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October 23, 2013 - Phil Hodgen

Chapter 1 – A Quick Overview of the Exit Tax

Every year, more and more U.S. citizens renounce their citizenship. Green card holders give up their visa status. These actions trigger a tax problem: the exit tax.

The exit tax rules impose an income tax on someone who has made his or her exit from the U.S. tax system. The defining feature is that assets are treated as if they are sold on the day before citizenship or resident status is terminated.

Net capital gain (after an exemption) from the deemed sale is taxed immediately. There are other rules that accelerate income for a person leaving the United States. These rules apply to things like IRAs, pensions, deferred compensation plans, and beneficial interests in trusts.

Citizenship-Based Taxation

The United States is not alone in having an exit tax. Other countries have exit taxes, too. The United States is unique, however, in tying its exit tax to a change in visa or citizenship status. This is called “citizenship-based taxation“. If you are a U.S. citizen or resident alien, you are taxed on worldwide income.

Every other country on Earth (except Eritrea and a few other limited-case exceptions) follows a “residence-based taxation” system. If you are a resident (however defined) of that country, you are taxed. If you are a nonresident (however defined), you are not taxed. This is why it is easy for Canada (residence-based taxation) to allow its citizens to live abroad and be taxed as nonresidents, while it is impossible for the United States (citizenship-based taxation) to do so.

The citizenship-based tax principles in the DNA of the Internal Revenue Code are the reason that giving up citizenship or residence is a tax recognition event, and the reason that the exit tax rules exist.

Who Should Worry About the Exit Tax?

The exit tax applies to two categories of people:

  • U.S. citizens who terminate their citizenship; and

  • Long-term residents — lawful permanent residents of the United States (holders of a “green card” visa) who terminate that status after holding it for many years.

If you do not fall into one of those two categories, you do not need to worry further about the exit tax rules. Thus, for instance, someone living for decades in the United States under other visas (student, H-1B, L-1A, etc.) will never have a concern about paying exit tax.

Citizens

Citizens of the United States — when they voluntarily or involuntarily terminate that status — will trigger the exit tax rules. By giving up citizenship, they become expatriates, to use the Internal Revenue Code’s jargon.

It is usually simple to determine your U.S. citizenship. If you are born in the the United States, you are a U.S. citizen. It is sometimes a bit complex to determine whether someone born outside the United States (with U.S. citizen parents) is a citizen or not. A naturalized citizen will have a vivid memory–and some paperwork–to prove acquisition of U.S. citizenship. People will almost always know whether they are citizens of the United States or not.

Dual citizenship does not matter. Acquiring citizenship of a second country will not terminate U.S. citizenship, unless you successfully persuade the State Department that your acquisition of citizenship in another country is a relinquishment of your U.S. citizenship.

Long-Term Residents

People who are not citizens of the United States can also be subjected to the exit tax. They must be long-term residents of the United States.

  • Resident status means that they are lawful permanent residents of the United States. In normal conversation we call these people green card holders.

  • Long-term means that they have held lawful permanent resident status — even for a split-second of time — in at least eight out of the last 15 years. In making this “eight out of fifteen” calculation, there are special rules for disregarding years in which these people lived abroad and filed U.S. income tax returns claiming nonresident status under the terms of an applicable income tax treaty.

Example

For someone who became a lawful permanent resident in 2010 (and who has always filed Form 1040 since then), 2017 is the eighth year of holding the visa status. This person is a long-term resident. Taking one of the actions specified in the Code will make trigger application of the exit tax rules.

What Actions Trigger the Exit Tax?

You are not subjected to the exit tax rules simply because you are a citizen or a long-term resident. You must do something to trigger the application of the exit tax: terminate your citizenship or long-term resident status.

Citizens Relinquish Citizenship

U.S. citizens can choose to give up citizenship, or have it taken away from them. Losing citizenship makes a (former) U.S. citizen an expatriate under the exit tax rules.

Most people relinquish U.S. citizenship by renunciation. The process is straightforward: sign some documents, answer some questions, pay a $2,350 fee, and make an oath in front of a U.S. Consular official to voluntarily renounce your U.S. citizenship. Citizenship can be lost by methods other than formal renunciation. In a few instances, the government can take U.S. citizenship away from you.

When the process is complete, the State Department issues a Certificate of Loss of Nationality to confirm that you no are no longer a U.S. citizen.

Long-Term Residents Give Up Visa Status

Green card holders are also affected by the exit tax rules.

A green card holder must have been a lawful permanent resident in eight of the 15 years ending with the year of expatriation–in other words, the green card holder is a long-term resident (a defined term in the Code). Only green card holders who are long-term residents are affected by the exit tax rules.

Example

You become a lawful permanent resident in 2013. In 2017, you have been a lawful permanent resident in five years out of fifteen years.

You are not a long-term resident, so you need not worry about the exit tax rules if you decide to give up your visa and leave the United States.

Once long-term resident status is attained, there are two ways that a green card holder can trigger the exit tax rules. First, the green card holder can voluntarily abandon the visa status or the government may forcibly cancel the visa. This event causes the long-term resident to be an expatriate, subject to the exit tax rules. Visa status is voluntarily abandoned by filing Form I-407 with the USCIS.

Long-Term Residents Make a Treaty Election

Second, the long-term resident may trigger the exit tax rules–become an expatriate–by making a treaty election to be a nonresident, thereby ceasing to be a lawful permanent resident. The green card holder makes this election by filing a Form 1040NR for the year in question, with the treaty election on an attached Form 8833.

The election, if made after the green card holder becomes a long-term resident, will cause the individual to be an expatriate.

Are You a Covered Expatriate or Not?

Once you have determined that you have expatriated (given up citizenship for citizens, abandoned visa status or elected nonresident tax status for long-term residents), the next task is to figure out the consequences of that event.

The exit tax rules will create two possible income tax consequences for citizens and long-term residents who expatriate:

  • paperwork only, or

  • paperwork plus tax.

Covered expatriates face the prospect of paperwork plus tax liability, while noncovered expatriates bear the paperwork burden only. U.S. persons who receive gifts or bequests from covered expatriates also suffer: they pay a tax when receiving a wealth transfer from a covered expatriate.

Covered Expatriate vs. Noncovered Expatriate

“Covered expatriate” is a term of art, defined in the Code. It means someone who:

  • is an expatriate (a citizen who has relinquished citizenship, or a long-term resident who has given up green card visa status or has made a treaty election to be a nonresident), and

  • has failed (or satisfied, depending on your point of view) one of three tests.

The three tests are designed to identify people who are rich (in the eyes of the Internal Revenue Code) or noncompliant with U.S. tax law. They are covered expatriates.

Expatriates who are fully tax-compliant and of modest means (from the Code’s point of view) are not covered expatriates. The Code does not give these people a name, but for clarity’s sake they are informally referred to as “noncovered expatriates”.

Covered Expatriate Because of Net Worth

The first way to become a covered expatriate is to have net worth of $2,000,000 or more on the date of expatriation. The amount is not indexed for inflation. This is called the net worth test.

Covered Expatriate Because of Historic Tax Liability

The second way to become a covered expatriate is to have a high-enough average net income tax liability for the five tax years before the year of expatriation. The threshold amount for expatriations is 2017 is $162,000 and it is indexed for inflation. This is the net tax liability test.

Covered Expatriate Because of Tax Noncompliance

The final way to become a covered expatriate is to be noncompliant with tax obligations for the five tax years before the expatriation year. Full compliance with Title 26 (the entire Internal Revenue Code) is demanded. You must certify full compliance under penalty of perjury, and, if audited, prove it. This is the certification test.

Two Exceptions to Covered Expatriate Status

There are two categories of expatriates for whom the net worth test and the net tax liability test will not apply:

  • Dual citizens of acquired U.S. and another citizenship at birth; and

  • People who expatriate before age 18 1/2.

For those who qualify for one of the exceptions, personal wealth and prior years’ income tax liability will not cause the individuals to be covered expatriates. However, the taxpayers will still be required to satisfy the certification test, and failure to do so will make them covered expatriates.

How Covered Expatriates are Taxed

Covered expatriates face the prospect of being forced to pay tax in return for being allowed to escape the U.S. tax system’s worldwide tax net. The general principles are easy to understand:

  • Pay tax as you receive income. If the IRS can rely on tax withholding rules to assure full collection of income tax, the covered expatriate pays tax at a 30% rate on U.S. source income as it is received.

  • Pay tax on everything now. If the IRS cannot be assured of timely collection of tax at the source, the usual tax fiction of a deemed sale or deemed distribution (from an IRA, for instance) forces immediate recognition and taxation of unrealized income and capital gain while the individual is still a U.S. taxpayer.

The Code lays this out by identifying three categories of income for which special exit tax rules have been written. Everything else is subjected to a mark-to-market system that causes a deemed sale of assets at fair market value.

Specified Tax-Deferred Accounts

Specified tax-deferred accounts are things like IRAs or Health Savings Accounts: tax-advantaged creatures of Congressional creation. If the covered expatriate has any of these accounts, they are deemed to have received a full distribution on the day before expatriation. Early distribution penalties are not applied.

Deferred Compensation

Deferred compensation means pensions as well as other deferred compensation arrangements. If the covered expatriate has any of these, expatriation will trigger tax liability.

Pay as you go. Some deferred compensation arrangements are taxed to the covered expatriate on a 30% pay as you go arrangement. These are “eligible” deferred compensation arrangements. “Eligible” deferred compensation plans are those where the payor is a U.S. person. There is a simple reason why the government is willing to collect 30% as benefits are paid. A U.S. plan administrator means that there is a U.S. withholding agent. If a withholding agent screws up the tax withholding, it is personally liable to the IRS for the tax that should have been withheld, but was not. The government cannot lose: tax will be collected from the taxpayer (if withholding is done correctly) or from the U.S. pension plan administrator (if tax withholding is done incorrectly).

Lump sum. “Ineligible” deferred compensation arrangements are those where the payor is not a U.S. person. A foreign pension plan is a simple example of this. Now, the IRS cannot rely on a withholding agent to act, in effect, as a guarantor of tax payments. A foreign pension plan administrator, making a pension distribution to a foreign person (the covered expatriate) might not feel any particular compunction to satisfy an IRS request for tax withholding compliance. For ineligible deferred compensation arrangements, a covered expatriate is treated as having received a lump sum distribution on the day before expatriation equal to the present value of the accrued plan benefits.

Beneficiaries of Nongrantor Trusts

Covered expatriates who are beneficiaries of nongrantor trusts must pay 30% tax on the taxable portion of trust distributions they receive.

Mark-to-Market Rules

Everything that falls outside of those three special categories will be taxed according to mark-to-market principles. All assets are deemed sold on the day before expatriation, at fair market value. Capital gain or loss is computed in the normal way. An exemption amount ($699,000 for expatriations in 2017; this amount is indexed for inflation) is applied, and any net capital gain above the exemption amount is taxed using the usual capital gain tax rates.

The Exit Tax Paperwork

Predictably, the exit tax rules have spawned special-purpose tax forms.

  • Form 8854. Form 8854 is the main tax form. This form is due on the normal income tax filing deadline for the year of expatriation. Both covered and noncovered expatriates file this form. It captures all of the information that the Service needs to determine whether the taxpayer is a covered expatriate or not. For covered expatriates, it provides the details of the taxable income triggered by the event of expatriation, and where that income is reflected on the income tax return.

  • Form W-8CE. A special member of the W-8 family exists, just for covered expatriates. The covered expatriate gives this form to retirement plan administrators, pension and deferred compensation plan administrators, and trustees of nongrantor trusts where the covered expatriate is a beneficiary. This notifies the payor of taxable income of the recipient’s covered expatriate status, so the correct tax withholding can be applied. The recipient is also required to provide specified information to assist the covered expatriate’s calculation of the exit tax. For instance, an IRA custodian must report the value of an IRA on the day before expatriation, so the covered expatriate can treat that amount as a deemed distribution prior to expatriation.

  • Form 708. This form has not yet been published. Form 708 will be filed by recipients of gifts or bequests from a covered expatriate. The recipients pay tax at the highest gift tax rate on amounts received from covered expatriates. There are only a few exceptions. Proposed Regulations have been published to interpret and implement Internal Revenue Code Section 2801, which imposes this tax.

Where to Find the Law

The exit tax law is found in Internal Revenue Code Section 877A, which liberally borrows from Section 877 (the pre-2008 version of the exit tax law) for definitions. The Service has published Notice 2009-85, Guidance for Expatriates Under Section 877A, which amplifies some of the concepts of Section 877A. There are currently no published Regulations for Section 877A.

Section 2801 of the Internal Revenue Code contains the rules that impose a tax on the recipients of gifts or inheritances from covered expatriates. Proposed Regulations under Section 2801 have been published and in due course (with some likely modifications) will become Final Regulations.

Guidance for Would-Be Expatriates

Avoid Expatriate Status

When considering expatriation, the first line of defense against the exit tax is to avoid becoming an expatriate. This is impossible for citizens, but for green card holders, the strategy is to avoid becoming a long-term resident. Leave the United States and abandon the green card visa before the eighth year of holding that visa status.

Avoid Covered Expatriate Status

If expatriate status is unavoidable, paperwork burdens are unavoidable. But it may be possible to eliminate the tax cost of expatriation. Do this by re-engineering your life to eliminate covered expatriate status. Find ways to bring your net worth below $2,000,000. Find ways to bring your average income tax liability for the previous five years to a number below the inflation-adjusted threshold that applies to you. And, most of all, fix any noncompliance in tax returns for the five prior years. In our experience, most people believe they prepared and filed correct income tax returns, but a significant number Americans abroad have missed something when filing their tax returns.

Minimize Capital Gain

If covered expatriate status is unavoidable, attempt to reconfigure the expatriate’s asset holdings to minimize capital gain that will be subject to the mark-to-market rules. Holding $1,000,000 of cash assets yields zero capital gain when applying mark-to-market principles. Holding appreciated real estate will generate capital gain. Perhaps, for instance, you can engineer asset transfers so that an expatriating spouse can take full ownership of a $1,000,000 joint bank account while her non-expatriating spouse receives full ownership of the $1,000,000 family home.

Expatriation