State Income Taxation for ExpatriatesJanuary 31, 2017 - Phil HodgenExpatriation
The exit tax is a Federal tax law, but it can trigger State income tax.
There is no “standard” method for computing taxable income for State purposes, so this is a high-level overview, not an “Insert Tab A in Slot B” detailed instruction manual.
State income tax laws usually take Federal income as a starting point for calculating State income tax.
Noncovered Expatriates: No Problem
Noncovered expatriates have no additional income for Federal purposes that has been triggered by expatriation. This means they have no additional State income tax, either.
Covered Expatriates: Problem
Covered expatriates have potential State tax to pay. The amount of State income tax will depend on whether the person is a resident or nonresident of the State.
When a covered expatriate is a resident for State income tax purposes, the entire amount of income and capital gain triggered by the Federal exit tax rules will be included in State income.
When a covered expatriate is a nonresident for State income tax purposes, the mark-to-market rules of the exit tax will cause Federal capital gain recognition for assets in that State, and therefore State capital gain recognition as well. Other aspects of the Federal exit tax rules may also cause State taxation.
High Level Overview of State Tax Principles
How States Claim the Right to Tax You
States claim the right to tax an individual’s income based on two principles:
- Residence. If you are a resident of the State, you are typically taxable on all of your income. The definition of “resident” varies from State to State.
- Source. If you are a nonresident of the State but you have income that comes from sources within that State, you can be taxed on that income.
These are familiar concepts to international tax fans.
How States Compute Taxable Income for Residents
There are three basic ways that States compute your taxable income as a resident:1
- Start with Federal Adjusted Gross Income. Some start with Federal adjusted gross income (that’s the number at the bottom of page 1 of Form 1040), and then make their own idiosyncratic adjustments.
- Start with Federal Taxable Income. A few states start with Federal taxable income (that is adjusted gross income minus your itemized or standard deductions, and minus your personal exemptions).2
- “We Have Our Own Way of Doing Things Around Here”. Some States ignore the Federal income as a starting point, and have their own way of calculating taxable income for State purposes.
A few States have no income tax. Lucky them.
How States Tax Nonresidents
People who are nonresidents of a State will typically only be taxed on income derived from sources in that State. The rules for “source” vary from State to State.
For example, if you own rental real estate in a State, the rental income will typically be taxable in that State. When you sell the real estate, the capital gain will be taxable in that State as well.
State Resident, Covered Expatriate
Let’s look at people who are covered expatriates and are treated as residents of one of the States of the United States for the year in which they expatriate.
If the State tax base (the amount of income that is taxed in the State) has as its starting point either the Federal adjusted gross income or Federal taxable income, then expatriation (a Federal tax event) will cause State income tax to be triggered.
You are a covered expatriate and a State resident for its income tax purposes. You have $1,000,000 of mark-to-market capital gain included in your Federal adjusted gross income.
The State uses Federal adjusted gross income as its tax base, before introducing its own deductions, allowances, and exclusions.
That $1,000,000 of mark-to-market capital gain will be included in the State tax base for computing your State income tax.
You will need to look at the State in question and see how its tax system works. If State taxable income takes Federal adjusted gross income or Federal taxable income as its starting point, then you need to worry about the impact of expatriation on State income tax.
If, however, the State tax laws are of the “We do it our own special way” variety, then . . . vaya con Díos.
The basic principle, though, is simple: something (the IRC § 877A rules, specifically) created Federal taxable income (or capital gain). States that use Federal income as a starting point will therefore include that additional income in the State-resident covered expatriate’s State income tax return.
Other Categories of Income
The exit tax rules have special rules for imposing tax on a covered expatriate’s specified tax-deferred accounts,3 deferred compensation,4 and trust distributions.5
For a covered expatriate who is a resident of a State, the income item is included in Federal adjusted gross income, and therefore (for most States) it will be included in State income as well.
A covered expatriate is a resident of SomeState and has an IRA. The entire value of the IRA is treated as distributed to the covered expatriate on the day before expatriation.6
The IRA distribution is reported on Form 1040, Line 15a and Line 15b. It increases Federal adjusted gross income, so for States that take Federal income as a starting point, the IRA distribution will be subject to tax for State income tax purposes.
State Nonresident, Covered Expatriate
Nonresidents only have State income tax problems when they are (1) covered expatriates who (2) have income from sources within that State, or from assets in that State.
What Is Taxed?
To understand the State tax impact of the IRC § 877A rules, you will need to understand how the State defines taxable income for nonresidents of that State. Are IRA distributions to a nonresident taxable? (Probably not). Is rental income from property in the State taxable? (Probably).
You own rental real estate in SomeState. You are a nonresident of SomeState for income tax purposes. You renounce your U.S. citizenship and you are a covered expatriate.
Federal tax law treats you as if you sold the SomeState real estate when you renounce your U.S. citizenship.7 Whatever is included in Federal adjusted gross income will be taxable for State income tax purposes, too.
Mark-to-Market Gain is Net of the Exclusion
The mark-to-market rules say that you are treated as recognizing all capital gain on a “pretend” sale, minus an exemption of $699,000 for all capital gain recognized because of your expatriation.8
Since SomeState starts computing your tax base with Federal adjusted gross income, you will have taxable capital gain for State income tax on the amount of capital gain recognized because of the “pretend sale” minus the $699,000 exclusion, because that is the amount that will be included in Federal adjusted gross income.
You will report all of these gain or loss items on your Federal income tax return as if you had a real sale of the assets.9 This is how the mark-to-market capital gain will flow through to your income tax return and be included in your adjusted gross income. The reported gain will be net of the $699,000 gain exclusion.
The mechanics of computing the mark-to-market gain (after the $699,000 exclusion) to be included in adjusted gross income can be seen in Form 8854, Part IV, Section B, Line 8.
State Nonresident or Resident, Not a Covered Expatriate
If the person is an expatriate (relinquished U.S. citizenship or terminated lawful permanent resident status) but is not a covered expatriate,10 there is no Federal or State income tax problem to worry about.
Such a person is subject to Federal reporting requirements11 but is not subject to the various rules that impose income tax on covered expatriates.12
Since no Federal income or capital gain is deemed to be recognized when the individual expatriates, there will be no additional income in Federal adjusted gross income. Only the normal income items for the year will be reported and taxed on that final Federal income tax return.
Returning to the earlier examples given for covered expatriates:
- A noncovered expatriate is not treated as receiving an IRA distribution as a result of expatriation.13 The IRA simply continues to exist, as an IRA, until a normal distribution is made to the individual.
- A noncovered expatriate who has rental real estate in a State is not treated as having sold the property because of the mark-to-market rules.14 Therefore, there is no additional capital gain to be taxed for State income tax purposes.
Most people who renounce their U.S. citizenship (or abandon their green card visas) are living outside the United States when they do so. They are probably nonresidents for State income tax purposes.
If you still have U.S. assets when you expatriate, or if you have been filing a resident’s income tax return, beware of the State tax consequences. Do some planning before pulling the trigger.
- http://www.taxadmin.org/assets/docs/Research/Rates/stg_pts.pdf ↩
- Taxable income is the number on 2016 Form 1040, Line 43. ↩
- IRC § 877A(e). ↩
- IRC § 877A(d). ↩
- IRC § 877A(f). ↩
- IRC § 877A(e)(1)(A). ↩
- IRC § 877A(a)(1). ↩
- IRC § 877A(a)(3)(A). The amount of gain exclusion is adjusted for inflation. IRC § 877A(a)(3)(B). The gain exclusion amount for expatriations in 2017 is $699,000. Rev. Proc § 2016-55, § 3.33. ↩
- See the Instructions to Form 8854, Page 8. ↩
- A covered expatriate is defined at IRC §§ 877(a)(2), 877A(g)(1). ↩
- IRC § 6039G. ↩
- A covered expatriate is treated as receiving taxable income due to the expatriation event. See IRC § 877A(a), (d), (e), and (f) for the four categories of items that will be taxable, and how they will be taxed. ↩
- IRC § 877A(e)(1)(A). ↩
- IRC § 877A(a)(1). ↩