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The Certification Test and Open Audits
This week’s question is about the certification test. One of the signature features of the exit tax laws is that when you renounce your citizenship you tell the government that you are up to date with your tax filings and tax payments for the previous five years.
Well, what happens if you renounce your citizenship while the IRS is in the middle of an audit on one of your tax returns? Or what if the audit is opened AFTER you renounce your citizenship. By definition it is not entirely clear that you are up-to-date with your tax obligations. The result of the audit might mean you owe more money, or the audit results might turn up an omitted form or two.
If you “fail” the certification test (and I will tell you what that means), the result is that you are a “covered expatriate”. As a general rule you do not want to be a covered expatriate, because that means a potentially large tax bill for you, simply for the privilege of escaping the gravitational field of the U.S. tax system.
Here is the question I received, from a CPA reader of the newsletter. I have changed the key identifying facts:
I am facing another issue regarding the Certification, that maybe could be a newsletter topic, unless you have already addressed it? The IRS has launched an audit on the client’s 20xx return, after [s/he] expatriated in 20yy. It is still on-going, as they are being quite unreasonable, and we will be filing her 8854 this year. If the audit is not resolved by then, can [s/he] (and I!) sign the 8854?
The “too long, didn’t read” is that you can certainly (and should) certify that everything you put on the tax return being audited is true and correct. After all, that was your position when you filed the tax return, and it is your position until you concede defeat in the audit (or have defeat thrust upon you).
However, if you are audited and lose, there is a possibility that the loss you could flip from “not a covered expatriate” to “covered expatriate”. The law is unclear, but the downside risk is there. You should defend yourself vigorously on the underlying audit issues. If you fail there (you owe additional tax), you should fight any attempt by the IRS to treat you as a covered expatriate.
The Certification Test
This is what you, the taxpayer, must do in order to have a shot at avoiding covered expatriate status. (There are two more ways that you can become a covered expatriate, by using money measurements by which Congress has apparently decided that you are so rich that you should be tagged with a big tax bill when you renounce citizenship or give up your green card. I am not going to talk about those today.)
A taxpayer fails the certification test (and becomes a covered expatriate) if:
such individual fails to certify under penalty of perjury that he has met the requirements of this title for the 5 preceding taxable years or fails to submit such evidence of such compliance as the Secretary may require.
IRC §§ 877(a)(2)(C), 877A(g)(1)(A).
This is amplified in Notice 2009-85, Section 2(A). A covered expatriate is someone who:
[F]ails to certify, under penalties of perjury, compliance with all U.S. Federal tax obligations for the five taxable years preceding the taxable year that includes the expatriation date, including, but not limited to, obligations to file income tax, employment tax, gift tax, and information returns, if applicable, and obligations to pay all relevant tax liabilities, interest, and penalties (the “certification test”). This certification must be made on Form 8854 and must be filed by the due date of the taxpayer’s Federal income tax return for the taxable year that includes the day before the expatriation date. See section 8 of this notice for information concerning Form 8854.
In simple terms, you fail the certification test (and become a covered expatriate) if one (or both) of these things happen:
- you do not certify that you have met all of your tax obligations for the preceding five years; or
- you cannot give the IRS proof that you met all of your tax obligations for the preceding five years if the IRS audits you.
First: Certify That You Are Current With Your Tax Responsibilities
The first way to deal with the certification test is simple. Make the certification that you have met all of your tax requirements for the previous five years. In other words, if you renounce your citizenship (or give up your green card) in 2016, you tell the IRS that your tax returns are properly filed and your taxes fully paid for 2011 through 2015.
How and When
It is easy to make this statement: check the “Yes” box on Form 8854, Part IV, Schedule A, Line 6. It is at the bottom of page 2 of Form 8854.
It is not clear whether this state of total compliance with tax requirements must be measured as of the day of your renunciation, or the day you file Form 8854. I personally think it is the date that you file Form 8854. What is clear, however, is that you only pass the certification test if you file Form 8854 on time.
To do this right:
- Check the “yes” box on Form 8854, Part IV, Schedule A, Line 6. (Only if this is true, of course.)
- File Form 8854 on time — do not file late.
If You Are Being Audited, Check “Yes”
If you are being audited when you renounce, you can check the “yes” box on Line 6 to satisfy the certification test.
After all, when you signed the tax return that the IRS is auditing, you certified the truth of that return under penalty of perjury. On your Form 8854 you are making the same claim, under penalty of perjury. Your position on the tax return under audit is consistent with your position on Form 8854.
Second: “Prove It” Later
The second way to fail the certification test (and become a covered expatriate) is to be challenged by the IRS and lose. Remember, IRC § 877(a)(3)(C) says you become a covered expatriate if you:
[fail] to submit such evidence of such compliance [with your tax filings for the previous five years] as the Secretary may require.
The “Secretary” in this case is the Secretary of the Treasury, who is the Big Boss of the IRS. So you have to prove that your 2011 through 2015 tax filings and tax payments are correct to Jack Lew, the current holder of that office. Mr. Lew will have one of his underlings handle the job for him, I’m sure.
Interesting point: Notice 2009-85 says nothing about this second leg of the certification test, or at least nothing that I could find. (Please tell me if I missed something.)
There is nothing unusual about this requirement. The IRS has (and should have) the power to call “BS!” Otherwise, you could never file tax returns, check the “yes” box, and make a clean getaway without ever paying the tax that you owe.
The Downside Risk of “Prove It Later”
What is unusual is the draconian penalty risk. To pass the certification test, you answered “yes” to the magic question at the bottom of page 2 of Form 8854. The IRS challenges you to prove this is true, by way of an audit. If you fail, you are a covered expatriate.
Note the critical distinction in the downside risk. Here’s an example:
Consider you and your identical twin. You expatriate in 2016, and your twin remains a US citizen.
Both of you earn the same amount of money, work at the same place, and have the same amount of money in a bank account.
Both of you file your 2014 tax returns and both of you accidentally forget about $1,000 of interest income that you earned in 2014.
The IRS audits both of you, asking questions about your 2014 tax return. The IRS finds the omitted income, and you pay tax, penalties, and interest to the IRS.
Your twin (the US citizen) is finished. The financial pain is all that he experiences.
You (who renounced US citizenship), however, pay the tax, penalties, and interest. In addition, you were unable to prove to the satisfaction of the Revenue Agent that your 2014 tax return was correct. You have now failed the certification test, at least according to the plain language of IRC § 877(a)(3)(C), which makes you a covered expatriate, according to the plain language of IRC § 877A(g)(1)(A).
You Are Audited, You Lose? Fight Like Hell
I happen to believe this is a wrong result. My opinion is that the “certify under penalty of perjury” stuff means that the IRS can make you a covered expatriate only if you screw up your prior year tax returns in some magnificently malevolent way. If a Federal Judge would be looking at throwing you in jail for perjury or some serious tax crime, then covered expatriate status would be warranted. Normal errors and foot faults? No.
But no one knows. At least, I don’t know. Maybe some of you who have expatriated have gone through the wars and come out on the other side unscathed. I have only had that experience with people who were covered expatriates anyway, due to high net worth. So there was no life-or-death consequence to failing the certification test.
Given the profound risk, the prudent person who wishes to expatriate should do two things:
- Preventive Defense. Fix everything you can with the prior five years of tax returns. Be anal-retentive. Be obsessive compulsive. Give the IRS nothing to gnaw on. Yes, it is expensive to do, and yes, you might pay extra tax. But your objective is to get away from the IRS forever. Fix it. This is your preventive medicine.
- Two-Level Audit Defense. If you are audited and you are not already a covered expatriate, defend vigorously. Take it to Tax Court. If your Revenue Agent gives you the assurance in writing that you will not be flipped to covered expatriate status as a result of the audit, you mightrelax a bit.
If you are audited, your strategy will be two-fold. First, you will fight to prove the IRS wrong in the audit. If that fails (because you had a malfunction – heh! – in your tax returns for prior years), and if they think you should flip from “not” to “definitely” covered expatriate status, you will need to fight this in Court. Concede the tax if you must but do not concede the conversion to covered expatriate status.
The “Do This” and Disclaimer
In that podcast, Derek talks about reading books and realizing the importance of distilling out the key “Do This!” advice that each book has — action steps for people who are not interested in reading the long form explanation.
I have given you actionable suggestions:
- Play defense: fix things so you are bulletproof.
- Mama Bear defense if audited: calculate the tax cost of being a covered expatriate and then throw every resource at defeating the audit. If that fails, throw every resource at defeating the “you are a covered expatriate” attack. You are the Mama Bear, and the IRS wants your cub.
I am not your lawyer and this is not legal advice to you. I know nothing about you, your prior year tax returns, or anything else about you. Go hire someone if you need help. The stakes are high. That’s my disclaimer.
Also, I want to emphasize that fighting hard against an audit (or taking a position in Court) does not mean lying, being rude, or anything like that. Be kind, be honest, be responsive in your dealings with the government. But hold your ground and work really, really, really hard. But hold on to your integrity. Do nothing that would make you feel ashamed of yourself.
And . . . if a tax protestor or “The constitution says I don’t have to pay taxes” person would do it or say it? Stay away from it.
See you in a couple of weeks.