When you give up your U.S. citizenship (or green card), there are tax consequences. The tax consequences are benign (paperwork only) or malignant (paperwork and actual taxes to pay), dependent on whether you are a “covered expatriate” or not.
A “covered expatriate” is someone who is too rich, as far as the IRS is concerned. You’re rich if your net worth is $2,000,000 or more. You’re rich if your Federal income tax liability was high–$151,000 or more in average Federal income tax liability for the prior five years, if you gave up your citizenship/green card in 2012.
This post discusses how you compute your Federal tax liability in order to determine whether you are a covered expatriate.
Use Line 55 from Form 1040.
Form 8854, Part IV
This whole exercise ends up with you filling in five blanks on Form 8854, Part IV, Line 1. There, you report your actual Federal tax liability for the five years before the year in which you terminate your U.S. citizenship or green card. If, for instance, you terminated your U.S. citizenship in 2012, then you would fill in the blanks for 2007 through 2011.
The instructions to Form 8854 have absolutely nothing to tell you how to fill in these blanks. I guess that’s the government’s way of saying GFY. Fortunately, I’m here for you. This post will tell you exactly how to figure out the right numbers.
The Law Says…
Always start with the Internal Revenue Code. Section 877A(g) says:
For purposes of this section . . . [t]he term “covered expatriate” means an expatriate who meets the requirements of subparagraph (A), (B), or (C) of section 877(a)(2).
Section 877(a)(2)(A) says that an individual is a covered expatriate if:
. . . average annual net income tax (as defined in section 38(c)(1)) of such individual for the period of 5 taxable years ending before the date of the loss of United States citizenship [or termination of green card status] is greater than [$151,000.]
OK. We know something. We have to figure out your net income tax by using the rules in Internal Revenue Code Section 38(c)(1). We do this for the five years before the year you expatriated. We take the average of those amounts.
Let’s look at Section 38(c)(1) to see how to calculate “net income tax”. It says:
[T]he term “net income tax” means the sum of the regular tax liability and the tax imposed by section 55, reduced by the credits allowable under subparts A and B of this part. . . .
In summary, you add the regular tax liability and the AMT, then subtract credits allowable under “Subparts A and B of this part”, which mere mortals can find in Sections 21 through 30D of the Internal Revenue Code.
Internal Revenue Code Section 26(b) defines “regular tax liability”:
(b) Regular tax liability. For purposes of this part [26 USC §§ 21 et seq.]–
(1) In general. The term ‘regular tax liability’ means the tax imposed by this chapter [26 USC §§ 1 et seq.] for the taxable year.
(2) Exception for certain taxes. For purposes of paragraph (1), any tax imposed by any of the following provisions shall not be treated as tax imposed by this chapter [26 USC §§ 1 et seq.]:
(A) section 55 [26 USC § 55] (relating to minimum tax),
(B) section 59A [26 USC § 59A] (relating to environmental tax),
(C) subsection (m)(5)(B), (q), (t), or (v) of section 72 [26 USC § 72] (relating to additional taxes on certain distributions),
(D) section 143(m) [26 USC § 143(m)] (relating to recapture of proration of Federal subsidy from use of mortgage bonds and mortgage credit certificates),
(E) section 530(d)(4) [26 USC § 530(d)(4)] (relating to additional tax on certain distributions from Coverdell education savings accounts),
(F) section 531 [26 USC § 531] (relating to accumulated earnings tax),
(G) section 541 [26 USC § 541] (relating to personal holding company tax),
(H) section 1351(d)(1) [26 USC § 1351(d)(1)] (relating to recoveries of foreign expropriation losses),
(I) section 1374 [26 USC § 1374] (relating to tax on certain built-in gains of S corporations),
(J) section 1375 [26 USC § 1375] (relating to tax imposed when passive investment income of corporation having subchapter C earnings and profits exceeds 25 percent of gross receipts),
(K) subparagraph (A) of section 7518(g)(6) [26 USC § 7518(g)(6)] (relating to nonqualified withdrawals from capital construction funds taxed at highest marginal rate),
(L) sections 871(a) and 881 [26 USC §§ 871(a) and 881] (relating to certain income of nonresident aliens and foreign corporations),
(M) section 860E(e) [26 USC § 860E(e)] (relating to taxes with respect to certain residual interests),
(N) section 884 [26 USC § 884] (relating to branch profits tax),
(O) sections 453(l)(3) and 453A(c) [26 USC §§ 453(1)(3) and 453A(c)] (relating to interest on certain deferred tax liabilities,
(P) section 860K [26 USC § 860K] (relating to treatment of transfers of high-yield interests to disqualified holders),
(Q) section 220(f)(4) [26 USC § 220(f)(4)] (relating to additional tax on Archer MSA distributions not used for qualified medical expenses),
(R) section 138(c)(2) [26 USC § 138(c)(2)] (relating to penalty for distributions from Medicare Advantage MSA not used for qualified medical expenses if minimum balance not maintained),
(S) sections 106(e)(3)(A)(ii), 223(b)(8)(B)(i)(II), and 408(d)(9)(D)(i)(II) [26 USC §§ 106(e)(3)(A)(ii), 223(b)(8)(B)(i)(II), and 408(d)(9)(D)(i)(II)] (relating to certain failures to maintain high deductible health plan coverage),
(T) section 170(o)(3)(B) [26 USC § 170(o)(3)(B)] (relating to recapture of certain deductions for fractional gifts),
(U) section 223(f)(4) [26 USC § 223(f)(4)] (relating to additional tax on health savings account distributions not used for qualified medical expenses),
(V) subsections (a)(1)(B)(i) and (b)(4)(A) of section 409A [26 USC § 409A] (relating to interest and additional tax with respect to certain deferred compensation),
(W) section 36(f) [26 USC § 36(f)] (relating to recapture of homebuyer credit), and
(X) section 457A(c)(1)(B) [26 USC § 457A(c)(1)(B)] (relating to determinability of amounts of compensation).
Bwahahahahaha! Read it and weep. Can you say “Tax law is 100% bureaucratic sludge!” with me now?
For you, Ladies and Gentlemen: use Line 44 from your Form 1040.
Section 26(c) defines the term “tentative minimum tax”–needed because Section 38(c)(1) says you need it:
(c) Tentative minimum tax. For purposes of this part [26 USC §§ 21 et seq.], the term ‘tentative minimum tax’ means the amount determined under section 55(b)(1) [26 USC § 55(b)(1)].
Simple. Find this number on Line 45 of your 2012 Form 1040.
The IRS, Bein’ All Helpful ‘n Stuff
As I noted, the instructions to Form 8854 are silent. There’s nothing there. Not even wrong information. Just silence.
Notice 2009-85 tells you this, at Section 2(B):
For guidance on determining whether an individual is a covered expatriate by reason of the tax liability test or the net worth test, see Section III of Notice 97-19, 1997-1 C.B. 394.
We then look at Notice 97-19 [PDF], which tells us this at Section III:
For purposes of the tax liability test, an individual’s net U.S. income tax is determined under section 38(c)(1). An individual who files a joint income tax return must take into account the net income tax that is reflected on the joint income tax return for purposes of the tax liability test.
This is useful, because it tells us to look where we already looked (Section 38 of the Internal Revenue Code). And it is useful because it tells us what to do if you filed a joint tax return with your spouse.
Joint Tax Returns
We come now to the practical part of this blog post: what to do.The first thing is for those of you who filed joint tax returns with your spouse. When extracting the numbers from your prior year tax returns, do not divide by two. Your net tax liability is calculated using the numbers on the joint tax return, not 50% of the numbers (which would seem logical but nope, you can’t do that).
If you are thinking about expatriating at some point in the future, start filing your tax returns using the status “Married Filing Separately” rather than “Married Filing Jointly”. You may be able to avoid covered expatriate status that way.For example, if your annual Federal tax liability is $200,000 when you are filing jointly, you are going to be a covered expatriate. If you file separately from your spouse, you will have an annual tax liability of $100,000, which is well under the $151,000 (2012 amount) threshold.
Addition and Subtraction
In order to calculate your net tax liability, you will compute your tax liability for regular income tax and alternative minimum tax. Then you will subtract a bunch of tax credits from the total. What you end up with is the number you need to fill in the blanks on Form 8854, Part IV, Line 1.
I am going to give you the theory and the places to look on your 2012 Form 1040 to find the numbers you need. From year to year the government changes Form 1040, so for other years the Line numbers may/will be different. I’m doing 2012 for you. For other years, you’re on your own.
Start With 2012 Form 1040, Line 46
The top line number is found at Line 46 of your 2012 Form 1040. This is your total regular tax liability (Line 44) plus your alternative minimum tax liability (Line 45). Write this number down. You are going to subtract a bunch of stuff from it. Remember, it does not matter whether you your filing status was “married filing jointly” or “married filing separately”.
Then Subtract Tax Credits (TL;DR Version)
Internal Revenue Code Section 38(c)(1) told us to subtract all of the tax credits found in subparts A and B. This means Internal Revenue Code Sections 21 through 30D. Here are the tax credits you will subtract from your Line 46 amount: take the total on Form 1040, Line 54.
The Scholar’s Explanation
Because you are scholarly, you want to know the reasons behind the math. “Line 46 – Line 54 = Answer” is not enough for you. I’m here to quench your thirst for truth.
Remember that Internal Revenue Code Section 38(c)(1) told us to compute net tax liability by subtracting all of the tax credits in Subparts A and B, meaning Internal Revenue Code Sections 21 through 30D? Here they are:
- Section 21. Credit for dependent and child care. Computed on Form 2441 and reported on 2012 Form 1040, Line 48.
- Section 22. Credit for the elderly and the permanently and totally disabled. Computed on Schedule R and reported on 2012 Form 1040, Line 53.
- Section 23. Adoption credit. Computed on Form 8839 and reported on 2012 Form 1040, Line 53.
- Section 24. Child tax credit. Computed on Form 8812 and reported on 2012 Form 1040, Line 51.
- Section 25. Credit on certain mortgage interest. Computed on Form 8936 and reported on 2012 Form 1040, Line 53.
- Section 25A. Education credits. Computed on Form 8863 and reported on 2012 Form 1040, Line 49.
- Section 25B. Elective deferrals and IRA contributions by certain individuals. Computed on Form 8880 and reported on 2012 Form 1040, Line 50.
- Section 25C. Nonbusiness energy property credit. Computed on Form 5695 and reported on 2012 Form 1040, Line 52.
- Section 25D. Residential energy efficient property credit. Computed on Form 8936 and reported on 2012 Form 1040, Line 52.
- Section 26 is a limitation on how much credit you can take. Nothing to see here; move along.
- Section 27. – Foreign tax credit. Computed on Form 1116 and reported on 2012 Form 1040, Line 47.
- Section 28. Nothing here in the Internal Revenue Code.
- Section 29. Nothing here in the Internal Revenue Code.
- Section 30. Certain plug-in electric vehicles. Computed on Form 8834 and reported on 2012 Form 1040, Line 53.
- Section 30A. USC economic activity credit. Applies to corporations, not humans.
- Section 30B. Alternative motor vehicle credit. Computed on Form 8910 and reported on 2012 Form 1040, Line 53.
- Section 30C. Alternative fuel vehicle refueling property credit. Computed on Form 8910 and reported on 2012 Form 1040, Line 53.
- Section 30D. New qualified plug-in electric drive motor vehicles. Computed on Form 8936 and reported on 2012 Form 1040, Line 53.
The number you need to compute your net tax liability for 2012 is found on 2012 Form 1040, Line 55.
I took you the long way around to show you how the Tax Code is a bunch of interlinked provisions that require you to follow carefully. Something that looks simple (Line 55 on your income tax return) hides a world of complexity beneath it. Now you know.