we explain–for income tax purposes–what happened, so when the covered expatriate later pulls out his money, he is not taxed again? So how do we create a legal fiction that explains how money never left the IRA but when it does come out, it should not be taxed?

That, after all, is the intention of the exit tax rules. You can see that in the Internal Revenue Code, which says that “appropriate adjustments” are to be made. And you can see that in Notice 2009-85, Section 6, which explicitly says this is the intended result.

This will probably be answered with Treasury Regulations when they arrive. But here is what I think the answer will look like.

We create a mirror-image legal fiction. We match the deemed distribution from the IRA will a deemed re-contribution of assets to the IRA immediately after the deemed distribution.

This creates many problems with the definition of “contributions” and when they are allowed, and how much is allowable. There is a set of rules that governs the problem of contributions, and penalties are imposed for excess contributions. If you put more than the allowable amount into the IRA, you pay a penalty.

It is not easy to write Treasury Regulations, because the IRS cannot go beyond the powers granted by Congress in interpreting and implementing the Internal Revenue Code. If there is a deemed re-contribution, there are conceptual hurdles for the author of Treasury Regulations to leap over in order to avoid the excess contribution penalty–Congress explicitly waived the early distribution penalty, but did not explicitly waive the excess contribution penalty.

The deemed re-contribution would be characterized as a new member of the “nondeductible” IRA contribution family. Nondeductible contributions do not reduce your taxable income, and are made with after-tax dollars. Significantly, the tax result that the IRS wants (a way to figure out how much of an IRA distribution is taxable and how much is a return of your after-tax dollars invested in the IRA) is exactly what we want to happen here, for a covered
expatriate: you get the nondeductible contribution amount back tax-free.

I think the path of least resistance for the IRS is to say that the cash money remaining inside the IRA is there because of a deemed nondeductible contribution to the covered expatriate’s IRA. The Regulations will need to work around the dollar limits to nondeductible contributions, and will need to avoid the excess contribution penalties.

There is an anonymous person in Washington DC wrestling with this right now. Let’s wish him or her well.

IRA Behavior After Expatriation And Before Real Distributions

The covered expatriate has an IRA, and 100% of the contributions to the IRA are nondeductible contributions.

This means that interest, dividends, and capital gain will not be taxed when earned. Rather, U.S. income tax will be paid when actual cash money is distributed from the IRA to the covered expatriate. Until the covered expatriate takes a distribution, then, there will be no U.S. income tax imposed on these assets.

This ability to invest and defer income tax on investment earnings is the primary benefit of keeping the IRA open after expatriation.

Distributions After Expatriation

After expatriation, the covered expatriate will be entitled to pull out, tax-free, the money that was taxed on the day before expatriation.

This means that only the investment gains after expatriation are taxable to the covered expatriate.

Here’s a really simple example to show you how it works.

A covered expatriate has an IRA with $100,000 in it on the day before expatriation. He pays income tax on the $100,000, based on the “pretend” distribution rules. He leaves the $100,000 in the IRA.

The investments do well, and a year later he has $120,000 in the IRA. Of that, $100,000 is the money that was there on the day before expatriation, and $20,000 represents investment gains–dividends, interest, and capital gains. He closes the IRA and transfers all of the money into his regular checking account.

He has a distribution of $120,000. Of that, he has $100,000 “investment in the contract” (this is the phrase used in Section 72 and in Notice 2009-85) because that is money he paid income tax on already, so he should not pay income tax on it again.

The $20,000 is taxable income to him.

This, vastly simplified, is the way that Section 72 works for IRAs.

The default tax rate to distributions from an IRA to a nonresident alien (because that is what a covered expatriate is) will be 30% of the taxable portion of the distribution.7 If the covered expatriate lives in a country that has an income tax treaty with the United States, the U.S. tax imposed on the taxable IRA distribution might be lower than 30%. Of course, the covered expatriate might be taxable on the IRA distribution in his home country, and the IRS’s opinion on what is taxable and what is tax-free is irrelevant for that purpose.

Strategy: Close Your IRA, Take Your Money

I think there are a few reasons why a covered expatriate should close an IRA quickly after expatriation.

– Tax Deferral Isn’t Wildly Profitable

The primary benefit for leaving money inside the IRA is to allow it to grow tax-free. This result is true from a U.S. tax perspective. It is not at all necessarily true from the covered expatriate’s home country point of view.

From the U.S. tax point of view, bluntly, it looks like a bad move. Let’s say you have a choice between leaving the money inside the IRA or not.

  • Inside the IRA, U.S. source interest income will be taxed at 30% when it is distributed. Outside an IRA, U.S. source interest income is not taxed.
  • Inside the IRA, capital gains will be taxed at 30% when distributed. Outside an IRA, capital gains on stock transactions are tax-free.

Leaving money inside an IRA might mean your U.S. income tax is actually higher.

– Your Home Country Tax System

The deemed distribution from the IRA is a taxable event for U.S. income tax purposes but is not a taxable event for your home country’s tax system.

The last thing you want to have happen is to pay a U.S. income tax on your IRA when you expatriate, and pay a home country income tax when you take an actual distribution from your IRA after expatriation.

This, incidentally, militates for closing the IRA yourself and taking the distribution, rather than having the exit tax system’s deemed distribution get thrust upon you. If you face the unpleasant result of double taxation of your IRA, you are probably better off taking an early distribution and paying Uncle Sam an extra 10% for the early distribution tax. Then you have the ability, at least, to use the foreign tax credit in your home country to mitigate some of the damage.

Anyway. You get the point–it’s complicated, so use your head.

– U.S. Estate Tax

The IRA you leave behind is subject to U.S. estate tax if you die before taking a full distribution.

– Procedure and Paperwork

Cynical me. I think IRA custodians will be clueless and will bollox everything up, issuing Form 1099-R instead of Form 1042 and Form 1042-S, withholding at the wrong rate or not at all, etc. This is an exceedingly rare event for IRA custodians and they will not have their brightest people working from battle-tested operating procedures. 🙂 Expect brain damage.

– My Best Thinking

Since expatriation helps remove tax-induced brain damage from your life, why not call in a pre-emptive strike to eliminate this problem from your life? Close the IRA before expatriation, or if not, close it as soon as possible after expatriation, and pull the money out of the USA.

At the very least, don’t just blithely assume that it is a good idea to keep the IRA open.

Routine Disclaimer

What would an Expatriation Only email be without a disclaimer? Here you go!

I am not your lawyer and this is not legal or tax advice to you. I know that it is fascinating and well worth a spirited discussion over a cocktail, but you should not make tax or legal decisions based on what this email contains. Indeed, relying on an every-Tuesday email you get from some guy (Hi there!) is a bad idea. Go get specific legal and tax advice before you take action. Screwing this stuff up could be expensive.

Next Week

Next week I will answer another question about expatriation. Send me an email!

Phil


  1. 26 U.S.C. §877A(e)(1). 
  2. 26 U.S.C. §877A(e)(1)(A). 
  3. 26 U.S.C. §877A(e)(1)(A). 
  4. 26 U.S.C. §877A(e)(1)©. 
  5. Notice 2009-85, Section 6. 
  6. 26 U.S.C. §408(d)(1). 
  7. 26 U.S.C. §871(a). 
Expatriation