How expatriation works is something we talk about with clients all the time, and it’s worth devoting a little blog space to a general description of the basic mechanics every once in a while.
Imagine we are now boarding an airplane and zooming up to 30,000 feet. Let’s see how the expatriation process works from 6 miles up.
But first… Some warnings
From this far up, we can see the mountains and oceans and rivers, but not the cars or trees or houses or people.
Because we are taking a very high-level view, we must ignore the details, the nuances, and all the little things that make this topic so complicated.
If we were using art metaphors, we would be sketching on a napkin, not painting the Sistine Chapel.
It would be in very poor judgment to make your life choices based on an email newsletter or a blog post you found on the internet, especially one that is claiming at the beginning to ignore all the important stuff. Talk to a professional about the specifics of your situation and get advice that is designed for you before you expatriate.
What do we mean when we talk about expatriation?
Typically when people talk about “expats” or “expatriates” they are talking about citizens of one country who live in another country. Most expats in this meaning of the word keep their citizenship from the first country and simply live abroad, possibly returning back to their home country at some point or moving elsewhere on the planet.
When we CPAs and tax lawyers talk about expatriation, we mean people who are US citizens or green card holders and who terminate their citizenship or green card. For green card holders, there is a test for the amount of time you have the green card that must be satisfied for you to be an “expatriate” under the meaning of the term we are using here.1
Two tasks to expatriate
When you want to expatriate, there are two things that you must do. You must convince the State Department or USCIS that you are no longer a citizen or green card holder, and you must convince the IRS that you are no longer a US taxpayer.
Logging out of the citizenship or green card system
The first (and easiest) part is to terminate your citizenship or green card.
Citizens must convince the State Department that they are no longer citizens. This requires paying a fee of around $2,500, filing some papers (look at DS-4079, DS-4080, and DS-4081), and having an in-person interview or two at a US embassy or consulate.
Green card holders must convince USCIS that they are no longer green card holders. This involves putting the original green card and Form I-407 in the mail, or delivering those items by hand.
Logging out of the tax system
Step two is to convince the IRS that you are no longer a part of the US tax system. That is the hard part.
The IRS sorts all expatriates into two categories: “Rich”, and “not rich”.
“Rich” expatriates have to pay an exit tax. They also have to file a tax return that ranges in difficulty from fairly complicated to extremely complex.
“Not rich” expatriates do not have to pay exit tax, but they do still have to file some extra paperwork.
Rich = paperwork + tax. Not rich = just paperwork.
Financial tests for whether you are “rich”
Whether you are rich or not for exit tax purposes is unfortunately not a matter of how you see yourself.
The IRS has two tests to determine whether you are rich. Satisfy either one of them, or both, and you have to pay exit tax.
One is the net worth test. Look at your personal net worth (assets minus liabilities) and if the number is $2 million or more, you are “rich” and you will be paying exit tax.
The other is the net tax liability test. Here is how to do a rough back-of-an-envelope calculation: Look at your tax returns for the past five years. Write down the number on the line that says “total tax” for all five years. Add those up, then divide by five. If the result is more than about $160,000 (this number changes every year with inflation), you are “rich” and you will be paying exit tax.
Exit tax calculation for someone who is “rich”
For a rich person who turns in their passport, there is a “mark-to-market” event. Pretend you will sell all your worldwide assets at their market values the day you expatriate. The first approximately $700,000 of gain (another number that changes with inflation each year) is tax-free. The rest is subject to tax at normal rates.
There are special rules for some assets, like pensions and trusts. But the general rule is that you will pretend you sold everything you own on the planet and pay real cash money tax on the gains.
Exit tax paperwork
The tax return you file for the year you terminate your citizenship or green card will be more complicated than the return you usually file. It gets filed according to the normal filing deadlines, so if you expatriate in 2018, you will file the return in 2019.
The tax return is typically a “dual-status” return: Part of the year you are taxed as a citizen or resident, and part of the year (after you expatriate) you are taxed as a nonresident. You also file (along with your tax return) Form 8854, to report to the IRS that you expatriated, and to give them information about yourself, your assets, and your income.
Prior five years must be clean
Regardless of whether you are “rich” or not, it is imperative to make sure the tax returns for the five years before expatriation are squeaky-clean and all your tax is paid.
There are consequences to not doing this: If you are “not rich” according to the tests I described above, you could be treated as if you are anyway. If you are already paying exit tax because you are “rich”, not having the prior five years filed correctly could mean audits and other lengthy, unpleasant conversations with the IRS.
An abundance of caution is the right amount to have
There are a lot of things to consider when you expatriate, and this very short newsletter simply can’t cover most of them. Remember that we are in an airplane at 30,000 feet looking down on the expatriation landscape. We can see the major contours, but none of the detail.
Make sure you understand all the details that pertain to your situation before you decide to terminate your citizenship or green card, or you could end up in a very uncomfortable position.
Some shameless promotion
We do lots of expatriation work.
We help clients make well-informed decisions: How to expatriate, how long it takes, what the estimated tax hit (if any) will be, and what planning can be done to reduce or eliminate taxes or paperwork.
If you hire us, we can take you through the planning stages to the filing of your final US tax return. We find that the “get out of the citizenship or green card” part is straightforward but the tax stuff is not. We do the pre-expatriation tax planning. We help get the prior five years of tax returns squeaky-clean. We do the exit year returns for you and the following year of tax returns as well because there are usually some lingering things to report in that year; it is rare that someone gets their financial affairs arranged so that their US taxes are completely wrapped up by the time they leave.