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September 13, 2011 - Phil Hodgen

Exit tax is a one-time tax

I received this question from reader M:

I hate to ask a stupid question but IRS Notice 2009-85 gave me brain freeze. If your assets consist of property in the US and you sell all the property and pay the proper tax to the IRS before leaving the US, is there another tax or “exit fee” on the net amount received for the property on top of this or on any money removed from US banks upon leaving the US? Thanks.

Section 877A

We are in the land of Section 877A — the law that applies to U.S. citizens and green card holders who give up their citizenship or permanent residence visas.

• Not every person who gives up a passport or green card is going to file some paperwork with the IRS to log out of the U.S. tax system.
• And not everyone who gives up a passport or green card is going to pay tax because of this tax law.

Let’s assume M is in the unfortunate position where she must do the paperwork and she will have to pay a tax when she gives up her citizenship or green card.

Simple Example of the “Exit Tax”

The phrase “exit tax” is sloppy, informal tax lawyer slang. So it is easy to get confused if you don’t know what those teenage delinquents — that would include me, international tax lawyer extraordinaire 🙂 — are talking about.

The “exit tax” is the regular income tax applied to special people, but at an earlier date than would otherwise be the case. The special people are those who give up their U.S. citizenship or green cards.

Example

You bought Google stock for $300/share and now it is worth $400/share. If you remained a U.S. citizen or green card holder, you would only have to pay tax when you actually sold the stock.

On the other hand, if you give up your U.S. citizenship or green card, you have to pay tax on your $100 profit as if you sold your stock the day before your “expatriation date.” (“Expatriation date” means the the day on which you gave up your citizenship or green card. Another piece of jargon!)

It is the same tax amount that you would pay if you had chosen to sell the stock voluntarily. It is just a question of timing and the event that triggered the tax.

Paying the tax on your Google stock because you gave up citizenship or green card status — this is part of what we refer to as the “exit tax.”

Once you have paid the “exit tax” (either in a giant lump sum up front, or because of the 30% withholding made on payments as you receive them) you have cash in your pocket. The IRS will not tax you a second time. You are free to move about the planet.

“Exit Tax” Consists of Several Things

The phrase “exit tax” that we use consists of four different ways in which you pay tax when you give up U.S. citizenship or green card status:

• Mark-to-market. The example I gave above is technically–and correctly–defined as capital gain tax (the regular kind) on mark-to-market gain. Simply put, the IRS pretends that you sold everything you own on the day before you gave up your citizenship or green card. You did your “pretend” sale at market price. (Hence the phrase “mark-to-market”). You pay tax on the capital gain on “pretend” capital gain you received.
• IRAs and other specified tax-deferred accounts. There is a whole zoo of little accounts like IRAs in the Internal Revenue Code. Political boondoggles all. Well-meaning, bleeding-heart, social-engineering boondoggles, but boondoggles nonetheless. The IRS pretends that all of these accounts were completely distributed to you on the day before you gave up your citizenship or green card. Pay income tax at regular tax rates.
• Deferred compensation accounts. These are normal and normal-ish pension plans. If they are “good” deferred compensation plans, the IRS will take 30% of your monthly pension payment as tax, as the distributions are received by you, for the rest of your life. If they are “bad” deferred compensation plans, pretend they dumped the whole amount in your wallet on the day before you gave up your citizenship or green card, and do some complex math. Pay tax.
• Trust distributions. Weirdness. Not important for our purposes here. I will write more about this in some other blog post.
• UPDATE. Gifts/bequests. The sins of someone subjected to the exit tax in all of its glory (a “covered expatriate” is the technical description of that person) are visited upon his/her children. Someone who gives money or leaves property at death to a U.S. heir will also leave that heir with a whacking great big tax bill. (Because why would the U.S. government want capital to come into the USA? It’s not like we need business investment or jobs or anything. . . . Oh, wait. . . . ) (Update to blog post jogged by the comment below; thanks.)

Exit tax — (mostly) a one-time thing

Four very different items, with different tax rules for each. The teenage delinquents international tax practitioners refer to all four collectively as “exit tax.” That’s confusing.

The general idea is that the IRS wants to tax you as you are leaving. The reason they want to do this is because they are afraid that once you are gone you won’t every come back and voluntarily pay tax to the United States government if they can’t force you to do it. That’s why all of your tax is due immediately. The only exceptions are for things like pensions, where there is a pension plan in the United States who can be forced to do tax withholding for the IRS.

Finally, here is M’s answer

In direct answer to M’s question — you will pay tax once and once only when you exit the United States. In most cases it will be in one giant lump in the year that you give up your U.S. citizenship or green card. In a few cases the tax will be imposed by 30% withholdings on payments to you, forever and ever into the future until you don’t receive any more payments (this is for things like pension payments).

And when you have paid that exit tax, there is no further tax imposed when you want to move your cash out of the United States.

No hope for future guidance, I think

This area is fiendishly complex, not because it needs to be, but because of the peculiar way in which Congress conceived (in the “let’s be fruitful and multiply” sense of the word) this law.

Congress wrote a skanky piece of legislation — stupidly conceived (in the thinking sense, not the “let’s make a baby” sense), poorly written, and full of entirely predictable consequences that are damaging economically and diplomatically to the United States. (Can you guess that I have an opinion about this?)

Congress left next to no legislative history. (Legislative history is the stuff that Congress says so you can figure out what their intentions were, so if you find an ambiguity in the law they wrote you can try to reverse engineer the law to achieve the intent of Congress). You can’t look there for help if you’re puzzled.

Notice 2009-85 is, in my estimation, all you’re going to get in this area of tax law in terms of guidance. There may be a few odds and ends of Notices and Announcements from the Service in the future. But not much.

I don’t think you will get Treasury Regulations issued during our lifetimes. The law is messy (so it is a hard job) and the number of taxpayers to whom it will apply is small (relative to the total population of taxpayers). I don’t think the Commissioner will carve off a bunch of brainpower to throw at this problem.

How will you know what the rules are? You won’t.