The phrase “exit tax” is not used in the Internal Revenue Code, but is a shorthand that everyone seems to use. I will use it here.
The exit tax is a Federal tax law that is designed to collect tax, one last time, on citizens and green card holders who are taking themselves out of the U.S. tax system.
The exit tax rules impose an income tax on someone who has made his or her exit from the United States. The defining feature is that all assets are treated as if they are sold on the day before citizenship or resident status is terminated. If there is any profit from that “pretend” sale, it is taxed immediately. This is the “mark-to-market” feature of the exit tax rules.
There are other rules that accelerate income for a person leaving the United States. These rules apply to things like IRAs, pensions, deferred compensation plans, and beneficial interests in trusts.
All of these tax rules — designed to collect tax from an individual who is permanently leaving the U.S. tax system — make up the exit tax.
Countries impose an exit tax because of a belief that the infrastructure and economy of that country enabled the taxpayer to profit. President Obama’s “You didn’t build that” is an example of the attitude behind an exit tax. The economic system gave you a foundation. You created wealth using that foundation, so you should pay tax on the wealth that the system helped you generate.
This is not wrong. A stable government can allow entrepreneurs and investors to flourish. Paying tax in return seems appropriate. We may differ in our opinions about how much tax is appropriate, but supporting the systems that enable us individually to thrive . . . I think we can agree on that general concept.
The United States is not unique in having an exit tax. Other countries have exit taxes, too.
The United States is unique, however, in tying its exit tax to a change in visa or citizenship status. A Canadian who moves abroad can be taxed as a nonresident while remaining a Canadian citizen. An American citizen who wishes to be taxed as a U.S. nonresident must relinquish U.S. citizenship in order to do so.
This critical distinction — taxation tied to change in nationality or immigration status — is due to the general philosophy of the U.S. tax system. “Citizenship-based taxation” is the system that the United States follows.1 If you are a U.S. citizen, you are taxed on worldwide income and assets. Every other country follows a “residence-based taxation” system. If you are a resident (however defined) you are taxed. If you are a nonresident (however defined), you are not taxed.
This is why it is easy for Canada (residence-based taxation) to allow its citizens to live abroad and be taxed as Canadian nonresidents, while it is impossible for the United States (citizenship-based taxation) to do so. The United States has unnecessarily tied nationality to taxation.
Let’s put it another way. To remove the U.S. tax system from your life, there is only one solution. If you are a U.S. citizen, stop being a U.S. citizen. If you are a U.S. resident (for income tax purposes), stop being a U.S. resident. Tying your passport to your wallet — that is the unique feature of the U.S. exit tax rules.
The exit tax applies to two categories of people:
If you do not fall into one of those two categories, you do not need to worry further about the exit tax rules.
You are not subjected to the exit tax rules simply because you are a citizen or a long-term resident. There is another critical requirement: an event must occur that terminates your citizenship or long-term resident status.
You will care about the exit tax rules only if you have the correct starting status, and if the correct type of event happens in your life. These two things make you an expatriate:2
If you like arithmetic, the formula looks like this:
Starting Status + Status-Changing Event = Expatriate
There are only two categories of people who care about the exit tax rules:
People who are residents (and noncitizens) of the United States under any other type of visa status will have no risk from the exit tax when they become nonresidents.
A U.S. citizen who relinquishes citizenship will always be an expatriate.3
A green card holder will be an expatriate only if he is a “long-term resident”.4 This requires the person to have held the permanent resident visa for a sufficiently long period of time.
“A sufficiently long period of time” is not simply a matter of counting years. After counting the number of years that the individual has held the green card, a review of income tax returns for the years in question will be necessary. If the green card holder elected to be treated as a nonresident alien for U.S. income tax purposes in any year, the year does not count toward the required number of years.
A citizen or long-term resident (a green card holder who meets the time test) will become an “expatriate” if his personal status changes, from citizen to noncitizen or from green card holder to former green card holder.
Green card holders also become expatriates if, once they have attained long-term resident status, they make an election to be taxed as a nonresident of the United States for income tax purposes using an income tax treaty.
U.S. tax law changed in mid-2008. This book discusses the laws that apply to people who relinquish U.S. citizenship or terminate green card status on or after June 17, 2008.
There is a different set of exit tax rules that applies before that date.5 This book will not talk about those rules, but if you relinquished your citizenship or terminated your resident status before June 17, 2008, you will need to find someone who can help you sort out your situation.
To see if the the exit tax rules apply to you, follow this sequence:
Determine whether you are an expatriate. Were you a U.S. citizen or long-term resident? Did that status terminate?
If you are not an expatriate, the exit tax rules do not apply to you. If you are an expatriate,
you have some paperwork requirements to satisfy. In addition, you need to determine whether you have additional tax to pay because you expatriated. Proceed to the next step.
If you are an expatriate, determine whether you are a covered expatriate.
A covered expatriate is someone who is an expatriate and who satisfies (or fails, depending on your point of view) one of three tests. You are a covered expatriate if you are:
If you are a covered expatriate, you have the same tax return requirements (and other forms) that regular expatriates have.
In addition, you will also pretend that you sold all of you assets on the day before the action that terminated your citizenship or long-term resident status, and pay tax on most of the artificially-created capital gain.
You are also treated as having received full distributions from IRAs and other accounts, and from most foreign pension plans. Deferred compensation plans trigger immediate income taxation, too.
Finally, your heirs may face an unwanted tax. U.S. persons will pay a tax on gifts or inheritances received from covered expatriates.
The exit tax law is found in Internal Revenue Code Section 877A. The only other significant piece of information from the government (so far) about how the exit tax works is found in Notice 2009-85, Guidance for Expatriates Under Section 877A.
Section 2801 of the Internal Revenue Code contains the rules that impose a tax on the recipients of gifts or inheritances from covered expatriates. Proposed Regulations have been published and in due course (with some likely modifications) will become Final Regulations.
Because it is a tax law, there is paperwork. In addition to the tax filings required by normal circumstances, there are three special-purpose tax forms spawned by the exit tax laws:
In normal conversation, an expatriate — “expat” is usually how the term is used — is someone living outside his home country. The Internal Revenue Code has hijacked a perfectly sensible word and mangled it to serve an artificial tax purpose.
For U.S. tax law, an expatriate (as a noun) is someone (citizen or long-term resident) who does a precisely defined act (ceases to be a citizen or long-term resident).6 That is the way we will use the word in this book.
Confusing, it is.
The Internal Revenue Code does not use the word “expatriate” as a verb. The actions that a U.S. taxpayer can take are defined in the Internal Revenue Code but not referred to (individually or as a class) as acts of expatriation.
Therefore, using “expatriate” as a verb (“I plan to expatriate in November; I already have an appointment scheduled at the Embassy.”) is a commonsense use of the word, not a technical use.
The actions that collectively cause an individual to become an expatriate fall into two categories, one for citizens, and one for long-term green card holders. For readability, it is easier to refer to all of these actions collectively using the verb “expatriate”.
All three of these situations use the word “expatriate” as a verb to describe different actions that cause an individual to be an expatriate.
- “I plan to expatriate in November; I already have an appointment scheduled at the Embassy” could refer to an individual who plans to renounce citizenship by following the required procedures. Renunciation of U.S. citizenship causes an individual to be an expatriate.
- “I plan to expatriate in November; I already have an appointment scheduled at the Embassy” could refer to someone who plans to terminate status as a permanent resident of the United States by filing Form I-407 and handing over his green card. Termination of permanent resident status after holding that status for many years will cause an individual to be an expatriate.
- “If you file an election under an income tax treaty to be treated as a nonresident of the United States for your income tax returns this year, you will expatriate” would also be a correct use of the word “expatriate” because that action can cause someone who still holds a green card to be an expatriate.
This book will be much easier to understand if I refer to all of these actions collectively, and using the word “expatriate” as a verb — in addition to the noun used in the Internal Revenue Code — seems to be the easiest way to do this.
Sorry. I will do my best to keep it clear and keep it simple.
And that’s the end of today’s excursion into grammar.