The U.S. exit tax system contains a perverse incentive. Because the United States is in no need of capital inflows, the tax system is designed to punish U.S. citizens who give up their citizenship, then want to make gifts or inheritances to their U.S. heirs.

This blog post discusses one such situation.

Situation

Consider 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 Defined

Fred’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 Haircut

U.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–

(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.

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).

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 Taxed

Let’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.

Strategies

What 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. Recipients

Trusts 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.

Action and Reaction

I see two real-life responses to this law. (Well, three actually. I’m not counting the “Submit and be assimilated” response to the Borg that the Borg really expects from all of us).

The first response is that this law encourages whole families to terminate U.S. citizenship, even if some members do not necessarily want to do so. The financial cost is too high to retain citizenship if you expect to inherit wealth from your covered expatriate parents.

The second is that capital does not flow into the United States. In most families there are U.S. citizen family members and non-citizen members. Wealth simply goes to the non-citizens to the maximum amount that the family can stomach. And sometimes that is all of it.