Covered expatriates are subject to exit tax. For most types of assets, a pretend sale applies, and the covered expatriate must pay tax on gains (after an exclusion is applied) from the pretend sale of all their worldwide assets. This is referred to as the mark-to-market regime.
There are a few types of assets to which an exit tax still applies, but the exit tax works a little differently than for the mark-to-market assets. These are specified tax deferred accounts, deferred compensation, and interests in nongrantor trusts.
In the last couple months, I covered how specified tax deferred accounts and deferred compensation are taxed. This month, I am talking about nongrantor trust interests – how the exit tax works, and the options that you have.
A nongrantor trust is any trust or portion of a trust where the covered expatriate is not the owner under the normal grantor trust rules.1 If your parents created a trust for your benefit, your beneficial interest in that trust will be subject to special exit tax rules.
- The trust document or local law says that the covered expatriate can get a distribution of principal or income;
- The covered expatriate has the power to distribute trust assets to himself or herself; or
- The trust could distribute principal or income to the covered expatriate if it terminated.
If you are a beneficiary of a nongrantor trust under any of these three criteria on the day before expatriation, then you are considered to have an interest in a nongrantor trust for the purposes of the exit tax.
Nongrantor trust interests are not taxed as if lump sum distributions are made; instead, the “taxable portion” of any trust distribution is taxed at 30 percent as distributions are made.
The taxable portion of a distribution is “that portion of the distribution which would be includible in the gross income of the covered expatriate if such expatriate continued to be subject to tax as a citizen or resident of the United States.”4
Generally that means distributions of current or accumulated income will be taxable, whereas distributions from trust principal will not be.
The 30 percent tax on distributions continues even after the covered expatriate is long gone from the US, and even if the trust is foreign.
The 30 percent tax must be withheld by the trustee as distributions are made.
Recall that the 30 percent tax applies only to the “taxable portion” of a distribution, so the trustee must withhold tax according to that principle.
The covered expatriate does not get to claim the benefit of any tax treaty with respect to the withholding on distributions.5
If property other than cash is distributed, then the trust is required to recognize gain if the fair market value of the property distributed to the covered expatriate exceeds the trust’s basis in the property.
The gain is recognized “as if such property were sold to the expatriate at its fair market value.”6
See Notice 2009-85 Section 7.B.for how to determine whether the covered expatriate is subject to withholding on the distribution of property.
A covered expatriate is required to provide Form W-8CE to the trustee on the earlier of:
- The day prior to the first distribution on or after the expatriation date, or
- 30 days after the expatriation date
This form instructs the trustee to withhold appropriately on the distributions.
There is one way out of the 30 percent pay-as-you-go-with-no-treaty-benefits system: you can apply for a private letter ruling from the IRS to be treated as having received the value of your trust interest on the day before expatriation.7 The IRS will issue the ruling as to the value of your interest in the trust. Once you have the private letter ruling, you are eligible to elect this treatment on Form 8854.
If you get the private letter ruling and make this election, you are not required to waive your treaty benefits and you can potentially take advantage of reduced withholding rates on future distributions.
If you have a nongrantor trust just before expatriation and it later converts to a grantor trust, the conversion is deemed to be a taxable distribution. Withholding takes place the way it would on actual distributions.
These rules apply to nongrantor trusts; they do not apply to grantor trusts.
If you are the owner of a grantor trust, then upon expatriation you are taxed under the mark-to-market regime with respect to the trust assets. This makes sense, because a grantor trust owner is considered to be the owner of the underlying assets for tax purposes.
Nongrantor trust interests are generally not taxed at the time of expatriation. Distributions after expatriation are taxed at 30 percent, which must be withheld by the trustee.
The covered expatriate must provide Form W-8CE to the trustee, instructing him or her to perform the appropriate withholding.
There is an option to convert to a single lump sum payment option, but it requires a private letter ruling, which can be time consuming and costly.