The term “exit tax” is not used or defined in the Code or regulations anywhere. It is a shorthand to describe the federal law that requires some citizens and green card holders who are leaving the US tax system to pay US tax, one last time, on their worldwide assets.
The defining feature of the exit tax is that all assets are treated as if they are sold on the day before citizenship or resident status is terminated. If there are any profits from the pretend sale, you pay tax on those profits. This is the “mark-to-market” feature of the exit tax.
There are some assets – certain types of retirement accounts, trust interests – that also are subject to income tax acceleration.
The general idea is that, when you expatriate, the US gets to tax you on items that may be out of its reach after your expatriation. You get a step-up in basis for the items subject to the mark-to-market sale, so if you have any assets that remain within the reach of the US tax system, the appreciation of the assets is not taxed again when you sell them.
Why does the exit tax exist?
The theory behind the exit tax is fairly simple: Without the infrastructure created by governments, individuals would not be able to obtain wealth. When you exit a nation’s tax system, that nation wants to be able to collect tax for the wealth you have accumulated using its infrastructure.
The United States is not the only country that has an exit tax. There are other countries that impose similar rules. But the United States is unique in that it ties the exit tax to immigration status.
A Canadian who moves abroad can be taxed as a nonresident while remaining a Canadian citizen, for example. An American citizen who wishes to be taxed as a US nonresident must relinquish US citizenship in order to do so.
The reason for this distinction – taxation tied to a change in nationality or immigration status – is that the US is unique in the way that it taxes individual humans. While you may have heard quite a bit in the news over the last year or so about the US adopting a “territorial” tax system, that is only true for corporations. Individuals must still operate within what is called a “citizenship-based” or “worldwide” tax system: If you are a US citizen, you are taxed on worldwide income and assets.
Every other country follows a “residence-based” tax system for individuals: If you are a resident, you are taxed in that country. If you are a nonresident, you are not taxed in that country.
This is why Canada (residence-based) allows its citizens to live abroad and be taxed as nonresidents, while it is impossible for the US (citizenship-based) to do so. The US has tied nationality to taxation.
Another way to say this is that if you want to remove the US tax system from your life, there is only one way to do it: You must cease to be a US citizen or resident (for income tax purposes).
Who should care about the exit tax?
The exit tax applies to only two categories of people:
- US citizens, and
- “Long-term residents” – these are US permanent residents, or “green card holders”, who have had that status for a certain amount of time.
If you are not in one of those categories, then the exit tax will not apply to you and you do not need to read further.
What must happen for the exit tax to apply
You are not subject to the exit tax rules simply because you are a US citizen or long-term resident. There are two more critical requirements:
- An event occurs that terminates your citizenship or long-term resident status, and
- You “fail” certain financial and/or paperwork tests.
Let us look at both of those requirements.
Status change to trigger expatriation
If you are a US citizen or long-term resident and retain that status indefinitely, no exit tax will apply to you because no “exit” from the US tax system has taken place. A critical requirement for the exit tax to apply is that an event must occur that terminates your citizenship or long-term resident status.
It is this equation – status as US citizen or long-term resident, plus an event that terminates that status – that makes you what is called an expatriate.1 Only expatriates have to worry about the exit tax.
The formula looks like this:
Starting status + status-changing event = expatriate.
There are only two categories of people to whom the exit tax can potentially apply:
- All US citizens, and
- Some US green card holders.
People who are residents of the US under a different type of visa have no risk of being subject to the exit tax when they become nonresidents.
A US citizen who relinquishes US citizenship will always be an expatriate.2
A green card holder who terminates his green card will be an expatriate only if he is a “long-term resident”.3 This requires the person to have held the green card for a sufficiently long period of time under a count-the-years test.
But “a sufficiently long period of time” is not as simple as just counting the years. If the green card holder elected to be taxed as a resident of another country under a tax treaty for any entire tax year, that year will not count toward the count-the-years test. This subject will be the focus of a separate edition later in the year.
A citizen or long-term resident becomes an expatriate if his personal status changes from either citizen to nonresident alien or from green card holder (and specifically long-term resident) to nonresident alien.
A green card holder also becomes an expatriate if, once he has become a long-term resident, he makes a treaty election to be taxed as a nonresident of the US for income tax purposes.
On or after June 17, 2008
The US law on expatriation changed in the middle of 2008. All discussions that take place here will be in reference to people who expatriate on or after June 17, 2008. In other words, we are only talking about the rules as they exist right now.
A different set of rules applies to people who expatriated before that date.4 If you expatriated before June 17, 2008, what I talk about here does not apply to you.
Analysis: Does the exit tax apply to you?
All people who expatriate have to file some extra paperwork when they expatriate. Some also have to pay exit tax. Here is how you see whether the exit tax applies to you.
Are you an expatriate?
First, determine whether you are an “expatriate”. If you were a US citizen or long-term resident, and then terminated that status, you are an expatriate.
If you are not an expatriate, then the exit tax does not apply to you. If you are an expatriate, proceed to the next step to see whether you need to pay exit tax.
Are you a covered expatriate?
Next, you need to know whether you are a “covered” expatriate to see if you have to pay exit tax. Covered expatriates are subject to exit tax. Non-covered expatriates are not subject to exit tax.
There are three tests to check for covered expatriate status. If you satisfy (or fail, depending on your point of view) any one of these three tests, then you are a covered expatriate:
- You are “too rich” because your net worth was $2 million or more when you expatriated, or
- You are “too rich” because your average US tax bill for the five years before expatriation was above a certain threshold (indexed for inflation each year), or
- You didn’t file your tax returns correctly or pay all your tax for the five years before expatriation.
Consequences of being a covered expatriate (hint: exit tax)
If you are a covered expatriate, then you have to file the same tax return paperwork as regular, non-covered expatriates.
In addition, you are also subject to the exit tax. You will have to pretend that you sold all your worldwide assets on the day before your expatriation. You will pay US tax on the gains from the pretend sale.
You also have to pretend that you received distributions in full from your IRAs and most foreign pension plans. Some other types of retirement assets and trust interests trigger immediate taxation, as well.
The impact of expatriation does not end with you. US persons to whom you make gifts or leave an inheritance also must pay tax on what they receive from you.
Where to find the law
The exit tax law is found in Internal Revenue Code section 877A. The only other significant communication from the IRS on how the exit tax works is found in IRS Notice 2009-85, Guidance for Expatriates Under Section 877A.
Some definitions from section 877 (the section that contains the old, outdated expatriation rules) still apply.
There are no regulations to accompany either section 877 or 877A.
Section 2801 of the Internal Revenue Code contains the rules that impose tax on the recipients of gifts or inheritances from covered expatriates. Proposed Regulations have been published and will likely become Final Regulations at some point.
Special tax forms
There are three special forms you should be aware of as an expatriate. One of them does not exist yet:
- Form 8854 must be completed by all expatriates, covered or non-covered.
- Form 708 (not yet published) is what a US person files to report the receipt of a gift or inheritance from a covered expatriate.
- Form W-8CE is one of the W-8 series forms, used to tell a withholding agent that a recipient of a payment is a covered expatriate.
I have heard, but cannot verify, that it is possible we will see a Form 708 and Final Regulations for gifts and inheritances from covered expatriates soon.
A note about grammar
When people to speak to each other in normal conversation, the word “expat” is used to describe someone living outside his home country. Expat is, of course, short for expatriate.
The Internal Revenue Code has taken that word and given it a specific meaning for US tax law: a citizen or long-term resident who ceases to be a citizen or long-term resident.5 This is different from how people normally use “expatriate”.
The word can also be used as a verb, although it is never used that way in the Internal Revenue Code. When I say it as a verb, I use “to expatriate” to mean the act of terminating one’s citizenship or long-term resident status.
This usage of the term “expatriate” generally has been and will continue be consistent throughout all of our articles – as both a noun, using the tax law meaning of the term (and not the common usage), and a verb, to mean the action you take to become an expatriate.
See you next month
Thanks for reading. Next month, I will talk about how US citizens expatriate, including a somewhat detailed discussion of precisely when a citizen who terminates her citizenship becomes an expatriate.
As always, please don’t try to get your tax advice from a blog post. It probably won’t work out well for you. Hire someone to help you if you want advice that is relevant to your situation.