Tax Liabilities and Your Form 8854 Balance SheetFebruary 27, 2018 - Phil HodgenExpatriation
Net Worth Test and Covered Expatriate Status
We help many, many people with their expatriation, and the number 2 problem we fix is net worth. Bad tax things happen if a person is a covered expatriate.
A person is a covered expatriate if he or she has a net worth of $2,000,000 or more.1 An expatriate reports all assets and liabilities on Form 8854.
The planning question is simple: “How can I reduce my net worth so I can report a value below $2,000,000 on the Form 8854 balance sheet?”2 If you are able to reduce your net worth below $2,000,000, you may be able to avoid covered expatriate status.3
I know only a few ways to engineer a person’s net worth to a number below $2,000,000:
- Use cash to pay a liability that might not otherwise show up on your personal balance sheet (let’s look at tax liabilities);
- Incur a new liability without acquiring an offsetting asset (e.g., get sued);
- Give assets away; or
- Get believable and favorable valuations for hard-to-value assets.
I will talk here about tax liabilities and how they show up on a balance sheet. The other strategies are worth considering–just not today.
Net worth means your personal assets minus your liabilities. There is absolutely no guidance whatsoever from the government on how to determine whether you have a liability, and how to value it.
The biggest question comes up for income tax liabilities. Should you list the tax you expect to pay when–someday–you sell an asset?
You own real estate worth $1,000,000 that you bought for $600,000 cash. There is no mortgage on the property. You therefore have $400,000 of unrealized capital gain–you know when you sell there will be capital gain of $400,000 that will be taxed.
Let’s pretend that using today’s tax laws the capital gain tax would be $100,000.
Can you report a liability of $100,000 on your Form 8854 balance sheet for the expected but not-yet-due capital gain tax when, some day, you sell the real estate?
This matters because you will either report net worth of $1,000,000 (an asset worth $1,000,000), or you will report net worth of $900,000 (an asset worth $1,000,000 minus the expected tax liability of $100,000).
Since there is no specific guidance from the government, what should you do? In tax jargon terms, I think that where income has been recognized for income tax purposes, the accompanying income tax liability can be listed on your balance sheet if you have not paid it yet. This is a conservative position.
You own real estate worth $1,000,000 that you bought for $600,000 cash. There is no mortgage on the property. You therefore have $400,000 of unrealized capital gain.
You actually sell the property. Now you have $1,000,000 of cash. You have taxable capital gain of $400,000, and let’s assume the tax liability is $100,000.
Your balance sheet will show an asset of $1,000,000 (cash) and a liability for taxes due of $100,000, for a net worth of $900,000.
Look at situations where you can sell assets and create an income tax liability before your expatriation date. If you are going to have to pay the income tax anyway, it will be a matter of timing only: pay this year or pay next year.
If, by paying the income tax this year you can avoid covered expatriate status, then the “sell it now” maneuver may be worth doing.
Example: New IRC §965
There is an interesting opportunity for 2018 expatriates who own foreign corporations. Brand new Internal Revenue Code Section 965 says that all deferred earnings and profits will be taxable on their 2017 income tax returns.
Ignore the technicalities of Section 965. The big picture is that a deferred tax liability (“You’ll have to pay tax someday on those foreign corporate profits!”) has, because our friends in Washington DC said so, become a giant immediate tax liability.
This may be an opportunity for some would-be expatriates who are teetering on the edge of covered expatriate status because of net worth.
You own a normal operating business in Canada, and you operate it in a Canadian corporation. It is your only asset in the world.
The business, as a going concern, is worth $2.5 million. (All values are expressed in US dollars).
You discover that Section 965 has created a US tax bill of $600,000 for you. This will show up on your 2017 income tax return.
I think you have a net worth of $1,900,000. You have an asset worth $2,500,000 and a locked-in US tax liability of $600,000.
My logic here is the idea of “recognition”. The tax event (in this case, an arbitrary event made up by Congress) has occurred and the tax liability is definitely due.
Deferred Tax Liability
Financial accounting standards have a concept of “deferred tax liability“. It is a logical concept. If you own an asset worth $2,000,000 but you will have to pay $500,000 when you sell it, your true net worth is only $1,500,000.
The accounting problem in these situations is usually the problem of making a realistic estimate of the deferred tax liability. A liability definitely exists, but you might have to make a number of assumptions to quantify the liability.
If you can find a way to avoid covered expatriate status in other, more conservative ways, I would do that. Use gifts and gain recognition events first. These are hard for the IRS to challenge–the result is obvious.
However, if your net worth is high enough to make covered expatriate status unavoidable, then this is position worth considering. Do some archeology in your favorite accounting standards, document your position well on Form 8854, and claim the liability.
Look at your assets for built-in capital gain or other tax liabilities–situations where someday you will have a tax bill to pay, when a certain event occurs. That event might be a sale of an asset or a distribution from a retirement plan.
Can you somehow create a liability (in the financial accounting sense) that can show up on your personal balance sheet on Form 8854?
- IRC §§877(a)(2)(B), 877A(g)(1)(A). ↩
- Form 8854, Part V, Schedule A, Line 25. ↩
- There are other ways to become a covered expatriate, even if your net worth is below $2,000,000. These are the certification test and the net income tax liability test. See IRC §§877(a)(2)(A), 877(a)(2)(C), and 877A(g)(1)(A). ↩