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July 21, 2015 - Phil Hodgen

Green card + treaty election = exit tax danger

Hi, it’s Phil again.

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Send in your question and get a free answer. I will answer it on a future weekly edition of this email newsletter.

This Week

This week’s question is about a non-obvious way to expatriate: by filing a form with your income tax return. This matters to you if you are a green card holder:

  • thinking about expatriating, or
  • you want to keep the green card, live abroad, and stop paying income tax in the United States.

TL;DR: green card holders, do not unthinkingly take a position on your U.S. tax return that you are a nonresident of the United States for income tax purposes by claiming that status under an income tax treaty. Look before you leap and figure out the tax consequences before you file that Form 1040NR with Form 8833 attached.

Situation: get the green card, leave the country

Let’s say you are a citizen of another country, and you are living there. You also happen to hold a U.S. green card.

Within two years of living in the United States, you decide to return to your home country to live permanently. You will no longer live in the United States. So you leave and you have been living in your home country for a year or so.

Since you are leaving the United States and will no longer live here, you want to stop paying U.S. income tax and filing U.S. income tax returns.

How to do this

There are two ways to go about this:

  • One way is to give up your green card. You do this by filing Form I-407.
  • The other way to stop paying U.S. income tax is by taking advantage of the income tax treaty between your home country and the United States (if such a treaty exists).

The lesson this week

The email this week highlights how you make a treaty election to be a nonresident of the United States for income tax. Specifically as to the exit tax, I also highlight when it is safe to do so, and when filing this income tax election will trigger the exit tax.

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, where you are on 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 (not a citizen) 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.

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; but
  • if the tax results are better by making an election to apply the income tax treaty rules, do that instead.

What the treaty election achieves

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 (how much money you owe) to the United States as if you are a nonresident of the United States; but
  • For all other tax paperwork 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 most of the ridiculous paperwork — Form 5471, and most of the other intrusive and privacy-destroying paperwork you can imagine will still apply to you.  There are some exceptions to this rule–for example, Regulation section 1.6038D-2(e)(2) lets you skip Form 8938, but there is no general waiver of the information returns.

And if you do not file all of the paperwork? All of the insane penalties 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. But leaving it off is not fatal.

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.

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 real question: should you make the treaty election to be a nonresident of the United States and a resident of your home country for tax purposes? Here are some considerations:

  • Will the election to be a U.S. nonresident under the income tax treaty actually save you some tax?
  • Are you willing to do all of the rest of the tax paperwork demanded by the IRS? Filing the tax return with all of the required paperwork may still be a big job with substantial risks if you screw something up.
  • Will making the election to be a nonresident for income tax purposes create immigration risks for you? Making this election is an indication to the U.S. immigration bureaucracy that you do not want to be a permanent resident of the United States anymore and might be used in an attempt to revoke your green card. OTOH, you may not care. 🙂
  • Will making the election to be a nonresident for income tax purposes create any exit tax problems for the green card holder?

I’m going to talk about the exit tax implications here. You should think about the other complications before using the income tax treaty to make yourself a nonresident of the United States for tax purposes, but . . . well, life’s too short for me to write it all in this email today.

Exit tax implications of the treaty election

Green card holders may be 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 green card visa status.

But — and here is the weird, nonintuitive thing to watch out for — green card holders may 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.

Strange, right? Expatriation is supposed to be all about breaking your citizenship or permanent resident ties with the United States, yet a piece of tax paperwork can achieve the same result.

You can expatriate and be subjected to the exit tax, even though your green card status remains intact.

Long-term residents only

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 holder 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). See Internal Revenue Code Section 877(e)(2).

Figure out the first year that you received the green card. Count forward from that year and see if that number adds up to eight.

Example 1

You received your green card on December 31, 2010. You have held your green card for six years (2010, 2011, 2012, 2013, 2014, 2015). You are not a long term resident.

Example 2

You received your green card on December 31, 2007. You have held your green card for nine years (2007, 2008, 2009, 2010, 2011, 2012, 2013, 2014, 2015). You are a long term resident.

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. Here is why:

  • Only “expatriates” are subject to the exit tax rules and the requirement to file Form 8854.
  • Only U.S. citizens and long-term residents have the possibility of becoming “expatriates” — by doing an action that is an “expatriating event”. One of the things that is an expatriating event is your election to be a nonresident of the United States (using an income tax treaty).

Thus, if you are a green card holder who never held the green card long enough to become a long-term resident, then the exit tax rules will not apply to you. You have an expatriating event (electing under the income tax treaty to be a U.S. nonresident) but you are not a “long-term resident” when you do that.

Under eight years right now

OK. Simple stuff. If you have counted the years and the total number of years that you held a green card is seven or fewer, you can make the treaty election to be a nonresident of the United States and not wake up the angry bear that is the exit tax.

Also, fun fact: for every year that you make that treaty election as a green card holder (while still not a long-term resident) (let’s call you a short-term resident, OK?) (hey, this is starting to be fun, chaining one parenthetical to another) (cut it out, Phil, you’re distracting your readers. Ed.) you do not accrue another year towards the dreadful “8 out of 15”.

Example

You received your green card on December 31, 2010. You have held your green card for six years (2010, 2011, 2012, 2013, 2014, 2015). You are not a long term resident.

For 2015, you make the treaty election to be a nonresident of the United States for income tax purposes. You file Form 1040NR with Form 8833 attached.

You do not count 2015 as one of the years that you were a green card holder, when calculating whether you hit the “8 out of 15” mark for being a long-term resident. You have five years in the previous fifteen years as a green card holder.

Continuing the example to absurdity:

Example

The same facts exist as before. You received your green card at the end of 2010. You filed your U.S. tax return as a nonresident in 2015, so you had only five years as a green card holder (2010, 2011, 2012, 2013, 2014) toward the “8 out of 15” required to be a long-term resident.

You continue filing a U.S. income tax return as a nonresident for the next 10 years, and you keep your green card. You will never be a “long-term resident” because you do not count those years — filing as a nonresident, claiming the treaty benefits — toward your “8 out of 15”.

More than eight years already

What happens if you have already reached the magic “8 of the previous 15 years” mark and are therefore a long-term resident?

When you file that income tax return (Form 1040NR) and claim to be a nonresident of the United States per the income tax treaty (as you are allowed to do), you will have an expatriating event.

As a long-term resident making the treaty election, you are now an “expatriate”. You suddenly have some burdens facing you:

  • You may have a paperwork problem only (filing Form 8854 with the IRS, along with that year’s income tax return), or
  • You may have a paperwork problem plus a “I gotta pay some income tax” problem because you are a covered expatriate (you are “too rich” as the IRS defines that, or you have some failure in your income tax payment or paperwork filings in the previous five years).

Over/under

Note that making the treaty election after you have accrued eight years of holding a green card is dangerous. Making the treaty election before you have accrued those magic eight years is beneficial.

Tricky, right?

Meta

As a general principle it is a good idea to dump the green card unless you really, truly intend to remain a permanent resident of the United States forever. Dump it as early as possible to prevent yourself from becoming a “long-term resident”.

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.

Not Legal Advice

Now of course is a prudent moment to remind you that this is not legal advice. Holding a green card, living abroad, and dealing with U.S. income tax matters (and avoiding the exit tax) is a weird and complex situation. You need someone to look specifically at your situation and help you walk through the shower of poison darts that Congress is shooting at you.

Next Week

Next Tuesday there will be another expatriation-related question and answer. Send me a question.

Phil.

Expatriation