SituationConsider Fred. Fred’s parents are U.S. citizens, as are his two adult children. In order to keep things simple, let us assume that Fred is not married. Fred gives up U.S. citizenship. At the time of giving up citizenship, Fred’s net worth was $2,500,000, all in cash, so he was a covered expatriate under the exit tax definitions. For the purposes of this example, Fred’s parents then die, and he inherits their entire net worth of $1,500,000 cash. To compound this sad situation, Fred dies only days after his parents (again, for the purpose of this example only), leaving all of his assets to his two adult children. What tax must his two adult children pay on their inheritance of $4,000,000 of cash?
Aside–Covered Expatriate DefinedFred’s status as a “covered expatriate” means one of three things — when he terminated his U.S. citizenship, he had a net worth above $2,000,000; an average Federal tax liability in the previous five years above the exit year’s threshold [$151,000 for 2012, for instance]; or he failed to file Form 8854 on time. In the example, I assumed that his net worth exceeded the threshold.
Section 2801’s Inheritance HaircutU.S. persons who inherit assets from a covered expatriate must pay tax on whatever they receive. (This rule applies to gifts, too. However, this blog post is all about inheritances, so I am going to keep things simple and ignore gifts). Section 2801(a) of the Internal Revenue Code is where you find the rules:
(a) In general. If, during any calendar year, any United States citizen or resident receives any covered gift or bequest, there is hereby imposed a tax equal to the product of–This tax applies to everything the recipient gets above the “tax-free gift” amount in Internal Revenue Code Section 2503(b). See Internal Revenue Code Section 2801(c). In 2013, this amount is $14,000. It is indexed for inflation, so future readers of this blog post may have a different number to wrestle with. Simple math: what you receive from a covered expatriate multiplied by the highest tax rate you can find in Section 2001(c) of the Internal Revenue Code. This is the estate tax. The current rate is 40%. The recipient pays the tax. See Internal Revenue Code Section 2801(b).
(1) the highest rate of tax specified in the table contained in section 2001(c) [26 USC § 2001(c)] as in effect on the date of such receipt (or, if greater, the highest rate of tax specified in the table applicable under section 2502(a) [26 USC § 2502(a)] as in effect on the date), and
(2) the value of such covered gift or bequest.
Example Fred dies and leaves the princely sum of $15,000 to his U.S. citizen son. Fred’s son must pay a 40% tax on $1,000. The first $14,000 of the inheritance is exempt from tax, but the excess ($1,000, in this example) is taxable at the highest estate tax rate in force.
Untaxable Money Becomes TaxedLet’s go back to our example again. Fred had $2,500,000 when he expatriated. He inherited all of the money his parents had in the world ($1,500,000) and then died, leaving $2,500,000 to his two children, both U.S. citizens. The exit tax rules of Section 2801 are remarkably easy to apply here. And they are remarkably harsh. The entire $4,000,000 (minus $28,000) received by Fred’s children will be taxed at 40%. Section 2801(a) makes the entire inheritance taxable, but Section 2801(c) makes the first tranche of $14,000 per recipient exempt from the tax. The big problem in my example is that Fred’s parents had modest wealth–far beneath the estate tax threshold for them of $5.25 million each. Yet their $1,500,000 of net worth will be taxed at the highest possible estate tax rate. Money that should never have been taxed will now be taxed, simply because it went through the hands of a covered expatriate.
StrategiesWhat can the players in this game choose as a tax-minimizing strategy? Well, don’t die, of course. But after that, the options available are limited:
- A covered expatriate should not allow inheritance of assets at death by U.S. taxpayers. In other words, Fred should disinherit his kids.
- A recipient should not be a U.S. citizen. In other words, Fred’s two children should follow their father and renounce their U.S. citizenship.
- A U.S. citizen should not pass wealth to a covered expatriate if the successor inheritor will be a U.S. citizen. In other words, Fred’s parents should have configured their will to skip Fred. They should have left everything to their two U.S. citizen grandchildren. Alternatively, they should have created a trust in which Fred had an income interest for life, with Fred’s two children as the remainder beneficiaries.
Trusts for U.S. RecipientsTrusts won’t work. Congress didn’t fall off the turnip truck yesterday. If Fred left all of his money in trust for his kids, the tax will be imposed anyway.
- If the trust he created is a U.S. trust, then the tax is imposed as the money goes into the trust. Internal Revenue Code Section 2801(e)(4)(A).
- If the trust he created for his two children is a foreign trust, then the tax is imposed as distributions come out of it. Internal Revenue Code Section 2801(e)(4)(B).