The Tax Liability Test for Covered ExpatriatesMarch 28, 2017 - Phil HodgenExpatriation
You can become a covered expatriate if your average tax liability for the previous five years is above a certain amount ($162,000 for expatriations in 2017).
Calculating this average amount is a bit of a pain.
Covered Expatriate Status is Bad
Don’t be “covered expatriate”.
- Covered expatriates pay income tax when they renounce U.S. citizenship or give up permanent resident visa status.1
- Covered expatriates cannot make tax-free gifts or bequests to U.S. persons.2
- They also risk being barred from re-entering the United States, because they might be considered tax-motivated. The dreaded Reed Amendment gives the State Department the power to exclude these people from entering the United States.
Three Ways to Become a Covered Expatriate
There are three ways that you can become a covered expatriate.
One way to be a covered expatriate is to be insufficiently OCD when it comes to tax paperwork for the five years before you expatriate. You are a covered expatriate if your tax paperwork and payment obligations are not up-to-date when you give up U.S. citizenship or your permanent resident visa. This is the certification test.3
The other two ways to become a covered expatriate a function of your wealth at the time of expatriate:
- You are a covered expatriate if you are wealthy when you give up your U.S. citizenship or permanent resident visa. One measure of wealth is your net worth: is it $2,000,000 or more? This is the net worth test.4
- You are a covered expatriate if your Federal income tax liability was high enough during the five years before your expatriation year. This is the tax liability test and our topic for discussion.
The Tax Liability Test
Let’s talk about you figure out if your income tax liability makes you a covered expatriate.
You are a covered expatriate if your:
average annual net income tax (as defined in section 38(c)(1)) . . . for the period of 5 taxable years ending before the date of the loss of United States citizenship is greater than $124,000[.]5
In the case of the loss of United States citizenship in any calendar year after 2004, such $124,000 amount shall be increased by an amount equal to such dollar amount multiplied by the cost-of-living adjustment determined under section 1(f)(3) for such calendar year by substituting “2003” for “1992” in subparagraph (B) thereof. Any increase under the preceding sentence shall be rounded to the nearest multiple of $1,000.6
The key elements to understanding this rule:
- It’s all about income tax, not other types of taxes;
- It’s about your average income tax liability over a five year period; and
- There is a threshold value that is adjusted annually for inflation.
The Threshold Value
How much average income tax liability makes you an expatriate? The inflation-adjusted values for expatriations in recent years7 are:
|2015||$160,000||Rev. Proc. 2014-61, §3.30|
|2016||$161,000||Rev. Proc. 2015-53, §3.30|
|2017||$162,000||Rev. Proc. 2016–55, §3.32|
This is your threshold. If your “average annual net income tax” for the relevant time period is above that amount, you are a covered expatriate.
The Relevant Five Years
You will be calculating your “average annual net income tax” for the five tax years that end before the year in which you expatriate.
Your “taxable year” is the calendar year, so your taxable year ends on December 31. The taxable year that ends on December 31 before the calendar year in which you expatriate will be the fifth year of the five-year period you need to examine.
You renounce your citizenship in 2017. This is an event of expatriation.
The taxable year ending before the date of your expatriation is 2016. That is the fifth year of the five year period ending before the date of your expatriation.
Therefore, you will examine your income tax liability for 2012 through 2016 to determine whether your average annual net income tax is above or below the threshold.
What Does “Net Income Tax” Mean?
In order to calculate your “average annual net income tax” you will need to calculate your net income tax for the five years that matter.
“Net income tax” is a bit tricky to understand. You are supposed to calculate it using the methodology in Internal Revenue Code Section 38(c)(1). The flush language there tells you this:
[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 . . . .8
“The tax imposed by section 55” means the extra tax you pay because of the alternative minimum tax rules, if you are lucky :-/ enough to pay AMT.
So. Regular tax liability, topped up by the alternative minimum tax, minus some (but not all) of the tax credits hardwired into the Internal Revenue Code. That is what “net income tax” means.
Which Tax Credits?
The tax credits that reduce your regular (plus AMT) tax liability are the ones found in “subparts A and B of this part”. These are the tax credits found in Internal Revenue Code Sections 21 through 30D. Here is what the tax credits are, and where you will find them on your income tax return:
|IRC Section||Type of Credit|
|21||Expenses for household and dependent care services necessary for gainful employment|
|22||Credit for the elderly and the permanently and totally disabled|
|24||Child tax credit|
|25||Interest on certain home mortgages|
|25A||Hope and Lifetime Learning credits|
|25B||Elective deferrals and IRA contributions by certain individuals|
|25C||Nonbusiness energy property|
|25D||Residential energy efficient property|
|27||Taxes of foreign countries and possessions of the United States; possession tax credit|
|30A||Puerto Rico economic activity credit|
|30B||Alternative motor vehicle credit|
|30C||Alternative fuel vehicle refueling property credit|
|30D||New qualified plug-in electric drive motor vehicles|
Look for your regular income tax liability on Form 1040, Line 44. That is the line on the 2016 version of Form 1040. In previous years, the line numbering might be slightly different.
Look for your alternative minimum tax (the tax imposed by IRC § 55) on Form 1040, Line 45.
Add those two numbers together. That is the starting point for calculating your tax liability for a calendar year.
Minus Tax Credits
For most Americans living abroad, the foreign tax credit (IRC § 27) is the deciding factor. If your tax bill is $1,000,000 per year but you take a $995,000 foreign tax credit, your net income tax is $5,000. Look for the foreign tax credit on Form 1040, Line 48.
Usually, it is not necessary to do any additional work: the foreign tax credit usually drives the income tax liability so low as to be wildly under the annual threshold for the tax liability test.
For the other fiddly-a** tax credits, look for specific forms in your tax return. If they exist, you claimed the tax credit. Grab the number off those forms to do the math for the tax liability test.
Do This for Five Years
Do this for each of the five years before your expatriation year. You will come up with a tax liability amount for each year.
Write these tax liability numbers on Form 8854, Part IV, Section A, Line 1.
If you want to calculate the average income tax liability for the five years, add all of your calculations together, and divide by five. Note that this number does not go onto Form 8854. This exercise is strictly for your own edification.
Married Filing Jointly? Don’t Divide By Two
Don’t divide your tax liability by two if you are filing a joint tax return with your spouse:
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.9
- IRC § 877A(a), (d), (e), (f). ↩
- IRC § 2801. ↩
- IRC §877(a)(2)(C), applied to expatriations occurring after June 16, 2008 by IRC §877A(g)(1)(A). ↩
- IRC §877(a)(2)(B), applied to expatriations occurring after June 16, 2008 by IRC §877A(g)(1)(A). ↩
- IRC §877(a)(2)(A), applied to expatriations occurring after June 16, 2008 by IRC §877A(g)(1)(A). ↩
- IRC §877(a)(2), flush language, applied to expatriations occurring after June 16, 2008 by IRC §877A(g)(1)(A). ↩
- I am too lazy to go back all the way to 2004. ↩
- IRC §38(c)(1), flush language. ↩
- Notice 97-19, § III. ↩