Covered Expatriates: Asset Taxation During and After Expatriation Q&A

This post is a collection of questions and answers from Debra Rudd’s February 12, 2021 International Tax Lunch webinar on Asset Taxation During and After Expatriation.The below questions were asked by viewers of the webinar, and answered by Debra during the webinar. Some questions have been slightly edited for clarity.This post is not legal advice. Do not make big life decisions without consulting an expert.Q1: Why would a Green Card holder risk her Green Card by claiming treaty protection after 8 years, but not before?A1: This is because section 7701(b)(6) in the flush language says that an individual ceases to be treated as a lawful permanent resident when they make a treaty election to be taxed as a resident of another country. Section 877A says to use that section to determine when a long-term resident has expatriated. So, once you’ve reached long-term resident status by meeting the 8-year test, the treaty election becomes an act of expatriation.Q2: The tax liability test only looks at federal taxes - not state or local, right?A2: That's correct.Q3: I'm curious about state asset taxation on rental real estate. If an expat pays federal tax upon exit -- giving the property a step-up, do you typically track state tax basis/depreciation separately for post-expatriation?A3: Yes, exactly, since states do not have an exit tax provision. Also, there are some situations where the exit tax might apply at the state level, if the expatriate is covered and is a resident of the state up until expatriation. This can be a real headache :)Q4: Hi Debra, have you ever had a situation where someone filed I-407 at year-end but was not received by USCIS until the following year? The client thinks it was not sent "return receipt requested" because that option didn't exist in Japan. As I read the regulations, he might be in a grey area as to whether the taxpayer expatriated in 2020 or 2021. In this situation do you have any best practices?A4: Yes, we've seen this exact situation - for one client, when they finally got the confirmation from USCIS that they expatriated, it was dated March of the following year. For that client we were able to move the date to Jan 1 by treaty election because they happened to be eligible to make a treaty election. Our best practices for green card holders because of that situation has become "expatriate earlier in the year or have a backup plan to make a treaty election" wherever possible.Q5: Where do Roth 401(k) accounts fall in this classification? Are they treated differently from Roth IRA in this context?A5: I am not sure if they would be specified tax deferred accounts or deferred compensation. It's an important distinction to make because for deferred comp there is the option of postponing taxationQ6: Is that treaty election on a calendar year basis? So, I could make treaty election for Japan resident as of Jan 1, 2021. File 2020 as full year 1040 and 2021 as full year 1040NR. Is that right? And a (probably minor) risk that expatriation might have occurred in late 2020?A6: I think that could potentially be a viable solution, assuming they are eligible to make that treaty election. We used a similar solution for our client under the UK treaty. We will be doing that like you said - 1040NR with treaty election starting 1/1/2021, full year 1040 for 2020.Q7: I think you mentioned that U.S. trust becomes a foreign trust on a day or day before the expatriation, does it mean Form 3520-A is required, or something else has to be done?A7: Yes, in some situations a trust could become a foreign trust and the owner could be deemed to no longer be its owner. In that case, expatriating would cause a deemed contribution into a foreign non grantor trust. For that a Form 3520 would be required.Q8: Are unvested RSUs included for purposes of determining the $2M threshold for purposes of being a non-covered expatriate?A8: This is a point that seems a little strange to me - it appears that the unvested RSUs generally do not get included for purposes of the $2M threshold. Yet if you are covered, they are then considered vested and subject to exit tax when you expatriate. This is my understanding of how to apply these rules, at least.Q9: For this 30% NR withholding does that likely mean an expatriate is filing US taxes each year even though they are no longer a Citizen? If so, they may as well retain Citizenship right since tax treaty would have the same effect on US taxes anyway?A9: That is correct, in some situations you would have to file for a refund every year if the withholding is 30% and you can use treaties to reduce tax to zero. It’s not always better to retain citizenship, but it’s definitely a very individual choice based on a lot of factors.Q10: Does personally owned life insurance policies form part of the net worth for the $2 million test?A10: Yes, and there is a special rule in notice 2009-85 to value the life insurance policy under the gift tax rules.Q11: For Roth IRAs, do you have to literally withdraw the money from the account, or could you opt to leave it there? I can see the case for paying the exit tax and leaving the money in the account if your destination country recognizes Roth IRAs.A11: For Roth IRAs, no you are not required to withdraw the money and you can leave the account in place if the account custodian agrees to keep your account. And I think for Roth IRAs they wouldn't generate exit tax because distributions are usually not taxed.Q12: Debra, just to clarify...although a covered expatriate can't utilize the reduced rates of withholding under a treaty (the 30% flat rate applies), these rules don't apply to an individual who is NOT a covered expatriate...correct?A12: That's correct. A covered expatriate must agree on Form 8854 to waive their rights to treaty benefits with respect to withholding. Non-covered expatriates do not have to do that.Q13: Thanks Debra. For foreign life insurance policies, what is the "practical" approach you use to value the policy for purposes of the net worth test?A13: It really depends on the type of policy. Most often, I see term life policies and private placement type policies. For term policies the value is often just the unearned premium. For life policies that are really just wrappers for investment accounts, we are usually able to treat them like investment accounts for valuation purposes.Q14: Is the $2 mil net worth test split evenly for a married couple (i.e. $4 mil total), or is it required to follow named assets, or does this depend on the asset?A14: The $2M net worth test is not split for a married couple. It is necessary to determine which spouse owns what assets, and each person has their own $2M net worth test.Q15: Does the exit tax have any interactions at the state or even local level? I'm curious if, say, California could consider the deemed sale of taxable stocks to be a taxable event.A15: It could, if the expatriate is a resident of a state up to the time of expatriation. See this article from Phil: https://hodgen.com/state-income-tax-expatriates/Q16: I find clients will prefer to use up their exclusion now before expatriating to get their net worth under $2m rather than re-establish domicile.A16: That’s my experience as well. Whenever possible it's better to be non-covered and avoid the covered gift and bequest stuff completely. Especially since... they haven't published the form to report it yet.Q17: Re 401(k)s, wouldn't you normally have the option to choose between tax at flat rates or at graduated rates? Or do we lose that ability in the context of expatriation?A17: If it's eligible for the treaty, most often the treatment is that it's taxed in the country of residence, meaning the treaty would make it not subject to US tax.Q18: Debra - your response seemed to indicate that a 401k would likely be found in the pension section of a treaty eligible for treaty rates, so that would be a flat rate rather than a graduated rate. So, if a 401k is eligible for a treaty rate you would not have to apply graduated rates? (even if it was considered ECI?)So if a treaty applies a 15% tax rate to a 401k, then a Form 1040NR would be filed to claim a refund of 15% (30% withheld less 15% tax treaty rate) - do you agree? and the amount would be reported on Schedule NEC of Form 1040NR? Otherwise if you put it on page one of the 1040NR the graduated rates get applied.A:18 That sounds logical if there is a treaty that creates that situation for a 401k... Otherwise you would not be able to properly claim the 15%.