The exit tax applies to everything a covered expatriate owns. The method of calculating tax, however, differs depending on the asset involved.
For most types of assets, the mark-to-market tax applies. In the last chapter, I discussed the rules for how to calculate the mark-to-market tax, the exclusion that applies, how to value your assets, and some special considerations.
In this chapter, I am discussing a type of asset that is excepted from the mark-to-market rules: specified tax deferred accounts. These are IRAs and other types of accounts that contain a tax deferral benefit. Covered expatriates must pretend that their specified tax deferred accounts were distributed to them in full on the day before their expatriation date and pay tax on the pretend distribution as if it were real.
I will explain what specified tax deferred accounts are, the paperwork you must provide to your account custodian if you are expatriating, how the accounts are taxed upon expatriation, and where they are reported on your expatriation year tax return.
Specified tax deferred accounts are IRAs and other statutorily-created accounts found in the Internal Revenue Code. In other words, they are US accounts, because the US Tax Code does not provide the rules for how foreign accounts work.
A “specified tax deferred account” is defined as any of the following:1
- An individual retirement plan as defined in section 7701(a)(37), but excluding anything described in section 408(k) or section 408(p);
- A qualified tuition program established under section 529;
- A Coverdell education savings account as defined in section 530;a
- A health savings account as defined in section 223; and
- An Archer MSA as defined in section 220.
I will discuss these below.
The first bullet point refers to an “individual retirement plan as defined in section 7701(a)(37)”. That section defines an individual retirement plan as:2
(A) an individual retirement account described in section 408(a), and
(B) an individual retirement annuity described in section 408(b).
An individual retirement account described in section 408(a) includes traditional IRAs, Roth IRAs, spousal rollover IRAs (which are traditional IRAs that are funded by contributions from a nonworking spouse), and inherited IRAs (inherited upon the death of the original IRA owner).
In other words, most IRAs are specified tax deferred accounts.
Note that SEPs and simplified retirement accounts are not considered specified tax deferred accounts. That does not mean that the holders of these types of accounts are free from exit tax, however; these are covered under the exit tax rules for deferred compensation.
While IRAs will be the most frequently-encountered type of specified tax deferred account for purposes of the exit tax, there are others included in the term as well:
- Qualified Tuition Program, also known as section 529 plans;
- Coverdell Education Savings Account;
- Health Savings Account; and
- Archer Medical Savings Accounts.
I will not discuss these accounts in detail here; for our purposes it is sufficient to know that if you have any of these types of accounts, they are considered specified tax deferred accounts and are subject to a special set of rules when you expatriate.
Form W-8CE is for covered expatriates (“CE” = covered expatriate) to provide to their account custodians when they expatriate.
You must provide Form W-8CE to your account custodians on the earlier of:
- The day prior to the first distribution on or after the expatriation date; or
- 30 days after the covered expatriate’s expatriation date.
For custodians of specified tax deferred accounts, Form W-8CE instructs them to treat the balance of your account as of the day before your expatriation date as a deemed distribution so that they can make the necessary basis adjustments when reporting future distributions to you. Future Forms 1042-S should report the taxable and nontaxable portions of the distributions to you.
Also, within 60 days of receiving your Form W-8CE, the custodian should provide the value of the IRA or other specified tax deferred account as of the day before your expatriation date to you.
In practice, I have found that custodians do not always perform the actions required of them upon receipt of this form, and my clients and I must sometimes perform calculations so that we can accurately report their income and compute their tax. Note that a custodian’s failure to provide the necessary information does not absolve the expatriate from having to report and pay tax on the deemed distribution.
Non-covered expatriates do not have to worry about special rules for specified tax deferred accounts because those rules only apply to covered expatriates. Non-covered expatriates should simply provide W-8BEN to their account custodians to notify them that they are no longer US residents for tax purposes. Distributions are then taxed as they normally are for nonresidents.
The tax treatment of a covered expatriate’s specified tax deferred account is simple: there is a “pretend distribution” of the entire balance of the account to the expatriate on the day before expatriation.
A covered expatriate must determine the taxable amount of the distribution and include it in his taxable income.
An early distribution penalty of 10 percent is ordinarily applied to IRA distributions that are made before the account holder has reached age 59 ½. In the case of pretend distributions to covered expatriates from IRAs, however, the penalty does not apply.
If you have a pretend distribution from your IRA account because you are a covered expatriate, and you subsequently take an actual distribution before age 59 ½, you will be subject to the early distribution penalty on the taxable amount actually distributed.
The “pretend distribution” causes income taxation of the entire balance of your specified tax deferred account, whether or not you take an actual distribution. So it would be possible for you to pay the exit tax and leave the specified tax deferred account (let’s say it is an IRA) in place.
When you later receive actual distributions, you are not taxed again on the previously-taxed balance. The amount that you are taxed on under section 877A(e)(1) is treated as an investment in the account under section 72. You have “basis” in your account. This is how you get the money (mostly) tax-free when it is distributed to you later.
You have a choice, therefore. You can immediately liquidate the IRA and move the money outside the US. It has been fully taxed and there is nothing to stop you, except where there is a taxable amount to which the early distribution penalty applies.
Or, you can leave the specified tax deferred account in place after expatriation. If you do so, only the earnings accrued after you expatriate will be taxable in the US. A single 30 percent tax will be imposed on distributions of these earnings. Your later withdrawal of the balance that was taxed at the time of expatriation will not be taxed again.
There are two main areas where you report things related to your specified tax deferred accounts on the income tax return that you submit to the IRS for the year of your expatriation:
- Form 8854, Part IV, Section B, Line 7c, and
- Form 1040 (assuming you are filing a dual-status return and using Form 1040 as your dual-status statement) in the appropriate place for reporting a distribution from that type of account.
Note that the value of the account also gets included in your personal balance sheet on Form 8854 and likely the Form 8854 income statement, as well.
Specified tax deferred accounts are a type of asset that has a special tax treatment for covered expatriates: the balance of the account is considered to be distributed to the covered expatriate on the day before his expatriation date, and he must pay tax on the pretend distribution as if it were actually distributed to him (with the exception of early distribution penalties).
The covered expatriate is responsible for providing Form W-8CE to his account custodian and for properly reporting the deemed distribution on his income tax return and on Form 8854.