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December 23, 2014 - Phil Hodgen

Death as an exit tax avoidance strategy, part 2

This week's episode was written in stages. I started writing this while sitting in Seat 25C on U.S. Airways flight 865 en route to Sint Maarten. I rarely fly U.S. Airways, because the planes are usually well worn. It's like riding a bus. On this flight, two of the three seat trays in row 25 were broken and hung at an angle. The middle seat has gum stuck on it. In the bathroom, the cabinet door under the sink would not latch, so the door swung wildly as we bounced along. But hey. We arrived safely, and Sint Maarten is lovely.

More writing occurred on Anguilla, where I finished this off and posted it to Mailchimp. Anguilla is lovely. We are staying in an exquisite home on Shoal Bay.

But First, Restaurant Recommendations in Anguilla

Definitely eat at Madeariman's on Shoal Bay beach. All of us had different dishes, each excellent. Beef kebabs, mahi mahi, hamburger, and a pepperoni pizza. In fact the pizza was the biggest surprise: tasty and a perfectly-baked thin crust.

Definitely avoid Italia at the Cuisinart resort (a giant golf resort–we went there because many other restaurants were closed on Sunday night). Food was meh (rissoto too salty, bolognese sauce watery), pricey, with slow and inattentive service.

Once again, human-scale businesses beat corporate-scale. There is a human owner behind Madeariman's. And it shows.

This Week's Question is Last Week's, Continued

Welcome back to the second week of answering Daniel Hayden's question:

Hi Phil,

Here is another question, that – as far as I remember – has not been covered in your question-of-the-week-emails:

Is there any exit tax, if a green card holder, who returned to his country, but never returned the green card, dies (probably because he heard the latest FATCA news)?

If he surrenders his green card during his lifetime, I assume he would be subject to the exit tax. But is there also an exit tax upon death? Since he has no U.S. situs assets (and no U.S. citizen heirs), there would be no inheritance tax.

Would it make a difference, if his return to his home country happened a long time ago? I am thinking of the “at least 8 taxable years during the period of 15 taxable years”-language in § 877(e) IRC here…

I am looking forward to your answer, whenever it is suitable for you.

Thank you very much for your great newsletter.

TL;DR

If you don't want to read to the end (this email is long and I geek out a little bit on the history of the exit tax law), here's the too long, didn't read:

Daniel's green card holder can live out the rest of his life without triggering the exit tax, if:

  • the U.S. Department of Homeland Security stays asleep (this is a bad bet);
  • he does not proactively cancel his green card; and
  • he does not proactively file anything with the IRS claiming nonresident status for tax purposes.

Daniel's green card holder creates other U.S. tax problems for himself. Living a quiet life abroad will create decades of non-filing of tax returns and non-payment of U.S. income tax. He risks running afoul of the Leviathan that is FATCA, which may cause practical problems for him in the future. But maybe this does not matter to Daniel's green card holder.

But Daniel's green card holder does not fully control his future. Sooner or later the U.S. government will upgrade its data capabilities to find green card holders who are not living in the United States. The Big Brother outcome is what I am predicting–“We are doing this for your benefit, because terrorists”.

This is an easy database search: cross-check green card holders against income tax returns filed. These people will find their visas revoked. If this happens, Daniel will have an exit tax thrust upon him.

Daniel's green card holder needs to do some Dirty Harry tax planning: “Do you feel lucky, punk? Well, do you?”

What We Learned Last Week

We figured out that a green card holder could leave the United States and live abroad indefinitely without notifying the immigration boffins. The green card visa would continue to be valid in the eyes of the Department of Homeland Security. (The name of that department makes me queasy. Far be it from me to invoke Godwin's Law, but … yeah. The agency's name is Orwellian.)

We also figured out that if the immigration boffins do not officially revoke the green card holder's visa, and the green card holder does not officially give up the visa (“abandon” is the technical word used when a green card holder voluntarily gives up his visa) then as far as the IRS is concerned this person is still a “resident alien” which means the green card holder is still a U.S. taxpayer.

Still a U.S. taxpayer? Almost but not quite.

Quick Recap on the Law

Daniel's green card holder is a resident alien (and therefore a U.S. taxpayer subject to tax on worldwide income) when he receives his green card visa. Internal Revenue Code Setion 7701(b)(6)(A). This status continues until one of three things happens.

We identified two of those three things:

  • the U.S. government says “Your visa is officially cancelled” or
  • the green card holder saying “I am officially cancelling my visa”.

Internal Revenue Code Section 7701(b)(6)(B) is where you will find those two things. The IRS Chief Counsel's office thinks so, too. Look at Chief Counsel Advice Memoranda 200243020.

The Third Way

But there's a third way to stop being a resident alien, and that is something we haven't looked at yet. Internal Revenue Code Section 7701(b)(6) says, in flush language that Congress bolted onto the back end of Section 7701(b)(6):

An individual shall cease to be treated as a lawful permanent resident of the United States if such individual commences to be treated as a resident of a foreign country under the provisions of a tax treaty between the United States and the foreign country, does not waive the benefits of such treaty applicable to residents of the foreign country, and notifies the Secretary of the commencement of such treatment.

We are about to explore the impact of this sentence on Daniel's green card holder. Can this cause him to “cease to be treated as a lawful permanent resident”, thereby causing him to be an expatriate and subject to the exit tax? More to the point, can this single sentence cause Daniel's green card holder to be subject to the exit tax without him doing anything at all?

“Ha, ha! You just accidentally expatriated and you didn't even know it!” Can this happen?

Foreshadowing the conclusion … accidental expatriation is probably not what Congress intended and I would be flabbergasted if the IRS pressed for this result. But it is possible.

Open the Pod Bay Door, Hal

The flush language in Section 7701(b)(6) says that loss of lawful permanent resident status happens when three things are true:

  • The individual commences to be treated as a resident of a foreign country under the provisions of a tax treaty between the United States and the foreign country,
  • The individual does not waive the benefits of such treaty applicable to residents of the foreign country, and
  • The individual notifies the Secretary of the commencement of such treatment.

Easy logic. If and only if (A + B + C), then (D).

The Code says “You are a lawful permanent resident until all three of these things happen, and if one of those three things never happens, you are still a lawful permanent resident.”

If you are still a lawful permanent resident as defined by Section 7701(b)(6), you cannot have expatriated, because an expatriate is someone who ceased having the status of being a lawful permanent resident. Section 877A(g)(2)(B).

Daniel's green card holder would like to prove that he is still a U.S. taxpayer under the “lawful permanent resident” definition of Section 7701(b)(6), because then he would never expatriate and would never be subject to the exit tax.

First: Commences To Be Treated

The first requirement is (at least to me) easy to understand. Look at Daniel's green card holder, and then look at the income tax treaty for the country in which he lives. Would the definition of “resident” apply?

Usually how the treaty works is straightforward. A treaty usually says, in roccoco DiplomatSpeak “if the regular domestic tax law of the country would treat this person as a resident, then he will be a resident for purposes of the tax treaty.”

Let's assume that this first requirement just asks whether the income tax treaty between the United States and the country of residence would treat the green card holder as a resident of the other country.

Second: No Waiver of Treaty Benefits

The second requirement says that the individual doesn't waive the benefits of the treaty. What this is intended to mean is not exactly clear. But it seems to me is that you cannot waive your rights without doing something affirmative. Something visible.

So let's assume that there is no waiver of treaty benefits. Daniel's green card holder did not do anything or tell the IRS anything to waive the treaty benefits.

Third: Notification Requirement

In Ye Olden Tymes, the only way a green card holder stopped being a resident alien was by having his visa status revoked (the U.S. government says so) or abandoned (the green card holder says so). Before the flush language was added, Section 7701(b)(6) read in full:

For purposes of this subsection, an individual is a lawful permanent resident of the United States at any time if—

(A) such individual has the status of having been lawfully accorded the privilege of residing permanently in the United States as an immigrant in accordance with the immigration laws, and

(B) such status has not been revoked (and has not been administratively or judicially determined to have been abandoned).

It would seem to be abundantly clear. Tax status as a lawful permanent resident was tied to immigration status. You kept tax status as a lawful permanent resident until you gave up the green card or you had it taken away by the government.

The Late, Unlamented Section 7701(n)

Regrettably, it wasn't that simple. Again, in Ye Olden Tymes, the Internal Revenue Code contained another rule, this one found in (now repealed) Section 7701(n), which said:

An individual who would (but for this subsection) cease to be treated as a citizen or resident of the United States shall continue to be treated as a citizen or resident of the United States, as the case may be, until such individual—

(1) gives notice of an expatriating act or termination of residency (with the requisite intent to relinquish citizenship or terminate residency) to the Secretary of State or the Secretary of Homeland Security, and

(2) provides a statement in accordance with section 6039G.

Pretty amazing, right? Congress said that even if you were no longer a U.S. citizen or resident, you could be taxed as a U.S. citizen until you gave the right piece of paper to the right people in the Immigration Borg (Section 7701(n)(1)) and the right piece of paper to the right people in the Tax Borg (Section 7701(n)(2)).

Here is how (now-repealed) Section 7701(n) worked. Let's say a long-term resident (aka green card holder who has held the visa for the 8/15 year time frame) filed Form I-407 and voluntarily abandoned his green card visa. This would clearly terminate lawful permanent resident status under Section 7701(b)(6). (Remember: you're a lawful permanent resident–a U.S. taxpayer–when you get a green card and you continue that way until you abandon that visa or it is revoked). So this former green card holder would think “Aha! I'm free of the U.S. tax system!”

Section 7701(n)(2) threw a trump card on that. It said, yeah, you might THINK your status as a lawful permanent resident terminated when you filed Form I-407 (authority: Section 7701(b)(6)(B)), but it really didn't, because Section 7701(n)(2) says you continue to be a U.S. taxpayer–even though you are not a green card holder anymore–until you file the right piece of paper with the IRS. “Right piece of paper” meant Form 8854, because that is the form used to satisfy the requirements of Internal Revenue Code Section 6039F.

Same deal for a citizen. You could renounce your citizenship, but until you filed Form 8854 the IRS considered you to be a U.S. taxpayer. For years and years and years.

This law, of course, created conceptual, diplomatic, and practical problems for the IRS. Citizenship-based taxation (you have to pay income tax on your worldwide income if you are a U.S. citizen) is the rule. But when you say “Oh, and that means we can tax non-citizens on their worldwide income, too, based on this rule we just made up requiring a piece of paper to be filed” the logic behind this law starts to crumble.

The diplomatic implications are obvious. Let us assume that a U.S. citizen renounced citizenship under the old rule and became a German citizen, living in Germany.

In the Bad Old Days, the IRS would assert that someone who is a German citizen, living in Germany, should really be paying tax on worldwide income in the United States. The German government might get grumpy, and, quoting the ever-eloquent Barry McKenzie, might tell the IRS to go stick its nose in a dead bear's bum. Germany would not willingly let Uncle Sam waltz in and tax an individual with no ties to the United States whatsoever.

This of course created practical problems for the IRS. The Primary Mission of the IRS is to collect tax. How can it collect tax from people who are no longer U.S. citizens (or green card holders), living abroad, with no U.S. assets, in the face of diplomatic hostility? We can't have the IRS be a visibly toothless tiger, can we? It might be bad for business.

Ooopsie! Do Over! = The Flush Language of Section 7701(b)(6)

This practical reality caused the law change that resulted in the flush language. Congress attempted to fix the problem it created with Section 7701(n) by repealing it, then replacing it with the flush language to Section 7701(b)(6).

If you look at the new way that Congress solved the problem, there is a key difference.

The old way (which did not work) required a green card holder or citizen to file Form 8854 with the IRS; otherwise, the person who severed immigration or citizenship ties with the United States would continue to be a U.S. taxpayer.

The new way requires the green card holder to EITHER lose the green card by revocation or abandonment, OR lose tax status by using income tax treaties to be a nonresident of the United States for income tax purposes.

The old way [Section 7701(n)] allowed continued tax status after immigration status terminated. The new way [Section 7701(b)(6) flush language] allows continued immigration status after tax status ends.

But Wait. Must You Give Notice?

There is an interesting problem–as yet untested in the expatriation context, as far as I know. Internal Revenue Code Section 6114 and Treasury Regulations Section 301.7701(b)-7 both require a taxpayer to give notice to the IRS when taking a position for tax purposes that invokes rights under a treaty. Form 8833 is the paper you use to do this.

If you do not give notice, you pay a penalty. But you do not lose the right to claim the treaty protects you from the Internal Revenue Code. In other words, the IRS cannot force you to file a piece of paper in order to claim treaty benefits. The worst thing they can do is imposed a penalty. Sometimes the penalty is just $1,000.

I think there is an argument to be made that a green card living abroad can expatriate by doing nothing. A person takes a tax reporting position not by filing Form 8833, but by behaving (for U.S. tax purposes) in a way that is consistent with the treaty's rules. Could this extend all the way to “I did not file anything because I am not a U.S. taxpayer anymore”?

This is a topic whose exploration is probably not suitable for this email list, because it is an esoteric and technical argument. It asks whether the Internal Revenue Code trumps the income tax treaty, or vice versa.

Why would you do this? Probably because you want to argue that you in fact expatriated years and years ago, long before Section 877A was enacted. This would allow you to escape from the United States and its tax system without paying the exit tax.

For Daniel's green card holder, I do not know whether it is interesting to force the issue and claim that under a treaty he lost his status many years ago.

The IRS is unlikely to push this argument against the taxpayer's will. The IRS thrives on requiring notice and filing of paperwork. The argument that Daniel's green card holder would push is that not giving notice and not filing paperwork is sufficient for treaty purposes to take him out of the tax system. This is the complete opposite of what the IRS would like.

TL;DR – the flush language in Section 7701(b)(6) requires filing some paperwork with the IRS. It may be possible to achieve the result of ceasing to be a U.S. taxpayer without this, but I would need to write a hairy long analysis to prove it to you (and frankly, to myself). The safer assumption is that the government will treat you as a lawful permanent resident until you actually file paperwork claiming nonresident status in the United States.

Side Effects

Daniel's green card holder can live as a lawful permanent resident until the rest of his life. He just needs to be sure nothing triggers the attention of the U.S. government. FATCA, travel to the United States, and investment in U.S. assets are all problematic for him. Having U.S. heirs is a problem, too.

Daniel's green card holder also continues, every year, to not file U.S. tax returns. This creates obvious problems, and he needs to be willing to live with the risk.

Hence my reference to Dirty Harry. If Daniel's green card holder is lucky, these risks evaporate when he dies. He never has to pay the price.

So. Do you feel lucky?

Expatriation