Strategic Reasons to become a US Tax Resident AgainFebruary 13, 2018 - Phil HodgenExpatriation
Sometimes people who expatriate become U.S. taxpayers again. This might happen because life intervenes (family or job reasons make a return to the United States necessary or desirable). Or, becoming a U.S. taxpayer again might be good for tax reasons.
Let’s look at this piece of the expatriate’s life after expatriation.
Two Types of Tax Residents
There are two types of “residents” for U.S. tax purposes:
- Income tax. A nonresident noncitizen of the United States might become a resident of the United States for income tax purposes only. The result? Pay U.S. income tax on worldwide income, and file all of the tax paperwork that the United States demands of its residents and citizens.
- Estate tax. A nonresident noncitizen might become a resident of the United States for estate and gift tax purposes only. The result? Assets located anywhere on the planet will be taxed by the United States when the individual dies. Gifts are potentially taxable by the United States as well, even if the asset given is outside the U.S. and the recipient is a nonresident noncitizen of the United States.
Someone who renounces U.S. citizenship or gives up permanent resident status by definition is not a citizen of the United States and almost certainly lives outside the United States. So an expatriate need not worry about paying U.S. income tax or estate tax.
Why Jump Back Into the U.S. System?
Why on earth would an expatriate jump back into the U.S. tax system?
- Income Tax. You might want to be a U.S. tax resident because you, the expatriate, are married to a U.S. person and your spouse might pay less U.S. income tax by filing a joint income tax return with you. Or life might intervene, forcing your hand–work or family life may dictate a return to the U.S.
- Estate Tax. Covered expatriates with U.S. heirs might be able to leave their heirs more money (after estate tax) by re-entering the United States and conceding the application of the U.S. estate tax system.
Let’s talk about those topics.
What Makes a U.S. Income Tax Resident?
There are four ways you can be a U.S. income taxpaying human, if that is your objective. One is by being a U.S. citizen.
The other three are by being what tax law calls a “resident alien”. You are an “alien” because you are not a U.S. citizen, but you are a resident of the United States and therefore fully within the reach of the income tax system.
The three ways to be a resident alien are:
- Be a U.S. green card holder;
- Spend enough time in the United States;
- Choose to be a U.S. taxpayer using an election available to you in the Internal Revenue Code.
This is the permanent resident visa. You are entitled to live in the United States indefinitely, and the visa status you hold automatically makes you a resident alien for income tax purposes.1
This would be the typical path for an expatriate who wants to re-enter the United States and live here again.
Substantial Presence Test
The next way to be a resident alien is to spend enough time in the United States to qualify. Every country has a rule like this: spend enough time here, and you are a resident. If you’re a resident, you should pay tax because you are living here.
The U.S. system is more complex than other countries’ systems. You will be a resident alien for U.S. income tax purposes in a particular year if you:
- Spend more than 30 days in the United States in the current year;2 and
- Do some complicated math using a weighted average formula that looks at the current year and two preceding years, and get a number at the end of the equation that is 183 or higher.3
Usually, family reasons (coming to take care of elderly parents, for instance) or job reasons would cause someone to spend enough time in the United States to be a U.S. resident.
Choose to be an American Taxpayer
The next way to be a U.S. resident alien (and therefore taxable just like a U.S. citizen) in the year that you expatriate is to choose to that status.
There are three different places in the Internal Revenue Code that allow you to do this. Let’s talk about the one that expatriates are likely to use.4
If you are a nonresident alien and you are married to a U.S. citizen or resident, you can choose to be a U.S. taxpayer for income tax purposes (and for withholding of income at source on your wage income):5
“Two individuals who are husband and wife at the close of a taxable year ending on or after December 31, 1975, may make an election under this section for that taxable year if, at the close of that year, one spouse is a citizen or resident of the United States and the other spouse is a nonresident alien. The effect of the election is that each spouse is treated as a resident of the United States for purposes of chapters 1, 5, and 24 and sections 6012, 6013, 6072, and 6091 of the Code for the entire taxable year. An election made under this section is in effect for the taxable year for which made and for all subsequent years of the husband and wife. . . .”6
For a former U.S. citizen or green card holder who is married to someone who is still a U.S. taxpayer (whether U.S. citizen or green card holder), this election may make sense.
Who Should Consider This?
The people for whom this would make sense are couples where the U.S. person is the income-earner and the expatriate has no income.
Why? Married Filing Jointly Status
The income will be fully taxable in the United States anyway, and the U.S. spouse will file using the status “Married Filing Separately”. If the expatriate spouse elects to be a U.S. taxpayer, then the couple files using the status “Married Filing Jointly”. This may result in a lower income tax bill in the United States.
Why? Interspousal Transfers
A second reason to make the election is to facilitate asset swaps between spouses. Normally, U.S. income tax law says that assets can be moved between spouses without worrying about accidentally triggering capital gain tax.7
But when one of the spouses is a nonresident alien, that rule does not apply: a U.S. taxpayer transferring assets to a nonresident alien spouse might accidentally create capital gain tax liability in the United States.8
Why The U.S. Estate Tax Might Be Good
Becoming a U.S. resident for estate tax purposes will be useful for only a few people: covered expatriates with U.S. heirs, and especially those with personal net worth of under about $11,000,000.
A covered expatriate is someone who, when expatriating failed (or passed, depending on your point of view) one of three tests:
- Personal net worth immediately before expatriation was $2,000,000 or more.
- Average net income tax liability for the five years before expatriation was $162,000 or more (an indexed number; I have given you the threshold for 2018 expatriations).
- Something was wrong with tax payments or tax filing requirements in the five years before expatriation.
Covered Expatriates and Section 2801
A covered expatriate who wants to make a gift — or leave a bequest — to a U.S. person has a problem. The recipient of that gift or inheritance will pay tax at the highest gift tax rate.9
A covered expatriate has a U.S. citizen child. The covered expatriate leaves the child $1,000,000 in his will. The child must pay tax of $400,000.
There are a few exceptions — transfers to U.S. spouses are not taxed,10 among other things, but for transfers to almost everyone else, this is a painful tax indeed.
Here’s the deal, though. If assets are included in the gross estate of the covered expatriate are reported on a U.S. estate tax return then the recipient does not pay the Section 2801 tax for receiving something from a covered expatriate.11
It makes sense. The U.S. either extracts the estate tax from the estate of the covered expatriate, or it extracts a tax from the U.S. recipient of a gift or inheritance from a covered expatriate. One or the other.
Current U.S. estate tax law says that the first $10,000,000 (actually more, but the precise number has not been published yet) of assets held by a U.S. resident or citizen will be free of estate tax. From our friends at the IRS:
Under the Tax Cut and Jobs Act, Pub. L. No. 115-97, the filing threshold for 2018 increases to $10,000,000, before taking into account the necessary inflation adjustment. The filing threshold for 2018 that includes the inflation adjustment has not yet been released. This information will be updated on IRS.gov as soon as it becomes available.
Here are two alternate strategies for a covered expatriate:
A covered expatriate lives outside the United States and has a net worth of $10,000,000. He dies, leaving everything to his U.S. citizen daughter. The daughter pays tax of $4,000,000 because of Internal Revenue Code Section 2801, leaving her with $6,000,000 after tax.
A covered expatriate returns to live in the United States and has a net worth of $10,000,000. He dies, leaving everything to his U.S. citizen daughter. The estate tax on his estate is zero, so his daughter inherits $10,000,000 tax-free.
Estate Tax Residency
The way to become a resident of the United States for estate tax purposes is to really, truly live in the United States. In tax jargon, it is called a “domicile” test. The individual must be physically in the United States with no intention to leave.
In selected cases, it may make sense for a covered expatriate to deliberately become a U.S. resident (in the estate tax sense) again. It will mean more tax-free assets for U.S. heirs when the covered expatriate dies.
What It All Means
We live. We die. One time through on the planet. Please optimize for a good life, rather than tax efficiency. But sometimes a good life and tax efficiency will both aim you in the same direction. And sometimes . . . paradoxically . . . that may mean you revert back to the place you left behind when you expatriated.
For the types of people I mentioned — expatriates married to U.S. persons, and covered expatriates with U.S. family members who will inherit assets — consider the possibility of re-entering the U.S. tax system. It may be a strategically useful move.
- IRC §7701(b)(1)(A)(i). ↩
- IRC §7701(b)(3)(A)(i). ↩
- IRC §7701(b)(3)(A)(ii). ↩
- The other two elections that allow nonresidents to be taxed in the United States as residents are for the first year of transition from nonresident status to resident status: IRC § 7701(b)(4) (for anyone, married or unmarried), and IRC § 6013(h) (for married couples). ↩
- IRC §6013(g). ↩
- Regs. §1.6013-6(a)(1). ↩
- IRC §1041(a). ↩
- IRC §1041(d). ↩
- IRC § 2801(a). ↩
- IRC § 2801(e)(3). ↩
- IRC § 2801(e)(2)(B). ↩