Covered Expatriates and Nongrantor Trusts. It’s Probably Pointless.March 14, 2017 - Phil HodgenExpatriation
Renounce, Receive Foreign Income and Get Tax Troubles1
Is it possible to renounce your U.S. citizenship, live outside the United States, collect 100% foreign income, and still be under the IRS’s thumb? (YouTube).
Yep. Or at least it looks that way.2 But who really knows?3
Here is what it takes:
- You are a covered expatriate.
- You are the beneficiary of a foreign nongrantor trust.
- The foreign nongrantor trust has no U.S. assets, and has no U.S. income.
- You receive a distribution from the foreign nongrantor trust.
Here’s what happens to you:
- No U.S. tax liability. You will not owe income tax to the United States because of the distribution you receive from the trust.
- But the trustee withholds 30% for U.S. tax. The trustee is required to withhold 30% of the taxable portion of the trust distribution and give it to the IRS.
Covered Expatriate + Beneficiary
Covered expatriates who are beneficiaries of foreign nongrantor trusts have a U.S. tax problem. Tax is required to be withheld from distributions they receive from those trusts, even if the distribution is tax-free.
First, start with being a covered expatriate.4 That happens if you expatriate and are tripped up by one or more of the following:
- Your tax history for the five years before the expatriation year is not entirely and 100% compliant with U.S. tax law;5
- Your average income tax liability for the five years before expatriation exceeds a certain inflation-adjusted threshold;6 or
- Your net worth at the time of expatriation is at least $2,000,000.7
Here is how to understand “nongrantor trusts”. When someone sets up a trust and puts money into it, someone must pay income tax on the interest, dividends, capital gain, etc. that the trust earns.
That “someone” can either be:
- the person who created the trust, or
- the trust itself or its beneficiaries.
If the trust’s creator/funder pays the income tax, we have a grantor trust. If the trust or its beneficiaries pay the income tax, we have a nongrantor trust.
Figuring all of this out just requires time, coffee, and the trust documents.
Foreign Nongrantor Trust
A nongrantor trust is “foreign” rather than “domestic” if, among other things, the trust is controlled by non-U.S. people. So, a foreign trustee makes a trust a “foreign nongrantor trust”.
How the Exit Tax Rules Treat Trust Distributions
Covered expatriates — when they receive distributions from nongrantor trusts — are taxed like every other nonresident alien.
No Special Tax Rule
Covered expatriates are taxed as if they sell everything they own when they renounce citizenship or give up their permanent resident visas.8
But that “let’s pretend” rule does not apply when we are trying to understand how a trust distribution is taxed when received by a covered expatriate.9
The Normal Rules Apply
So how is a covered expatriate taxed when receiving a distribution from a nongrantor trust? The answer is simple and logical: a covered expatriate is taxed like every other nonresident alien. And if for some reason the covered expatriate becomes a resident of the United States for income tax purposes, the covered expatriate is taxed like every citizen or resident taxpayer.
Nonresident aliens have a tax liability to the United States as defined in Section 871.
Trusts are designed to hold investment assets, and those assets generate investment income: dividends, interest, capital gain, rent, etc.
Investment income (income earned when you are not engaged in an active business) is taxable in the United States at 30%, if the income is from U.S. sources.
Notice 2009-85 saves us from a tour of the Internal Revenue Code.10 In describing the tax rules that apply to distributions from nongrantor trusts, it says:
Section 877A(f)(4)(A) provides that rules similar to the rules of section 877A(d)(6) shall apply. Thus, the tax that is imposed by section 877A(f) is imposed under section 871, but the payment is subject to withholding under section 877A(f)(1)(A) and not under section 1441. Any amount due under section 871 that is not paid by means of withholding must be reported on the income tax return filed by the covered expatriate for the relevant taxable year.11
The basic withholding requirement is imposed on the trustee of any nongrantor trust12 — whether the trust is foreign or domestic.13
The trustee of a trust is required to withhold 30% of the “taxable portion” of a trust distribution made to a covered expatriate.14
The “taxable portion” of a trust distribution is computed as if the covered expatriate were still a U.S. person.15
The tax rules that apply to the covered expatriate have a mismatch. The results is mandatory withholding of tax from trust distributions that will never be subject to U.S. income tax.
|To Figure Out||Treat the Covered Expatriate As|
|Is the trust distribution taxable?||Nonresident Alien|
|Must the trustee withhold U.S. income tax?||Citizen or Resident|
Ignore the Law, or Endless Refund Claims
For a covered expatriate who is a beneficiary of a foreign nongrantor trust that is entirely comprised of foreign assets and earns only foreign income, the principles of IRC § 871 mean that the trust distribution will never be taxable.
For the trustee of that trust, the principles of IRC § 877A(f) mean a life of difficult trust accounting (according to U.S. tax principles) followed by a withholding of 30% of the trust distribution.
I can foresee two responses by the trustee:
- Do not withhold tax. Logical. What can the IRS do to a foreign trustee of a foreign trust with foreign assets, distributing money that is not taxable to the recipient beneficiary?
- Withhold tax on the entire trust distribution and send it to the IRS and make the beneficiary claim a refund. Also logical. Why spend money on doing complicated trust accounting? The beneficiary will get all of his money back anyway, with or without good trust accounting records.
This means that the covered expatriate as a beneficiary is either happy or sad, depending on whether the pointless game of “withhold and claim a refund” is played or not.
- Wow there’s a mouthful of jargon right there. Sorry. ↩
- The law is a bit opaque, he said. ↩
- The IRS, that’s who. (YouTube). ↩
- IRC §877A(g)(1). ↩
- IRC §877(a)(2)(C). This is the “certification test”. ↩
- IRC §877(a)(2)(B). The amount for expatriations in 2017 is $162,000. Rev. Proc. 2016-55, §3.32. This is the “net income tax liability test”. ↩
- IRC §877(a)(2)(A). This, of course, is not inflation-adjusted, because why should tax law be internally consistent? This is the “net worth test”. ↩
- IRC §877A(a)(1). ↩
- IRC §877A(c)(3). ↩
- If you want to take the tour, here’s how to do it. Start with IRC §877A(f)(1)(A), which imposes a withholding requirement. Then drop down to IRC §877A(f)(4)(A), which tells you to pretend that the same stuff found in IRC §877A(d)(6) should be inserted here at IRC §877A(f). Go over to IRC §877A(d)(6)(B), where you will find a statement that says “if there is withholding imposed, then the income item that is withheld on will be subjected to income tax in the hands of the recipient according to the rules of IRC §871.” ↩
- Notice 2009-85, §7(C). Emphasis added. ↩
- IRC §877A(f)(1)(A). ↩
- Notice 2009-85, §7(A). ↩
- IRC §877(f)(1)(A). ↩
- IRC §877A(f)(2). ↩