A Covered Expatriate is an Expatriate who is too wealthy, paid too much in Federal income tax, or failed the paperwork requirements in some way.
Section 1. Certification Test
You will become a Covered Expatriate if:
- You are not up to date with all of your Federal tax obligations; or
- You are late filing Form 8854 after your expatriation event; or
- You tell somewhat less than the truth on your tax returns or Form 8854.
Specifically, you will be a Covered Expatriate if you:
“[fail] 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.”
Prior Five Years
The IRS wants to know that you have tax returns on file and you have paid all of your taxes (all types) for the five years before the year of expatriation. If you do not have tax returns on file, your first job is to get that done, even if you had no requirement to file, because (for instance) you had zero income.
File Form 8854 on Time
The certification must be made on a timely-filed Form 8854.
Form 8854 is filed as an attachment to your expatriation year tax return.
For people living outside the United States, the filing deadline for a U.S. income tax return is usually (but not always) June 15. You can also get a six month extension to file your tax returns. This means if you have a June 15 filing deadline, you can have as late as December 15 to file a timely income tax return.
Absolutely file on time. If you do not, you automatically become a Covered Expatriate.
Someone who is “too poor” to be a Covered Expatriate—even someone who paid no income tax and has a zero net worth—will nevertheless be a “Covered Expatriate” if Form 8854 is filed late.
The certification requirement applies to all Federal tax obligations, including information returns. Conceptually, then, this means all Title 26 (Internal Revenue Code) obligations are included in the certification.
What about obligations such as Form TD F 90-22.1, reporting signature control or a financial interest in foreign financial accounts? These are obligations under Title 31, and thus arguably someone out of compliance for filing these forms would nevertheless be able to certify compliance with his or her Title 26 obligations. This is an area of speculation and caution is urged until additional guidance is issued by the Internal Revenue Service. My suggestion is that you don’t get clever and attempt to skate past anything. You are trying to make a clean break with the United States.
Section 2. Net Worth Test
The most common way to become a Covered Expatriate is by having a net worth of more than $2,000,000. This is the “net worth” test.
The $2,000,000 figure is not adjusted for inflation.
The method for determining net worth is described in Notice 97-19 issued by the IRS.
What You Include
The assets that you look at are “any interests in property” that would be taxable as a gift if you gave them away the moment before you expatriated. Look at the gift tax rules to see if you would trigger a gift tax by giving the assets away.
An “interest in property” is a carefully defined term. It does not matter whether the property produces income or not. It includes the right to use property, as well as ownership.
For purposes of your analysis, you treat the assets you can give away as part of your balance sheet. However, gift tax exemptions and deductions are ignored in calculating net worth. These include the annual exclusion, transfers to certain minor’s trusts, transfers for certain medical and education expenses, the exemption for certain waivers of pension rights, and the exclusion of certain loans of artwork. In addition, the gift splitting, gift tax charitable deduction, gift tax marital deduction, and limitation on deduction rules are ignored for the net worth test in determining Covered Expatriate status.
Since it is a balance sheet test, you include debts as an offset to calculate your net worth. If you have a $1,000,000 house with a $600,000 mortgage, your net worth is $400,000.
How to calculate value
The method of establishing value is established by Section 2512 and regulations issued under that Section. These are the gift tax rules.
If you are thinking of using valuation discounts to reduce the value of the assets you own, too bad. You cannot invoke prohibitions or restrictions as a method for creating discounted value.
You may use good faith estimates of value. Formal appraisals are not required when you are determining whether you meet the $2,000,000 net worth test.
Beneficial interests in trusts
If you are a beneficiary of a trust, you must calculate the value of that beneficial interest to determine whether you reach the $2,000,000 threshold for being a Covered Expatriate.
The process of establishing the value for a beneficial interest in a trust requires an allocation of assets among all beneficiaries, followed by a valuation of the would-be expatriate’s beneficial interest.
Allocation among beneficiaries
First you will go through an allocation process.
Look at all the assets in the trust and allocate them among all the beneficiaries or potential beneficiaries of the trust. This is a “facts and circumstances” process. Look at the terms of the trust document. If there is a letter of wishes (or similar document), consider that, too. Look at the way trust distributions have been made in the past.
You are also instructed to consider the “functions performed by a trust protector or similar advisor.” To say this is unclear would be an understatement.
If, after looking at the documents, prior distributions, and the trust protector’s powers, you cannot determine the identity of the beneficiaries to whom the trust assets should belong, there is a default method for allocating ownership. You use the principles of intestate succession (use the trust settlor’s death as the starting point) as contained in the Uniform Probate Code. Whatever percentage you would inherit under the Uniform Probate Code is the percentage of trust assets you are deemed to own for the exit tax calculations.
Valuation after allocation
Once you have decided the identities of the beneficiaries who are deemed to own the trust assets, apply the valuation methodologies of Section 2512 (and the regulations under that Code Section), without regard to prohibitions or restrictions on the interest in the property.
Section 3. Net Tax Liability Test
A Covered Expatriate is someone who is sufficiently rich for the IRS to care about. (That’s a joke, not a statement of tax law.) Someone who pays a lot of income tax must be rich, at least according to the IRS.
$155,000 or more (expatriations in 2013)
Look at the five years of income tax returns you filed before the year of expatriation. How much was your Federal income tax liability each year? Add the five years’ amounts together, and divide by five. That is your number.
If the amount exceeds $155,000 (this is the threshold amount for expatriations occurring in 2013) you will be a Covered Expatriate under the net tax liability test.
The $155,000 amount is indexed annually for inflation. The number I have given here is for 2013 expatriations.
It is not simple
If only it were as easy as looking at a line on the last five years of Form 1040, doing a quick addition and dividing the result by five. Unfortunately, unnecessary complexity raises its head here.
“Net Tax Liability” Redefined
The rule to apply here is from Notice 97-19, Section III, 1997-1 C.B. 394. Even though this Notice applies to the prior expatriation tax regime under Section 877, it explicitly is applied to the current rules under Section 877A as well.
For purposes of the tax liability test, an individual’s net U.S. income tax is determined under section 38(c)(1). This means you will need to look at your tax returns for the five years before expatriation and make the adjustments required.
Married Filing Jointly
An individual who files a joint income tax return must take into account the net income tax that is reflected on the joint income tax return for purposes of the tax liability test.
This is not fair, but rules are rules. Let’s say you (but not your spouse) will expatriate. If you and your spouse filed joint tax returns and paid $200,000 per year of Federal income tax, you would think the logical (and fair) thing to do would be divide by two, and treat you as if you paid $100,000 of Federal tax per year. You would be wrong.
Part of the planning I do with people who plan to expatriate is to get them started with filing “Married Filing Separately.” That $200,000 of tax liability is then unambiguously a $100,000 per person net tax payment each year.
Section 4. Exceptions
If you fail the Certification Test to become a Covered Expatriate, there is no way out of that status. You are a Covered Expatriate. You are subject to the full brunt of the exit tax rules.
But if you become a Covered Expatriate because you have a net worth above $2,000,000 or you paid more than $155,000 of Federal income tax liability on average over the prior five years? There are two exceptions. One might work for you. Satisfy one of them and you will be a mere Expatriate with a paperwork problem. You will not be a Covered Expatriate with a tax bill to pay.
Dual citizen from birth
Regardless of your financial status, you are not a “Covered Expatriate” if you satisfy all the following items:
- You became a U.S. citizen at birth; and
- You also became a citizen of another country at birth; and
- On your expatriation date you “continue” to be a citizen of that country; and
- On your expatriation date you “continue” to be taxed as a resident of that country; and
- On your expatriation date you were not a U.S. resident for 10 of the 15 tax years that end with the year that you expatriated.
Note, however, that you will still have to certify that you are up to date with all U.S. tax requirements. Failure to do so will render you a Covered Expatriate even if you satisfy all the dual citizenship requirements.
Relinquish citizenship before 18 1/2
The second way that you can cease to be a Covered Expatriate is by relinquishing your U.S. citizenship before age 18 1/2.
The specific requirements you must satisfy in this situation are:
- You relinquish your U.S. citizenship before age 18 1/2; and
- You were not a U.S. resident for more than 10 taxable years before the date of relinquishment.
By relinquishing citizenship before age 18 1/2 you will avoid the impact of the net worth or net tax liability tests. But you will still be required to certify full compliance with all U.S. tax requirements, and failure to do so will render you a Covered Expatriate.