The U.S. is among the few industrialized countries that taxes citizens who live abroad, even if their income is entirely sourced in a foreign country. It is believed an estimated 6 million Americans live outside the United States but otherwise remain subject to taxation by the U.S.
During the past year, an estimated 1,800 people have renounced their American citizenship and Green Cards. That’s a record number since the Internal Revenue Service began publishing a list in the Federal Register pursuant to Internal Revenue Code (the “Code”) § 6039G of those who renounced in 1998. It’s also almost eight times more than the number of citizens who renounced in 2008, and more than the total for 2007, 2008 and 2009 combined.
Although such high profile individuals as Tina Turner and Facebook co-founder Eduardo Saverin have recently renounced their American citizenship, the vast majority of expatriates are “Moms and Pops,” normal folks living abroad who are adversely affected by the increasingly complex filing and reporting rules of the U.S. and have recently become mostly unable to even obtain a home mortgage in their country of residence due to their U.S. citizenship. The amount of foreign wages and salary a taxpayer can exclude per year is limited to the lesser of actual foreign earned income or the annual maximum dollar limit (which is $97,600 in 2013 and indexed for inflation for future years).
What are the general tax consequences and requirements resulting from renouncing United States citizenship?
Code § 877A (Tax Responsibilities of Expatriation) applies to all persons who expatriate from the United States after June 16, 2008, including any United States citizen who relinquishes their citizenship and any long-term resident of the United States who ceases to be a lawful permanent resident (green card holder) of the United States. § 877A(g)(2). Section 877A imposes an exit tax (“Expatriation Tax”) on certain persons who expatriate from the United States (referred to in the statute as “covered expatriates”). Code § 6039G (Information on Individuals Losing United States Citizenship) imposes an information reporting requirement on all individuals who renounce citizenship. This article only addresses the provisions under section 877A applicable to United States citizens who renounce their United States citizenship.
I. OVERVIEW OF THE EXPATRIATION TAX
The Heroes Earnings Assistance and Relief Tax Act of 2008 (P.L. 110-245, 6/17/08), known as the HEART Act, repealed the earlier expatriation tax provisions (set forth in section 877) and imposed a new Expatriation Tax as set forth in the new section 877A on any individual who expatriates after June 16, 2008 and who is considered a “covered expatriate” as defined in the Act (discussed in the next section below). Although the Treasury has not yet issued regulations under this statute, guidelines have been provided by the IRS in Notice 2009-85.
A. Mark to Market Tax
The Expatriation Tax is a “mark to market” tax that taxes covered expatriates (expatriates subject to the tax) on the appreciation on all of their property at the time they expatriate, to the extent the total combined gain on the assets exceeds a certain threshold ($668,000 for 2013). § 877A(a).
Section 877A(a) provides that all property of a covered expatriate will be deemed sold on the day before the expatriation date (the date an individual relinquishes United States citizenship) for its fair market value, and requires the taxpayer to recognize any gain or loss resulting from the deemed sale. To determine the gain or loss from a deemed sale, all gains are taken into account notwithstanding any other provision in the Code, but losses are taken into account only as otherwise allowed under the Code (except that the Code’s wash sales rules under section 1091 do not apply to limit the losses). § 877A(a)(2).
However, gains up to a certain threshold are excluded from tax under these rules. Section 877(a)(3) provides that the amount includible in gross income from a deemed sale is reduced (but not below zero) by $600,000, which is adjusted annually for inflation. For deemed sales under these rules in 2013, taxpayers are taxed on the total resulting gain from the sale only to the extent the gain exceeds $668,000. Rev. Proc. 2012-41.
B. Property Considered Owned for the Deemed Sale Rules
Section 877A(a) refers to “all property” of a covered expatriate. For purposes of the mark to market rules, a taxpayer is generally considered to own any interest in property that would be taxable as part of his or her gross estate for Federal estate tax purposes (determined under Chapter 11 of Subtitle B of the Code, without regard to sections 2010 through 2016), as if he or she had died on the day before the expatriation date. Notice 2009-85 § 3.A. The taxpayer is also considered to own his or her beneficial interest(s) in any trust (or portion of a trust), even if the interest would not considered part of his or her gross estate. Id.
C. Property Not Subject to the Deemed Sale Rules
The deemed sale rules do not apply to (1) deferred compensation items, (2) specified tax deferred accounts (such as an individual retirement plan), and (3) interests in certain nongrantor trusts. Instead, section 877A sets forth alternative tax rules applicable to these items. For deferred compensation items, items considered eligible deferred compensation items are generally taxed when the payment is made to the taxpayer through a 30% withholding tax, and other deferred compensation items are generally taxed as if the present value of the covered expatriate’s accrued benefit is received on the day before the expatriation date as a distribution under the plan. For specified tax deferred accounts, the taxpayer is generally taxed on the account as if the entire interest in the account were distributed to the taxpayer on the day before the expatriation date, without any early distribution penalty. For interests in nongrantor trusts, a 30% withholding tax generally applies to the taxable portion of any future distribution from the trust. The details of the tax treatment and rules applicable to these items are set forth in section 877A(c) – (f) and in Notice 2009-85.
D. Election to Defer Tax
Taxpayers subject to the Expatriation Tax have the option of electing to defer the tax until the appreciated property is actually sold or disposed of. This election can be made on a property by property basis, and extends the time to pay the tax until the due date of the return for the taxable year in which the property is disposed of or until the due date for the return for the taxable year in which the taxpayer dies. § 877A(b). Although the requirement to pay the tax is deferred, interest continues to accrue on the amount owed from the date the payment would otherwise be due.
To qualify for the election, the taxpayer must provide the IRS with adequate security with respect to the property (such as a bond), must waive any right under a treaty that would prevent the IRS from assessing or collecting any expatriation tax, and must designate a U.S. person to act as his or her limited agent for purposes relating to the deferral. Notice 2009-85 § 3.E.
II. INDIVIDUALS SUBJECT TO THE EXPATRIATION TAX
A. Definition of “Covered Expatriate”
There are three tests to determine whether an expatriate is considered a covered expatriate and, therefore, subject to the expatriation tax rules—the Tax Liability Test; the Net Worth Test; and the Certification Test. If the individual is described in any one of these tests, the individual is considered a covered expatriate under section 877A(g)(1)(A). Notice 2009-85 § 2.A.
A covered expatriate is defined as an expatriate who:
(1) for an expatriation date in 2013, has an average annual net income tax liability for the five preceding taxable years (i.e., 2008 to 2012 for a 2013 expatriation date) that exceeds $155,000 (this amount is adjusted each year for inflation) (Tax Liability Test);
(2) has a net worth of $2 million or more as of the expatriation date (Net Worth Test); or
(3) fails to certify, under penalties of perjury, compliance with all U.S. Federal tax obligations for the five taxable years preceding the taxable year that includes the expatriation date (Certification Test). This certification is made on a Form 8854, discussed in more detail in Section IV below.
B. Exception to the Expatriation Tax for Certain Dual Citizens by Birth
An exception to the Expatriation Tax applies to certain dual citizens by birth who have been residing outside the United States, as long as they certify under penalty of perjury that they have complied with all of their U.S. Federal tax obligations for the preceding five taxable years.
Under section 877A(g)(1)(B), even if an expatriate has an average net income tax liability above the threshold amount, or has a net worth of $2 million or more, the expatriate will nonetheless not be treated as meeting the Tax Liability Test or the Net Worth Test if:
(1) the taxpayer became at birth a citizen of both the United States and a citizen of another country (as opposed to becoming a citizen by naturalization) and continues to be a citizen of the other country, and
(2) is taxed as a resident of the other country (§ 877A(g)(1)(B)(i)(I)); and
(3) the taxpayer has not been a resident of the United States (under the “substantial presence” test set forth in section 7701(b)(1)(A)(ii)) for more than ten years during the fifteen year period ending with the taxable year during which the expatriation date occurs (§ 877A(g)(1)(B)(i)(II)).
The expatriate must still certify that he or she has satisfied all tax obligations for the past five years in order to be exempt from the expatriation tax under this exception.
C. Exception to the Expatriation Tax for Certain Children who Expatriate
An exception to the Tax Liability Test and the Net Worth Test also applies to any expatriate who relinquishes United States citizenship before age 18.5, if the individual has not been a resident of the United States for more than 10 taxable years before the date of relinquishment. As above, the expatriate must still certify that he or she has been tax compliant for the past five years in order to be exempt from the Expatriation Tax. § 877A(g)(1)(B)(ii).
III. FILING REQUIREMENTS FOR ALL INDIVIDUALS WHO EXPATRIATE
A. Form 8854
Section 6039G of the Internal Revenue Code requires individuals who relinquish their United States citizenship to file an information return that provides the IRS with certain information, including details of the individual’s income, assets, and liabilities. This information is required to be provided to the IRS on a Form 8854 (Initial and Annual Expatriation Statement). All expatriates, regardless of whether they must pay the Expatriation Tax, must file a Form 8854.
In addition to providing general information about the individual, the expatriate must provide information from which the IRS can determine whether the individual is a covered expatriate, including a box which states: “Do you certify under penalties of perjury that you have complied with all of your tax obligations for the 5 preceding tax years?” If the individual is a covered expatriate, the individual must also complete information relating to the application of the mark-to-market rules.
The individual must also complete a Balance Sheet and Income Statement on Form 8854 (Part V). The Balance Sheet and Income Statement is required of all expatriates pursuant to section 6039G, regardless of whether the individual is subject to the Expatriation Tax. The total value of all of the taxpayer’s assets must be reported on the balance sheet, with the fair market value of certain assets required to be separately reported, including cash, stock and securities holdings (including whether such stock is marketable or nonmarketable, and whether it is issued by a U.S. company or a foreign company), and real property both in the U.S. and outside U.S. See Part V of the Form 5548 for the full list of assets required to be separately reported.
Form 8854 is required to be filed by the due date of the taxpayer’s income tax return for the taxable year that includes the day before the taxpayer’s expatriation date, including extensions. For taxpayers who expatriate after June 16, 2008, the Form 8854 is a one-time filing requirement, unless the taxpayer elects to defer part of its Expatriation Tax. The Form 8854 must be filed even if the taxpayer is not required to file an income tax return (Form 1040 or 1040NR). See Notice 2009-85 § 8.C.
B. Tax Return for Year of Expatriation
A taxpayer who expatriates mid-year should file a dual-status return for the taxable year of expatriation, if a return is required. A dual-status return is a non-resident return (Form 1040NR) that is filed with a Form 1040 attached as a schedule. If the taxpayer expatriates on January 1st, then only a Form 1040 for the preceding tax year (the tax year ending December 31st) is required to be filed. The gains from a deemed sale pursuant to the expatriation tax rules are reported on the individual’s return for the tax year that includes the day before the expatriation date.
After the taxpayer expatriates, the taxpayer no longer has an income tax filing obligation for subsequent years, as long as the taxpayer has no income effectively connected with the conduct of a trade or business in the United States and tax is withheld at the source for any other U.S. source income. A taxpayer should file a Form 1040NR to report any income in subsequent years that is effectively connected with the conduct of a U.S. trade or business. See Notice 2009-85 § 8.B.
IV. PAST TAX COMPLIANCE REQUIREMENT
A. Must Be Current on Tax Related Filings for the Last 5 Years
All individuals who expatriate must certify on a Form 8854 whether they have complied with all of their United States federal tax obligations for the preceding five tax years. For an expatriation date in 2013, a taxpayer must certify that they are in compliance with all of their tax obligations for 2008 through 2012, otherwise the taxpayer will automatically be considered a covered expatriate subject to the Expatriation Tax.
A taxpayer’s federal tax obligations include any requirement to file a tax return, including income tax, employment tax, and gift tax; to file any applicable information returns; and to pay all relevant tax liabilities, interest, and penalties. Even if a taxpayer has not worked, the individual may nonetheless have a tax filing obligation if, for example, the individual had transfers to or received distributions from a trust or foreign corporation, the individual made or received gifts over a certain amount, or if the individual had income from investments.
If the individual had a financial interest in or signature authority over a financial account outside the United States, the taxpayer may have also had a Form TD F 90-22.1, Report of Foreign Bank and Financial Accounts (”FBAR”), filing obligation during the preceding five years. The FBAR filing requirement is not a tax obligation under the Internal Revenue Code—it is an information return that is required under the Bank Secrecy Act (codified in Title 31, U.S. Code). Therefore, section 877A does not appear to require compliance with past FBAR filing obligations in order to qualify for the exception to the expatriation tax rules.
However, the IRS has been delegated the authority to enforce the civil FBAR provisions, and the IRS has not issued any guidance to date relating to its position on individuals who renounce citizenship without being in compliance with their FBAR filing obligations. Moreover, regardless of whether it impacts the application of the expatriation tax rules, failing to file an FBAR carries with it the potential for extreme civil penalties in the case of willful failures to file an FBAR (50% of the balance in the financial account for each violation). Although this creates an area of potential uncertainty because renouncing citizenship would not in theory relieve a taxpayer of a civil FBAR penalty, the IRS has issued guidance (discussed below) that allows certain taxpayers who have been living abroad to come into compliance with both their tax and FBAR filing obligations without being subject to a penalty.
B. Coming into Compliance
The IRS has released new Streamlined Filing Compliance Procedures for Non-Resident, Non-Filer Taxpayers (described here: http://www.irs.gov/Individuals/International-Taxpayers/New-Filing-Compliance-Procedures-for-Non-Resident-U.S.-Taxpayers). For “low risk” non-resident taxpayers—non-resident taxpayers with simple returns who have little or no U.S. tax due ($1500 or less each year)—the IRS will not assert any penalties if the taxpayer files delinquent tax returns and any related returns for the past three years and pays any tax and interest due on those returns (but note that five years is required under the expatriation tax rules), files delinquent FBARs for the past six years, and completes a questionnaire with questions relating to the taxpayer’s eligibility, financial accounts, tax advisors, and tax positions.
Taxpayers who do not qualify for the penalty relief under the Streamlined Procedures may be subject to a full examination and may be required to pay applicable tax and FBAR penalties. In that situation, the taxpayer may wish to instead consider the IRS’ Offshore Voluntary Disclosure Program (described here: http://www.irs.gov/uac/2012-Offshore-Voluntary-Disclosure-Program), which imposes a penalty equal to 27.5% of the highest aggregate balance in foreign bank accounts and foreign assets during the period covered by the voluntary disclosure in lieu of any other applicable penalty. This penalty is reduced to 5% and limited to only the value of foreign financial accounts for certain taxpayers who reside outside the United States. A taxpayer’s maximum penalty exposure under a regular exam depends on the particular forms that are delinquent and the particular facts and circumstances of the case.
If the taxpayer only has unfiled FBARs and is otherwise in compliance with their tax obligations, the IRS allows taxpayers to simply file delinquent FBARs with a statement explaining why the FBARs are being filed late, without penalty. See FAQ #17 of the IRS 2012 OVDP FAQs.
V. OTHER CONSIDERATIONS
A. Reed Amendment
8 U.S.C. 1182(a)(10)(E), known as the Reed Amendment, provides that a former citizen of the U.S. who officially renounces United States citizenship for the purpose of avoiding taxation by the United States is ineligible to be admitted to the United States. Although this provision has never been officially used to deny an expatriate entrance to the United States, it remains on the books and some U.S. consular officers have improperly used the provision to refuse to grant a visa to a former U.S. citizen. See Bruce, Charles M. et al., “The Exit Tax — A Perfectly Bad Idea,” Tax Notes International Vol. 41, No. 10, 3/13/2006 at 869.
B. Publication of the Names of Expatriates
The IRS publishes on a quarterly basis the names of persons who renounce citizenship in the Federal Register pursuant to section 6039G(d). Under 6039G(d), the Secretary of State provides the IRS with a copy of each certificate as to the loss of American nationality, which the IRS uses to publish in the Federal Register the names of those who have expatriated.
For more information regarding this topic please contact Lacey Strachan – firstname.lastname@example.org Ms. Strachan is a tax attorney at Hochman, Salkin, Rettig, Toscher & Perez, P.C. and represents clients throughout the United States and elsewhere involving federal and state, civil and criminal tax controversies and tax litigation. Additional information is available at www.taxlitigator.com .
Specific factual differences can and often do result in differing tax consequences. As such, competent counsel should be consulted and presented with all relevant facts before any action(s) are taken based on any portion of the foregoing information. Any use, review, retransmission, dissemination, copying or other use of this information is prohibited.
Pursuant to recent requirements set forth in U.S. Treasury Regulation Circular 230, we are required to inform you that, unless otherwise expressly indicated, any federal tax advice contained in this communication is not intended nor written to be used, and may not be used, for the purpose of (i) avoiding penalties that may be imposed under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein.The information contained in this transmission is confidential and contains privileged attorney-client information or work-product.
 The HEART Act also created IRC section 2801, which is a new provision that applies to gifts received by U.S. persons from expatriates.