Net Worth Test: Use Gift Tax Resident or Income Tax Resident Rules?

The tax rules for expatriation are still (almost a decade after being enacted) approximately as precise as fog. An accountant friend, Ed R. (he does not have a website, otherwise I would link to it), sent me an email after my webcast about expatriation, with an example of this.

Are You a "Gift Tax Resident" or an "Income Tax" Resident?²

Here's the problem. The exit tax is an income tax rule, but the IRS tells us to use the gift tax rules for defining net worth so you can figure out if an individual is a covered expatriate or not. Then the IRS computes what the covered expatriate owes in tax based on the application of income tax rules.Gift tax and income tax have two different sets of definitions for "resident". It is possible for someone to be a resident under the income tax rules and a nonresident under the gift tax rules (and vice versa).So do we use the income tax definition of "resident" or do we use the gift tax definition of "resident" to determine a prospective expatriate's net worth?Here is Ed's email:

I listened to your CalCPA presentation on Friday. At the end of your presentation, you invited questions. :-) I have a question regarding the Form 8854 Balance Sheet in the case of a "green card" holder (i.e. U.S. income tax resident) who is domiciled in a foreign country.Notice 97-19 indicates that gift tax principles apply to the preparation of the Form 8854 Balance Sheet. In part, Notice 97-19, Section III says:

"For purposes of the net worth test, an individual is considered to own any interest in property that would be taxable as a gift under Chapter 12 of Subtitle B of the Code if the individual were a citizen or resident of the United States who transferred the interest immediately prior to expatriation." (Emphasis added)

Does that mean ". . . if the individual were a . . . resident within the meaning of Reg. Sec. 1.2501-1(b). . . ." (since gift tax principles apply to Form 8854)or does that mean ". . . if the individual were a . . . resident without regard to Reg. Sec. 1.2501-1(b). . . ." (since Form 8854 is an income tax form)

Two Definitions of "Resident"

For income tax purposes, you are a taxed as a resident of the United States if:

• You have a green card visa;³
• You spend too many days in the United States;⁴ or
• You choose to be taxed as a resident of the United States.⁵

For gift tax purposes, you are a resident of the United States if you have your "domicile" in the United States. Visa status is not a make-or-break factor for domicile status. Nor is the number of days spent in the United States a make-or-break factor for domicile status.⁶Domicile means physical presence plus intent to remain indefinitely:

A person acquires a domicile in a place by living there, for even a brief period of time, with no definite present intention of moving therefrom. Residence without the requisite intention to remain indefinitely will not constitute domicile, nor will intention to change domicile effect such a change unless accompanied by actual removal.⁷

For this discussion, consider this situation:

• someone who has green card and
• leaves the United States to return to his/her home country to live permanently.

That person will be domiciled outside the United States for gift tax purposes--and therefore will be a nonresident for gift tax purposes.

Use the Right Definition of "Resident"

With that in mind, let's look at the question: which definition of "resident" should we use?For exit tax purposes (an income tax question), when we are determining net worth (so we know whether the person is a covered expatriate or not) do we use the gift tax definition of resident or do we use the income tax definition of resident?

The Net Worth Test

The net worth test says you are a covered expatriate if your net worth is $2,000,000 or more.⁸Notice 2009-85 (the only thing we have so far that explains the exit tax rules) tells us to figure out net worth using the rules found in Notice 97-19.⁹Notice 97-17 says "use the gift tax rules" to determine net worth:

For purposes of the net worth test, an individual is considered to own any interest in property that would be taxable as a gift under Chapter 12 of Subtitle B of the Code if the individual were a citizen or resident of the United States who transferred the interest immediately prior to expatriation.¹⁰

The Scenario

Which brings us back to our question: which definition of "resident" do we use? Here is why it matters.

• A green card holder domiciled abroad, on the day before filing Form I-407 to abandon a the visa status, is a U.S. resident for income tax purposes.
• A green card holder domiciled abroad, on the day before filing Form I-407 to abandon the visa status, is a U.S. nonresident for gift tax purposes.

Here is an example:

You are a green card holder. You in the United States for 10 years, then decide to leave and return to your home country. You does so, but never file Form I-407. You just file a Form 1040 income tax return for the last year you lived in the United States, and go. From then on, you does not file U.S. income tax returns.As far as the USCIS is concerned, you are still a lawful permanent resident of the United States. The visa status is still valid until it is formally terminated by the government or by the visa holder.Six years after leaving the United States, you learn the truth about your tax and visa situation:

• you are still a resident for U.S. income tax purposes and should have filed Form 1040 income tax returns after leaving the United States;
• you are a nonresident for U.S. estate and gift tax purposes; and
• you are still a lawful permanent resident of the United States as your immigration status.

You decide to take care of this. You know about the exit tax rules, and decide to figure out if you are a covered expatriate or not.

Include All Assets in Net Worth, Or Not

For purposes of computing net worth and listing assets on Form 8854's balance sheet, include all assets worldwide if you think Notice 97-19 intends for you to use the gift tax definition of "resident".If you thnk Notice 97-19 intends for you to use the income tax definition, a green card holder living abroad will only include a limited set of U.S. assets, and exclude all foreign assets.

Using the Gift Tax Definition of "Resident"

A U.S. citizen or a U.S. resident ("domicile", remember?) is potentially taxable on gifts of any asset, anywhere in the world. I say "potentially" because there are exceptions and exemptions littered hither and yon in the Internal Revenue Code. Let's take the basic premise, though, as accurate: a green card holder domiciled in the United States is taxable on gifts of any asset, no matter where it is located.

Green Card Holder Domiciled in the United States

For a U.S. resident ("domicile", remember?) green card holder, we therefore include all assets owned by that person on the day before the expatriation date, when we are computing the individual's net worth.That is what Notice 97-19 tells us to do: look at the day before expatriation, pretend that the individual is a resident (and we are assuming the gift tax definition of "resident" applies), and make your decisions accordingly.

Green Card Holder Domiciled Outside the United States

The same result occurs for green card holders who are NOT a U.S. residents (because they are "domiciled" outside the United States).These people are nonresidents for the purpose of gift tax liability, but Notice 97-19 tells us to pretend as if they are residents. We use the gift tax definition of "resident" and the gift tax will apply to a hypothetical gift of all of their assets, no matter where they are located. Therefore, we include the green card holder's worldwide assets when computing net worth for determining covered expatriate status.

Income Tax Definition of "Resident"

An entirely different result occurs if we think that Notice 97-19 says "use the income tax definition of resident and determine what would be a taxable gift if an asset were given away on the day before expatriation" when computing net worth.A green card holder can be a resident under the income tax definition, but a nonresident under the gift tax definition. This leads to an interesting (too good to be true, I think) result.

Income Tax Resident Plus Gift Tax Resident

If the individual who will expatriate is domiciled in the United States, then he or she is a resident for gift tax purposes. We include all assets owned on the day before expatriation, which, if given away, would trigger a gift tax.Because the individual is domiciled in the United States (a resident for gift tax purposes), it does not matter what his or her income tax residency status is. As an income tax resident or an income tax nonresident, all of the individual's assets are included in computing net worth.

Income Tax Resident But Not Gift Tax Resident

Here is the interesting possibility. Ed R. would like this to be true, but he suspects it isn't.Notice 97-19 tells us to figure out net worth by pretending that the individual is a resident on the day before expatriation. If we use the income tax definition of "resident" then the individual's gift tax residency status is left untouched.And it is possible for a green card holder to be a resident for income tax purposes (because holding a permanent resident visa makes it so) and simultaneously be a nonresident for gift tax purposes (by being domiciled outside the United States).A green card holder who is domiciled outside the United States is not taxable on gifts of all assets, anywhere. Instead, what is included in taxable gifts for green card holders resident ("domicile", remember?) outside the United States will be limited to:

• Gifts of U.S. real estate; and
• Gifts of tangible personal property located in the United States.¹¹

What is NOT treated as a taxable gift for a green card holder domiciled outside the United States? The U.S. does not tax these gifts:

• Gifts of assets (real estate, bank accounts, anything else) that are treated (for gift tax purposes) as located outside the United States.
• Gifts of "intangible personal property" located in the United States. The classic example of "intangible personal property" is stock of a corporation.

This means that a green card holder domiciled abroad can have enormous assets outside the United States, give those assets away, and not pay any gift tax.And if that is true, then for computing the green card holder's net worth, we do not include those assets in computing net worth in determining whether the individual is a covered expatriate or not.Here is an example:

A green card holder wants to determine net worth for covered expatriate purposes. He is domiciled outside the United States. Using the income tax definition of resident, he pretends (as required by Notice 97-19) that he gave away all of his assets on the day before expatriation and tries to figure out what is a taxable gift and what is not.The green card holder's only asset are:

• U.S. real estate worth $1,000,000; and
• Foreign real estate worth $50,000,000.

What is this individual's net worth for the net worth test? Is this individual a covered expatriate or not?

• A gift of U.S. real property by a nonresident (i.e., nondomiciled) individual is a taxable gift. Include the $1,000,000 U.S. real property asset on the balance sheet of Form 8854 when you are telling the IRS about your net worth.
• A gift of foreign real property by a nonresident (i.e., nondomiciled) individual is not a taxable gift. Do not include the $50,000,000 foreign real property on Form 8854 when you are telling the IRS about your net worth for gift tax purposes.

For purposes of the net worth test, the green card holder domiciled abroad but using the income tax definition of "resident" for purposes of Notice 97-19 to determine covered expatriate purposes has a net worth of $1,000,000, and is not a covered expatriate.

Which Definition Applies?

I think logic demands that we use the gift tax definition of "resident" in determining net worth for an expatriate.In determining net worth, we are told to use gift tax principles. It seems logically consistent to use the gift tax definition of resident (meaning "domiciled") for that. Stay entirely within the gift tax rules for deciding what is taxable if given away.After net worth has been decided (and let's assume we have decided that the individual is a covered expatriate), we come to the question of how much exit tax must be paid? This is an income tax question. There is a "pretend" sale of all assets on the day before the expatriation date. On the day before the expatriation date, the individual is a U.S. resident for income tax purposes because he has a green card.

Planning Opportunity

For wealthy green card holders, this raises an interesting opportunity for exit tax planning:

1. Move assets from the United States to a foreign country.
2. Move yourself to a foreign country and establish domicile there.
3. Give away foreign assets until your net worth for all remaining assets is below $2,000,000.
4. For bonus points, consider using your unified credit (this is what lets you give away approximately $5,500,000 tax-free to anyone) to give away U.S. assets.
5. Abandon permanent resident status by filing Form I-407 or by making an election under an applicable income tax treaty to be a nonresident of the United States.

This will allow you to avoid covered expatriate status (at least for the net worth test), and pay no exit tax.I will leave it at that, except to say that you would be a damned fool to just read that four-step process and launch yourself into expatriation orbit. At the very least, I would make gifts in one calendar year and expatriate in the next.