Tax Considerations of Expatriating from the U.S.
By: Sarah Skinner, Esq, LLM and Gary Wells, Esq/CPA
Since the November 2020 election, we have been getting a lot of questions about moving from the United States to Europe and the Caribbean. Generally, their concern is that income and estate taxes will increase under the Biden / Harris administration. We are also finding that Americans are more open to retiring outside America, in Ecuador, Costa Rica, Belize and Thailand, for the lower cost of living and warmer climate.
There are many practices uniquely American, including our policy of citizenship-based taxation. For U.S. Citizens and long-term residents living abroad, this leads to multiple tax residencies and additional tax reporting requirements because the USA and the local jurisdictions will be competing to tax. the same income.
If the new administration or planned retirement abroad has you contemplating either relinquishing your U.S. citizenship or turning in your green card, it is important to consider the expatriation tax provisions found in the Internal Revenue Code. The tax consequences of such a decision may require more analysis.
1. Will I have to pay an exit tax?
You will be assessed a one-time exit tax if you qualify as a “covered expat” for purposes of sections 877 and 877A. If any of the following apply, you will be considered a covered expat or, in other words, are considered “rich enough” for the IRS to care about:
(1) your average annual net income tax for the 5 years ending before the date of expatriation or termination of residency is more than a specified amount that has been adjusted for inflation (in 2019, this amount was $168,000); OR
(2) your net worth is $2 million or more (this amount is NOT adjusted for inflation) on the date of your expatriation or termination of residency; OR
(3) you fail to certify on Form 8854 that you have complied with all U.S. federal tax obligations for the 5 years preceding the date of your expatriation or termination of residency.
Concerning the average annual net income tax calculation, married couples filing jointly must use the number from the joint income tax returns without reduction. If you are married and you and your spouse’s combined average annual net income tax for the 5-year period ending before your chosen date of expatriation or termination of residency is close to the current threshold level, it may be worth considering filing separately to make the tax result lower for each individual spouse (even if it results in a higher total tax being taken). Proper tax planning for those close to the threshold may be able to help you avoid the consequences of being classified as a covered expat.
When determining whether your net worth is $2 million or more, Notice 97-19 from the IRS provides greater details about the calculation. Essentially, your net worth takes into account your personal assets (property interests that would be taxable as a gift if you gave them away the moment before you expatriated) and liabilities. The assets you look at are any property interests that would be taxable as a gift if you gave them away the moment before your expatriated. Currently, an individual is entitled to an annual exclusion of $15,000 and married couples are entitled to an annual exclusion of $30,000. Therefore, although the general rule is that any gift is a taxable gift, gifts that are not more than the annual exclusion amount are not taxable gifts.
The most straightforward net worth calculation example is your personal residence. If, hypothetically, your only asset was your personal residence and you had a mortgage on this residence, your net worth would be the value of your home less the principal balance of the mortgage on your home. For married couples, each spouse will determine his/her net worth separately. Therefore, it becomes necessary to review the state marital property laws to determine specifically what belongs to each spouse. An experienced tax professional should be consulted to ensure the accuracy of your net worth calculation, especially if your net worth is close to $2 million.
It is also very important that Form 8854 be filed on time. This form is filed as an attachment to your expatriation year income tax return. For individuals living outside of the U.S., the filing deadline is usually June 15 and you can also get a six-month extension to file. The consequence of filing a Form 8854 late is, even if you paid no income tax and had a zero-net worth, you will be considered a covered expatriate. Additionally, the IRS will assess a $10,000.00 penalty for failing to file Form 8854.
2. I am considered a “covered expat”, what will my exit tax be?
The exit tax can be thought of as the IRS’ way of wrapping up your U.S. tax affairs. Section 877A, enacted as part of the Heroes Earnings Assistance and Relief Tax Act of 2008, imposes a “mark-to-market” tax regime on covered expats. Per 877A(a)(1), all property of a covered expat is treated as being sold on the day before his or her expatriation date for its fair market value. The exit tax is an income tax on not only the unrealized gain from a deemed sale of worldwide assets on the day prior to expatriation but the deemed distribution of IRAs, 529 plans, and health savings accounts. Any gain arising from the deemed sale will constitute income to the extent the gains exceed an inflation-indexed threshold income amount, which was $737,000 in 2020, for the tax year of the deemed sale. The deemed sale concept does NOT apply to:
- Deferred compensation items, such as:
- a plan described in Sec. 401(a) that includes a trust exempt from tax under Sec. 501(a),
- an annuity plan described in Sec. 403(a),
- a Sec. 457 plan,
- an annuity contract under Sec. 403(b),
- a simplified employee pension under Sect. 408(k),
- any simple retirement account under Sec. 408(p),
- a trust described in Sec. 501(c)(18), or
- any interest in a foreign pension plan or similar retirement arrangement.
- Specified tax-deferred accounts:
- IRAs (Secs. 408(a) and 408(b)),
- Sec. 529 accounts,
- Coverdell savings accounts (Sec. 530),
- health savings accounts (Sec. 223), an
- Archer medical savings accounts (Sec. 220).
- Interest in a nongrantor trust (though tax is imposed when distributions are made to a covered expatriate, at which time the trustee of a nongrantor trust must withhold 30% of the taxable portion of the distribution).
Covered expats with an interest in a nongrantor trust (or other certain deferred compensation assets) must annually file Form 8854. Per IRS Notice 2009-85, this filing requirement appears to have no time limit. Additionally, IRS Notice 2009-85 affirms that covered expats must file a Form 1040-NR in the event the individual has earned taxable income and U.S. income taxes are not fully withheld at the source. As foreign institutions are unlikely to withhold at the source, this requirement usually creates a mandatory filing obligation for covered expatriates. Lastly, IRS Notice 2009-85 confirms that covered expats with a beneficial interest in a nongrantor trust (or deferred compensation asset) must file a Form W-8CE (this form identifies the payor). Form W-8CE filing is required on the earlier of the date of the first distribution from the trust, subsequent to expiration, OR 30 days after the date of expatriation.
Additionally, Section 877A(a) requires “proper adjustments” for any gain or loss realized with respect to an asset deemed sold. Basis is either adjusted upward (or “stepped up”) by the amount of gain attributable to the deemed sale, to avoid double taxation upon the later actual sale of the property OR adjusted downward to the extent of a deemed loss. Keep in mind that not all assets are eligible for in-bound step up (i.e. U.S. property that was used or held in connection with a U.S. trade or business).
3. Besides determining whether an exit tax will be assessed, what are some of the other considerations to take into account prior to making the decision to expatriate?
Other than determining whether you are a covered expat for purposes of Sections 877 and 877A of the Internal Revenue Code, it is also important to consider any tax treaties the U.S. currently has in place with the country where you intend to reside. Talk to your tax advisor about your future residency plans so that your tax advisor can walk through the important provisions of the tax treaty with you (such as how your Social Security benefits will be taxed). Lastly, you should consider the estate planning implications of your decision to expatriate, especially where you will maintain real property in the U.S. or will be leaving property to U.S. citizens.
4. What are my obligations to the IRS during the expatriation process?
If you are a U.S. citizen, you may relinquish U.S. citizenship consistent with requirements under Section 349 of the Immigration and Nationality Act, 8 U.S.C. 1481. The process of relinquishing U.S. citizenship abroad is administered by the Department of the State. Typically, renunciation of U.S. citizenship will involve the U.S. citizen going to a U.S. Embassy or Consulate in a foreign state to turn in his/her U.S. passport and to take a formal oath of renunciation before a U.S. diplomatic or consular officer. The Department of State sets a U.S. consular fee for “Administrative Processing of Request for Certificate of Loss of Nationality,” which is currently $2,350. This fee cannot be waived. Compliance with all U.S. Income tax filings or obtaining a Social Security number is not a pre-condition to relinquishing citizenship under the Immigration and Nationality Act.
If you are a green-card holder, you can terminate your residency by formally relinquishing your green card. If you no longer reside in the U.S., or if you are otherwise subject to loss of your legal permanent residence status (LPR status), you must abandon your claim to LPR status by filing form I-407 – which has no filing fee. Choosing to abandon your LPR status is irrevocable but, it does not affect your ability to apply to immigrate to the U.S. at a future time (you will just have to begin the process again and go through the usual application process). A copy of your completed I-407 and your green card should be mailed to U.S. Citizenship and Immigration Services (USCIS). Always confirm the proper mailing address with USCIS. The typical processing time for form I-407 is two months. It is best to consult with an immigration attorney prior to beginning the residency termination process.
As for the implications of your expatriation decision on your federal tax obligations, you will be considered a resident for federal tax purposes if you are a lawful permanent resident of the U.S. at any time during the
calendar year. This is known as the “green card” test. You will continue to have U.S. resident status for federal tax purposes under the green card test unless:
- You voluntarily renounce and abandon LPR status in writing to the USCIS;
- Your LPR status is administratively terminated by USCIS; OR
- Your LPR status is judicially terminated by a U.S. federal court.
In addition to the green card test, the substantial presence test is also important. To meet the substantial presence test, you must be physically present in the U.S. on at least:
- 31 days during the current year, AND
- 183 days during the 3-year period that includes the current year and the 2 years immediately before that, counting:
- All the days you were present in the current year, and
- 1/3 of the days you were present in the first year before the current year, and
- 1/6 of the days you were present in the second year before the current year.
Generally, if you meet the substantial presence test, your residency end date will be your last day of presence in the United States followed by a period during which:
- You are not present in the U.S.,
- You have a closer connection to a foreign country than to the United States, AND
- You are not a resident of the U.S. during the calendar year following that of your last day of presence in the U.S.
Under the general rule, the residency ending date will be December 31 of the calendar year in which you left the U.S. However, keep in mind that your residency ending date may also include the last day of a calendar year that you are physically present in the U.S. if, for the remainder of the calendar year:
- Your tax home is in a foreign country (cf. Rev. Rul. 93-86); and
- You maintain a closer connection to that foreign country than to the United States (cf. Treas. Reg. § 301.7701(b)-2(d)).
If you currently have LPR status and plan to be absent from the U.S. for an extended period of time, it is best to consult with an immigration attorney to ensure you do not involuntarily give up your LPR status. If you are planning to remain in the U.S. but think your tax home may be in a foreign country per Revenue Rulings or that you maintain a closer connection to a foreign country than the U.S. per Treasury Regulations, it is a good idea to consult with a tax professional.
Regardless of how your LPR status ends, you must file a statement with the IRS to establish your residency termination date. This statement should be attached to your income tax return and must be signed, dated, and include a declaration made under penalty of perjury. For those who are not required to file an income tax return, the statement should be mailed to the IRS on or before the due date for filing income tax returns for that calendar year. More information about what should be included on this statement is found on the IRS website. IRS Publication 519, U.S. Tax Guide for Aliens also has a lot of useful information.
It is important to note that if you do not file the required statement with the IRS, you cannot claim a closer connection to a foreign country or countries. This does not apply to situations where it can be shown by clear and convincing evidence that you took reasonable actions to become aware of the requirements for filing the statement and significant steps to comply with those requirements.
5. What are my next steps?
Are you wondering if expatriation makes financial sense for you from a tax perspective? Give us a call at (919) 615-3768 to set up a consultation.
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advise. You should consult your own tax, legal and accounting advisors before engaging in any transaction.