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November 8, 2016 - Phil Hodgen

Death and Taxes and Expatriation

I have not really focused on the estate tax side of expatriation in any great depth. This will be the first of several blog posts where you get 26 U.S.C. §877A and §2801 stuff every two weeks. Plus other bonus coverage of other §§ of the Internal Revenue Code.1

Why IRC Section2 2801 Exists

This week let’s talk about the unheralded PITA embedded in the tax rules that haunt covered expatriates.

U.S. persons who receive gifts or inheritances from covered expatriates will have the privilege of paying $0.40 of every dollar they receive as punishment for having been acquainted with someone who renounced U.S. citizenship (or gave up a green card).3

There is some vague policy reason for this. Theoretically, a covered expatriate has taken wealth out of the U.S. estate and gift tax system. Tax will not be paid.

Example

You have a net worth of $10 million. All cash. You renounce your U.S. citizenship and pay zero in exit tax.4 Now you are no longer a U.S. citizen.

You die, leaving all of your money to your U.S. citizen kids.

In the normal course of things, there would be an estate tax imposed on about $4.5 million of the assets you owned when you died.5 The highest estate tax rate is 40%, so the worst-case estate tax will be $1.8 million.6

But you’re a nonresident noncitizen of the United States, and all of your cash is outside the United States. You and all of your assets are outside the U.S. estate tax. Your kids inherit $10 million from you.

In other words, expatriation was a tremendous estate tax planning boondoggle. Simply by giving up U.S. citizenship and moving your assets outside the USA, you could eliminate estate tax.

Congress hated that, and the countermeasure was IRC §2801. You can leave the U.S. tax system, but if your money comes back into the U.S. tax system by gift or inheritance (with some exceptions), it will be taxed. Since you (the giver of gifts, the dead person leaving bequests) cannot be taxed (you are a human outside the borders of the USA) and your stuff cannot be reached (it is cash in a foreign bank), Congress did the only logical thing: punish the recipient.

Flawed Logic

I won’t go any further than the mild epithet of flawed logic in heaping ridicule on the thinking that spawned Section 2801. You be the judge. Here are a few examples.

But I’m Not Rich Enough

U.S. recipients of gifts and inheritances from covered expatriates must pay the 40% tax on whatever they receive.7

You can be a covered expatriate if your net worth is $2,000,000.8 On the other hand, someone with a $2,000,000 net worth will not experience the glories of the estate tax. The unified credit will protect the first $5.45 million of your assets from estate tax.9 This creates an unfair situation for your heirs. But Congress doesn’t care, because you, dear expatriate, don’t vote.

Example

You have a net worth of $2,000,000 and you renounce your U.S. citizenship. You are a covered expatriate.

The very next day, due to a moment of poor judgment, you die. All of your assets are left to your U.S. citizen child.

Your U.S. citizen child pays a 40% tax for the privilege of receiving a $2,000,000 inheritance. $500,000. Ouch.

By contrast, assume you did not renounce your U.S. citizenship.

Example

You are a U.S. citizen and have a net worth of $2,000,000.

Due to a moment of poor judgment, you die. All of your assets are left to your U.S. citizen child.

The amount of your wealth at the time of your death is less than $5.45 million, so your child inherits the entire $2,000,000, without tax.

In short, Section 2801 is intended to put expatriates and citizens on (more or less) equal footing when it comes to estate and gift tax. It fails for people who have net worth above $2,000,000 and less than $5.45 million. Those people, as covered expatriates, leave a punishing tax burden to their children, where (as citizens or permanent residents) they would not cause their children to receive a punishing tax haircut at all.

But I Got Rich After I Renounced

The second way that Section 2801 is flawed is in its application to people who become wealthy after they expatriate.

Example

You have $2,000,000 when you renounce your U.S. citizenship. You are a covered expatriate.

Through hard work, cunning, and a smidgen of luck your inherent moral virtue, you turn that $2,000,000 into $20,000,000 — through business ventures and investments completely outside the United States.

You die and leave the entire $20,000,000 to your U.S. citizen child. Your child has the privilege of paying a tax of 40% of the $20,000,000, not the $2,000,000 you had in your pocket when you left the United States.

Why does Uncle Sam impose tax on wealth created outside the United States by a nonresident noncitizen of the United States?10

Well, the USA Certainly Doesn’t Need Capital

Thank God for Section 2801, which discourages covered expatriates from sending capital back to the United States, where it can be invested in new businesses, creating jobs and prosperity for thousands of people.

Given a choice between sending a dollar to the United States where it gets taxed at 40%, and keeping the dollar abroad, it’s pretty clear how Congress stacked the economic incentives.

We have altogether too much capital in the country. Businesses, inventors, and entrepreneurs simply cannot take a single dollar more.

(You can close that sarcasm tag now, Phil.)

What To Do?

In the next post (two weeks from now), I will talk about how to deal with Section 2801 and the punishing tax on capital returning to the United States from a covered expatriate. We do not have many planning opportunities, but I will give you the concepts and you see what you can do with them.

And with that, I will see you in a couple of weeks.

Phil.


  1. I first learned about § (the section sign) in law school. Had the hardest time making a plausible-looking one with a pen. I don’t know who else — other than lawyers — makes a fetish of this particular typographic symbol. 
  2. I just want to show you that I am not hopelessly doctrinaire about the whole § symbol thing. 
  3. IRC §2801, aka 26 U.S.C. §2801, because tax lawyers are too self-centered to acknowledge that there are Federal laws other than the Internal Revenue Code. (Do you see what I did there? I used § twice. And not a gratuitous use of the § symbol, either. Totally legit. Totally.) 
  4. With a net worth of $10,000,000 you are unquestionably a covered expatriate. IRC §§877A(g)(1)(A), 877(a)(2)(B). Your assets are subjected to a pretend sale when you renounce your U.S. citizenship, and you pay tax on that pretend capital gain. IRC §877A(a). If you sell a dollar of cash, you have no capital gain. Therefore, there can be no tax. Even in the land of pretend
  5. You have $10 million of assets when you die. Subtract approximately $5.5 million because that is the amount of assets not taxed because of the unified credit. That leaves $4.5 million of assets to be taxed by the estate tax. 
  6. This tax amount is too high, because the estate tax is a graduated tax rate. But I’m too lazy to compute the actual tax, and besides, for the purposes of my example, you will soon see that it is the difference between zero tax and lots of tax. How big lots of tax is . . . doesn’t matter. It’s bigger than zero, and that really bothered Congress. 
  7. IRC §§2801(a)(1), 2001(c). 
  8. IRC §§877A(g)(1)(A), 877(a)(2)(B).  
  9. IRC §2010, Rev. Proc. 2015-53, §3.33. The figure given is for people who die in 2016; the amount is inflation-adjusted annually. 
  10. It’s the same reason as the answer to the question Why do dogs lick their . . . ? Uhhh . . . never mind. 
Expatriation