Exiting U.S. tax system: Tax planning can be complex for expatriates
INSIGHT ARTICLE |
Having planned and executed an entry into the U.S. tax system, a (formerly) non-U.S. tax person may have become a U.S. tax resident, or citizen, by virtue of having acquired a green card or citizenship (see Garcia, "Tax Planning for High-Net-Worth Individuals Immigrating to the United States," The Tax Adviser (April 2016), and Garcia and Qian, "Tax Planning for a Nonresident Entering the U.S. Tax System," The Tax Adviser (April 2017). However, former non-U.S. taxpayers may wish to become non-U.S. once again and should have an exit strategy in mind to mitigate unexpected and potentially costly tax consequences upon departure from the United States.
The U.S. exit tax
In 2008, Congress created a ‘mark-to-market’ exit tax regime through section 877A, enacted as part of the Heroes Earnings Assistance and Relief Tax (HEART) Act of 2008, P.L. 110-245. Section 877A generally imposes a tax on expatriates by providing that all property of a covered expatriate is treated as sold on the day before the expatriation date at its fair market value (FMV). Any gain arising from the deemed sale constitutes income to the extent the gain exceeds an inflation-indexed threshold income amount, which was $713,000 for 2018 (Rev. Proc. 2017-58), for the tax year of the deemed sale.
Before continuing, several important definitions are helpful in examining exit strategies. The term ‘expatriate’ means (1) any U.S. citizen who relinquishes his or her citizenship and (2) any long-term resident of the United States who ceases to be a lawful permanent resident of the United States (Sec. 877A(g)(2)). A long-term resident is an individual who is a lawful permanent resident (i.e., a green card holder) of the United States in at least eight tax years during the period of 15 tax years ending with the tax year that includes the expatriation date (section 877A(g)(5)).
The term ‘covered expatriate’ means an expatriate who (1) has an average annual net income tax liability for the five preceding tax years ending before the expatriation date that exceeds a specified amount that is adjusted for inflation ($165,000 in 2018 (Rev. Proc. 2017-58)) (the ‘tax liability test’); (2) has a net worth of $2 million or more as of the expatriation date (the ‘net-worth test’); or (3) fails to certify, under penalties of perjury, compliance with all U.S. federal tax obligations for the five tax years preceding the tax year that includes the expatriation date, including, but not limited to, obligations to file income tax, employment tax, gift tax, and information returns, if applicable, and obligations to pay all relevant tax liabilities, interest, and penalties (the ‘certification test’) (section 877A(g)(1)(A)).
Exceptions apply in determining whether one qualifies as a covered expatriate. In particular, an expatriate will not meet either the tax-liability test or the net-worth test if (1) the expatriate became, at birth, a U.S. citizen and a citizen of another country and, as of the expatriation date, continues to be a citizen of, and is taxed as a resident of, that other country, and has been a U.S. resident for not more than 10 tax years during the 15-tax-year period ending with the tax year during which the expatriation date occurs, or (2) the expatriate relinquishes U.S. citizenship before the age of 18½ and has been a U.S. resident for not more than 10 tax years before the date of relinquishment (section 877A(g)(1)(B)).
The ‘expatriation date’ is the date an individual relinquishes U.S. citizenship or, in the case of a long-term resident of the United States, the date on which the individual ceases to be a lawful permanent resident of the United States (Sec. 877A(g)(3)).
The exit tax calculation
A person not excepted under either the dual-citizen or the age 18½ provision will thus need to take inventory of his or her assets (in addition to assessing whether the tax-liability test has been met) to assess exposure to the exit tax. The covered expatriate's property for purposes of the exit tax is that property that would be taxable as part of the expatriate's gross estate for federal estate tax purposes, and is generally valued in the same manner as if he or she had died on the day before the expatriation date as a citizen or resident of the United States (Notice 2009-85).
In addition, property also includes a person's beneficial interest in a trust that would not constitute part of his or her estate (Notice 2009-85, section 3(A), citing Notice 97-19, section 3). This inclusion applies only to a grantor trust in which the covered expatriate (1) is treated as the owner of the trust and (2) has a beneficial interest, such as a revocable trust. Other common estate-planning vehicles such as grantor retained annuity trusts (GRATs) and qualified personal residence trusts (QPRTs) would also be captured (J. Comm. on Tax'n, Technical Explanation of H.R. 6081 (JCX-44-08) at 43 (May 20, 2008)).
For purposes of calculating the exit tax, the built-in gain (or loss) of each asset is computed by subtracting the asset's adjusted basis from the asset's FMV (id.). Non-U.S. tax residents who have become U.S. tax residents should note a special rule. Solely for purposes of determining the exit tax, property that was held by a nonresident alien on the day that individual first became a resident of the United States will have a basis on that date of not less than the property's FMV on that date (section 877A(h)(2)).
That said, the IRS and Treasury have indicated their intent to exercise their regulatory authority to exclude from this step-up-in-basis rule U.S. real property interests within the meaning of section 897(c) and property used or held for use in connection with the conduct of a trade or business within the United States (Notice 2009-85). If, however, prior to becoming a resident of the United States, the nonresident alien was a resident of a country with which the United States had an income tax treaty, and the nonresident alien held property used or held for use in connection with the conduct of a U.S. trade or business that was not carried on through a permanent establishment in the United States under the income tax treaty of that country and the United States, then that property is eligible for a step-up in basis to FMV permitted by section 877A(h)(2) (id).
There are exceptions to the above gain calculation rules for specific assets. The deemed-sale concept does not apply to any (1) deferred compensation item; (2) specified tax-deferred account; and (3) interest in a nongrantor trust (section 877A(c)).
A deferred compensation item generally includes any interest in a plan or arrangement described in section 219(g)(5), which covers the following: (1) a plan described in section 401(a) that includes a trust exempt from tax under section 501(a); (2) an annuity plan described in section 403(a); (3) a section 457 plan; (4) an annuity contract under section 403(b); (5) a simplified employee pension under section 408(k); (6) any simple retirement account under section 408(p); and (7) a trust described in section 501(c)(18). A deferred compensation item also includes any interest in a foreign pension plan or similar retirement arrangement or program and any legally binding right as of the expatriation date to compensation that has not been actually or constructively received on or before the expatriation date, but is payable to or on behalf of the covered expatriate on or after the expatriation date (section 877A(b)(7)). This is intended to include nonqualified deferred compensation under section 404(a)(5), cash-settled stock appreciation rights, phantom stock arrangements, cash-settled restricted stock units, an unfunded and unsecured promise to pay money or other compensation in the future, and an interest in a trust described in section 402(b)(1) or (4) (Notice 2009-85, section 5(B)(4)).Finally, also excluded from the deemed-sale regime are statutory and nonstatutory stock options, stock and other property, stock-settled stock appreciation rights, and stock-settled restricted stock units, to the extent these have been taken into account under section 83 if they have vested or a valid section 83(b) election is made and the additional requirements detailed in section 5(b)(1) of Notice 2009-85 are satisfied.
Specified tax-deferred accounts include IRAs (sections 408(a) and 408(b)), section 529 accounts, Coverdell savings accounts (section 530), health savings accounts (section 223), and Archer medical savings accounts (section 220) (section 877A(e)(2)).
The third asset specifically excluded from the deemed-sale regime is an interest in a nongrantor trust. Unless an election is made, instead of the standard mark-to-market regime, section 877A essentially takes a wait-and-see approach to taxing nongrantor trusts. Tax is imposed when distributions are made to a covered expatriate, at which time the trustee of a nongrantor trust must withhold 30 percent of the taxable portion of the distribution (section 877A(f)(1)(A)). A covered expatriate can opt out of this method and elect not to use the wait-and-see approach, and to instead accelerate income recognition. If this election is made, the covered expatriate is treated as having received the value of his interest in the trust on the day before the expatriation date. As a result of this election, "no subsequent distribution from the trust to the covered expatriate will be subject to 30 percent withholding" (Notice 2009-85, section 7(D)).
Planning around the exit tax
These rules and exceptions present some exit planning opportunities. The most obvious step in expatriation planning is to reduce assets below the $2 million threshold so that the covered expatriate will fail the net-worth test. Because there is no lookback period to consider, a potentially covered expatriate can use the gift tax marital deduction by making unlimited gifts to a U.S. citizen spouse (assuming he or she will not be expatriating) or gifting up to $152,000 (the inflation-adjusted amount for 2018 (Rev. Proc. 2017-58)) to a noncitizen spouse before the departure date.
As an alternative to outright gifting, an expatriate might create and fund an expatriation trust such as an irrevocable self-settled, nongrantor U.S. discretionary trust under the laws of a jurisdiction that has asset protection legislation. Other essential considerations in structuring the trust include precluding classification as a grantor trust for U.S. income tax purposes under sections 671-679 and renouncing any retained limited testamentary power of appointment so as to sustain a position of noninclusion of the expatriation trust's assets.
Additionally, if the expatriate is a beneficiary in a trust and does not intend to benefit from the trust, he or she could try to eliminate any beneficial interest that will be included in his or her assets calculation by having the trustee indicate an intention to never make a distribution to the beneficiary.
Does the U.S. have an inheritance tax?
The complement to the exit tax discussed above is section 2801, added in conjunction with section 877A. In short, section 2801 imposes an inheritance-type transfer tax on recipients of gifts or bequests. But unlike the estate and gift taxes, which are imposed on the transferor, section 2801 imposes a tax on U.S. citizens or residents who receive, directly or indirectly, covered gifts or covered bequests (including distributions from foreign trusts attributable to covered gifts and covered bequests) from a covered expatriate (as defined in section 877A(g)(1)). The tax is equal to the value of the covered gift or bequest multiplied by the highest estate tax rate in effect on the date of receipt (section 2801(a)).
Administratively, the transferee presumes that a living donor is a covered expatriate and has the responsibility to determine if the transferor is a covered expatriate (see Prop. Reg. section 28.2801-7). Under limited circumstances, the IRS is authorized to disclose information to assist a recipient in making the determination (id.). Any covered gifts or bequests are to be reported on Form 708 (which is unavailable as of this writing) (see Announcement 2009-57). In practice, when a recipient reasonably concludes that a gift or bequest is not subject to section 2801, he or she may consider filing a protective Form 708 (Prop. Reg. section 28.6011-1(b)).There are several exceptions to the section 2801 tax regime, most notably taxable gifts or estates that have been reported on a timely filed gift or estate tax return, provided that taxes due thereon have been timely paid (section 2801(e)(2)).
Tax planning is usually a critical and complex exercise. Those that may potentially qualify as covered expatriates would be prudent to include an exit strategy to their entry into the U.S. tax system.
Excerpted from the April 2018 issue of The Tax Adviser. Copyright © 2018 by the American Institute of Certified Public Accountants, Inc.