There are two types of expatriates: covered expatriates, and non-covered expatriates.
Covered expatriates must pretend that they sold all their worldwide assets on the day before expatriation and pay tax on the pretend gains. There are a few types of assets to which other special tax treatments apply if you are a covered expatriate, as well.
Non-covered expatriates do not have to do the pretend sale. They are required to inform the IRS about their expatriation on Form 8854, but without a giant gain recognition event.
There are three tests for covered expatriate status:
- Certification test
- Net worth test
- Net tax liability test
If you meet (or fail, depending on how you look at it) any one of these tests, you are a covered expatriate. That is, of course, the general rule. There are also a couple exceptions you might be able to use to avoid covered expatriate status.
In this chapter, I will talk about each of the tests and the exceptions to the tests for covered expatriate status. In future chapters, I will discuss the implications of being a covered expatriate – the pretend sale of worldwide assets and other tax considerations.
You will become a covered expatriate under the certification test if any of the following are true:
- You are not up to date with all of your Federal tax obligations; or
- You are late filing Form 8854 after your expatriation event; or
- You tell somewhat less than the truth on your tax returns or Form 8854.
What you are certifying
Specifically, you will be a covered expatriate if you:1
“[fail] to certify, under penalties of perjury, compliance with all U.S. Federal tax obligations for the five taxable years preceding the taxable year that includes the expatriation date, including, but not limited to, obligations to file income tax, employment tax, gift tax, and information returns, if applicable, and obligations to pay all relevant tax liabilities, interest, and penalties (the “certification test”). This certification must be made on Form 8854 and must be filed by the due date of the taxpayer’s Federal income tax return for the taxable year that includes the day before the expatriation date.”
Prior five years
The IRS wants to know that you have tax returns on file and you have paid all of your taxes (all types) for the five years before the year of expatriation. If you do not have tax returns on file, then you should do that first – before you expatriate.
If you did not have a requirement to file tax returns because you had no income and were not required to file any information returns, we generally recommend filing tax returns to report zero income. This serves two purposes:
- It triggers the statute of limitations to begin to run on that tax year, and
- It proves to the IRS that you have met your tax obligations for the prior five years.
There is no risk to you for filing the returns late if this is your situation, because if you do not have income and you have no information return filing requirements, no penalties or interest will be assessed.
File Form 8854 on time
The certification must be made on a timely-filed Form 8854.
Form 8854 is filed as an attachment to your expatriation year income tax return.
For people living outside the United States, the filing deadline for a US income tax return is usually (but not always) June 15. You can also get a six-month extension to file your tax returns. This means if you have a June 15 filing deadline, you can have as late as December 15 to file a timely income tax return.
If you file Form 8854 late, you automatically become a covered expatriate. Someone who is “too poor” to be a covered expatriate—even someone who paid no income tax and has a zero net worth—will nevertheless be a covered expatriate if Form 8854 is filed late.
Also, a penalty of $10,000 may be assessed if you file Form 8854 late.
Becoming a covered expatriate and the risk of a monetary penalty are both very compelling reasons to file Form 8854 on time.
The certification requirement applies to all federal tax obligations, including information returns. Conceptually, then, this means all Title 26 (Internal Revenue Code) obligations are included in the certification.
What about obligations such as FinCEN Form 114, reporting signature control or a financial interest in foreign financial accounts? These are obligations under Title 31, and thus arguably someone out of compliance for filing these forms would nevertheless be able to certify compliance with his or her Title 26 obligations.
This is an area of speculation and caution is urged until additional guidance is issued by the IRS. My suggestion is that you don’t get clever and attempt to skate past anything. You are trying to make a clean break with the US.
Net worth test
The most common way to become a covered expatriate is by having $2,000,000 or more in personal net worth. That figure does not get adjusted for inflation.
The method you use for determining net worth is described in Notice 97-19 from the IRS.
What is included in your net worth
You include your personal assets and liabilities in your net worth. For married couples, each spouse determines his or her net worth separately. This often means reviewing the marital property laws that apply to understand specifically what belongs to each spouse.
The assets that you look at are “any interests in property” that would be taxable as a gift if you gave them away the moment before you expatriated. Look at the gift tax rules to see if you would trigger a gift tax by giving the assets away.
An “interest in property” is a carefully defined term. It does not matter whether the property produces income or not. It includes the right to use property, as well as ownership.
For purposes of your analysis, you treat the assets you can give away as part of your balance sheet. However, gift tax exemptions and deductions are ignored in calculating net worth. These include the annual exclusion, transfers to certain minor’s trusts, transfers for certain medical and education expenses, the exemption for certain waivers of pension rights, and the exclusion of certain loans of artwork. In addition, the gift splitting, gift tax charitable deduction, gift tax marital deduction, and limitation on deduction rules are ignored for the net worth test in determining covered expatriate status.
You get to include debts as an offset in calculating your net worth. If you own a house worth $1,000,000 and you have a mortgage with a principal balance of $600,000, your net worth is $400,000 (excluding other assets and liabilities).
How to calculate value
The method of establishing value is established by section 2512 and regulations issued under that section. These are the gift tax rules.
If you are thinking of using valuation discounts to reduce the value of the assets you own, too bad. You cannot invoke prohibitions or restrictions as a method for creating discounted value.
You may use good faith estimates of value. Formal appraisals are not required when you are determining whether you meet the $2,000,000 net worth test.
Beneficial interests in trusts
If you are a beneficiary of a trust, you must calculate the value of that beneficial interest to determine whether you reach the $2,000,000 threshold for being a covered expatriate.
The process of establishing the value for a beneficial interest in a trust requires an allocation of assets among all beneficiaries, followed by a valuation of the would-be expatriate’s beneficial interest.
Allocation among beneficiaries
First you will go through an allocation process.
Look at all the assets in the trust and allocate them among all the beneficiaries or potential beneficiaries of the trust. This is a “facts and circumstances” process. Look at the terms of the trust document. If there is a letter of wishes (or similar document), consider that, too. Look at the way trust distributions have been made in the past.
You are also instructed to consider the “functions performed by a trust protector or similar advisor.” To say this is unclear would be an understatement.
If, after looking at the documents, prior distributions, and the trust protector’s powers, you cannot determine the identity of the beneficiaries to whom the trust assets should belong, there is a default method for allocating ownership. You use the principles of intestate succession (use the trust settlor’s death as the starting point) as contained in the Uniform Probate Code. Whatever percentage you would inherit under the Uniform Probate Code is the percentage of trust assets you are deemed to own for the exit tax calculations.
Valuation after allocation
Once you have decided the identities of the beneficiaries who are deemed to own the trust assets, apply the valuation methodologies of section 2512 (and the regulations under that Code section), without regard to prohibitions or restrictions on the interest in the property.
Net tax liability test
A covered expatriate is someone who is “rich enough” for the IRS to care about. Someone who pays a lot of income tax must be rich, at least according to the IRS.
$165,000 for 2018
Look at your tax returns for the five years before the year in which you expatriate. Look at your federal income tax liability for each year. Add up all five years’ of tax liability, then divide by five. That’s (a simplified version of) the number you use for the net tax liability test.
If the amount exceeds $165,000 (this is the number you use if you expatriated in 2018), you will be a covered expatriate under the net tax liability test.
The number you use for the net tax liability test is indexed for inflation, so each year it increases slightly.
“Net tax liability” redefined
The description given just above is a simplified version of how the test works. In reality, it’s a little more complicated.
The rule to apply here is from Notice 97-19, section III, 1997-1 C.B. 394. Even though this Notice applies to the prior expatriation tax regime under section 877, it explicitly is applied to the current rules under section 877A as well.
For purposes of the tax liability test, an individual’s net US income tax is determined under section 38(c)(1). This means you will need to look at your tax returns for the five years before expatriation and make the adjustments required under that section to arrive at the tax liability for each year.
Once you calculate the tax for each year using that section, those are the numbers you add together and divide by five to arrive at the number you use for the net tax liability test.
Married filing jointly
An individual who is a joint filer on a married filing jointly income tax return must use the number from the joint income tax returns without reduction. If two spouses both expatriate, they still use the full number without reduction.
For example, let’s say that you will expatriate. If you and your spouse filed joint income tax returns and paid $200,000 per year of federal income tax, you would think the logical (and fair) thing to do would be divide by two, and treat each spouse as if they paid $100,000 of tax each year.
And you would be wrong. You each must use the entire $200,000 in your calculations.
That is not fair, but it’s the rule.
When we work with clients who plan to expatriate sometime in the next few years, one of the planning devices we use is to have them start filing separately each year. That makes the tax result lower for each spouse (even if it does not result in a lower combined tax), so that they can each meet the net tax liability test.
If you fail the certification test, you will be a covered expatriate without exception.
But if you meet the certification test and fail one of or both of the other tests – the net worth test and the net tax liability test – you may be able to use one of the exceptions to covered expatriate status. If you can use one of the exceptions, you will be a non-covered expatriate, even if your net worth or net tax liability is too high under the IRS rules for expatriates.
Dual citizen at birth
You can qualify for the “dual citizen at birth” exception to covered expatriate status if you satisfy all of the following conditions:
- You became a US citizen at birth; and
- You also became a citizen of another country at birth; and
- On your expatriation date you “continue” to be a citizen of that country; and
- On your expatriation date you “continue” to be taxed as a resident of that country; and
- On your expatriation date you were not a US resident for 10 of the 15 tax years that end with the year that you expatriated.
Note that you will still have to certify that you are up to date with all US tax requirements; in other words, you must meet the certification test to use this exception. Failure to meet the certification test will render you a covered expatriate even if you satisfy all of the dual citizen exception requirements.
Relinquish citizenship before age 18 ½
The second exception to covered expatriate status is available to people who relinquish their citizenship before age 18 ½.
The specific requirements you must satisfy in this situation are:
- You relinquish your US citizenship before age 18 1/2; and
- You were not a US resident for more than 10 taxable years before the date of relinquishment.
By relinquishing citizenship before age 18 1/2 you will avoid the impact of the net worth or net tax liability tests. But you will still be required to certify full compliance with all US tax requirements, and failure to do so will render you a covered expatriate.
Before you expatriate, check whether you will be a covered expatriate. Do this by checking the certification test, the net worth test, and the net tax liability test. If you fail any of these three tests, consider doing some planning and/or work to fix your tax compliance, reduce your net worth, or reduce your net tax liability before you expatriate. We routinely help our clients get certainty on their status as either covered or non-covered expatriates and help them in the planning stages before giving up US citizenship or permanent residence.
Thank you, as always, for reading.
Remember that I probably left out all the important details, so don’t try to use this blog post as legal advice to you. I know nothing about the specifics of your situation and I didn’t write this with you in mind. Hire a professional if you need help.
- IRS Notice 2009-85, section 2, subsection A. ↩