by Scott Andrew Bowman
As most recently highlighted by the controversy surrounding the expatriation of Facebook co-founder Eduardo Saverin, a misconception appears to be that U.S. expatriates somehow magically escape U.S. taxation by surrendering their U.S. passports.1 The reality is that certain U.S. expatriates, known as “covered expatriates,” are subject to tax under a complex tax regime. These expatriates are forced to navigate a mark-to-market “exit tax” upon expatriation, and any U.S. person who receives a gift or bequest from a covered expatriate is subject to a special succession tax. These tax ramifications require careful consideration as they may cause significant obstacles for the potential U.S. expatriate.
This article examines the tax considerations facing potential U.S. expatriates. Although tax benefits may await an expatriate who relocates to a no- or low-tax jurisdiction, such tax benefits are not a foregone conclusion. Instead, the decision requires sensitivity to the special income and transfer tax regimes applicable to certain U.S. expatriates and the planning opportunities that can mitigate these tax consequences.
In addition, potential expatriates face a host of nontax issues, which often include selecting a new country of citizenship, deciding which family members will expatriate, managing the formal expatriation process, and determining whether the expatriate will (or will be able to) come back into the United States. Although beyond the scope of this article, caution should be exercised in navigating these nontax issues as well. Notable among these are a provision of immigration law known as the “Reed Amendment”2 and the recently proposed “Ex-PATRIOT Act.”3 Invocation of the Reed Amendment would render a former U.S. citizen ineligible for admission to the United States if the U.S. Attorney General determined that the former U.S. citizen surrendered citizenship for tax avoidance purposes. Although the Reed Amendment appears never to have been enforced, rumors of enforcement and of threatened enforcement have begun to circulate recently. The Ex-PATRIOT Act, should it become law, would bar certain expatriates, including covered expatriates, from ever re-entering the United States, subject to a rebuttable presumption that the expatriation produced a substantial reduction in taxation. What these provisions make clear is that any individuals considering expatriating should retain immigration counsel in addition to (or prior to) their tax counsel.
Definition of “Covered Expatriate”
The current regime governing the taxation of U.S. expatriates was introduced in 2008 under the Heroes Earnings Assistance and Relief Tax Act of 2008 (HEART Act).4 The HEART Act created a category of expatriates dubbed “covered expatriates” who are subject to a tax regime provided by §§877A and 2801.5 As such, it is critical first to determine whether a potential expatriate will be a covered expatriate in order to determine the tax implications for the expatriate and the potential beneficiaries under his or her estate plan.
• Definition of “Expatriate” — For purposes of the U.S. expatriation regime, an “expatriate” generally means an individual who relinquishes U.S. citizenship. Relinquishing U.S. citizenship is typically done by renouncing U.S. nationality before a U.S. diplomatic or consular officer. Other acts of expatriation may include obtaining naturalization in another country upon application after reaching age 18, formally pledging allegiance to another country after reaching age 18, serving in the armed forces of another country in combat against the United States or as a commissioned or noncommissioned officer, or holding certain non-U.S. government positions.6
Additionally, and somewhat surprisingly, long-term green card holders may fall within the definition of an “expatriate.” If a non-U.S. citizen held a green card in eight or more of the last 15 tax years and ceases to be a U.S. resident, the green card holder will be treated as an expatriate for U.S. tax purposes.7 As the statute implies, holding a green card in any portion of a calendar year counts as a full year for purposes of this test. Termination of U.S. residency for a green card holder is most often achieved through abandonment of the green card; notably, the mere expiration of the green card does not terminate U.S. residency for income tax purposes. A green card holder also is deemed to cease being a U.S. resident if the green card holder establishes residency in another country and fails to waive the benefits under any tax treaty between that country and the U.S.8
Because the exit tax is tied to the date the expatriate surrendered U.S. citizenship or ceased to be a U.S. resident, as the case may be, the statute defines an expatriate’s “expatriation date.”9 In the case of a U.S. citizen, the expatriation date is the date the U.S. citizen relinquishes U.S. citizenship. In most circumstances, this will be the date the expatriate renounces U.S. nationality before a U.S. diplomatic or consular officer. In the case of a green card holder, the expatriation date is generally the date the green card holder abandons the green card; however, in the case of a green card holder invoking the residency tie-breaker provision of a U.S. tax treaty, the date may be retroactive to the date the green card holder’s non-U.S. residency commences under the treaty.
• Definition of “Covered” — Being an expatriate alone is not sufficient to subject an individual to the U.S. expatriation regime. In addition, the individual must be “covered.” A covered expatriate is an expatriate who meets one or both of the “tax liability test” and the “net worth test,” or who fails the “tax certification test.”10
The tax liability test is satisfied if the expatriate’s average annual net income tax liability for the five taxable years preceding the expatriation date is greater than $151,000 (for calendar year 2012, adjusted annually for inflation). This includes the total income tax liability shown on the individual’s return, even if filing jointly.
The net worth test is satisfied if the expatriate’s net worth exceeds $2 million on the expatriation date. For purposes of this computation, the individual is treated as owning any property if a transfer of that property would constitute a taxable gift for gift tax purposes.11 This determination is made without regard to exclusions from taxable gifts, such as the gift tax annual exclusion or transfers for education or medical expenses, and without regard to gift splitting and the charitable and marital deductions. Additionally, a covered expatriate’s beneficial interest in a trust is included in this computation. The value of the beneficial interest is determined under a two-step process.12
First, all interests in property held by the trust must be allocated to beneficiaries (or potential beneficiaries) of the trust based on all relevant facts and circumstances, including the terms of the trust instrument, letter of wishes (and any similar document), historical patterns of trust distributions, and any functions performed by a trust protector or similar advisor. Interests in property held by the trust that cannot be allocated based on these factors must be allocated to the beneficiaries of the trust under the principles of intestate succession (determined by reference to the settlor’s intestacy) as contained in the Uniform Probate Code. Second, interests in property held by a trust that are allocated to the expatriate must be valued under basic gift tax principles without regard to any prohibitions or restrictions on such interest.
Even if the expatriate does not otherwise qualify as a covered expatriate under the tax liability test or the net worth test, to avoid being treated as a covered expatriate, an expatriate must satisfy the tax certification test. Under the tax certification test, the expatriate must certify under penalties of perjury that the expatriate has satisfied all U.S. tax obligations for the five preceding taxable years and must provide any requested evidence of such compliance. This certification is provided by completing Form 8854. Any expatriate who fails to satisfy this obligation will be treated as a covered expatriate.
• Exceptions — Notwithstanding the general definition of a covered expatriate, certain exceptions apply to individuals who would otherwise constitute covered expatriates under the taxable income test or the net worth test.13 A dual-citizen who relinquishes U.S. citizenship is excepted if, at birth, the individual became a citizen of the United States and another country, as of the expatriation date the individual continues to be a citizen taxed as a resident of the other country, and the individual has been a U.S. resident (under the §7701(b)(3) “substantial presence test”) for 10 or fewer years during the 15-year period ending with the taxable year during which the expatriation date occurs. Alternatively, a dual-citizen who relinquishes U.S. citizenship is excepted if the individual’s relinquishment of U.S. citizenship occurs before the individual attains age 18½ and the individual has been a U.S. resident (under the substantial presence test) for 10 or fewer years before the date of relinquishment. An expatriate is also excepted during any period after the expatriation date during which the expatriate is subject to tax as a U.S. citizen or resident.
The Exit Tax
Expatriates who qualify as “covered expatriates” are subject to the exit tax. The exit tax treats expatriation as a deemed sale of all of a covered expatriate’s property. The sale is deemed to take place on the day before the expatriation date. All gain or loss realized from the sale is required to be recognized, notwithstanding any nonrecognition provisions of the Code. The recognized gain or loss results in an adjustment to bases in the covered expatriate’s property.14
• Exit Tax Base — Guidance from the IRS provides that the exit tax base includes any property that would be includible in the expatriate’s gross estate if the expatriate died on the day before the expatriation date.15 This determination is made under the basic estate tax includibility provisions of the Code.16 IRS guidance also indicates that a covered expatriate’s beneficial interest in any trust is subject to the exit tax, even if such interest would not be estate tax includible. The application of the exit tax to trusts can be divided into two types of trusts: trusts of which the covered expatriate is treated as the owner under the grantor trust rules and all others (irrespective of whether another individual may be treated as the owner under the grantor trust rules). The Code deceptively uses the term “nongrantor trust” to describe the latter.17
First, all of the assets of a grantor trust of which the covered expatriate is treated as the owner are subject to the exit tax. Although this requirement is far from clear based on the statutory language, which refers to “all property of a covered expatriate,” the Joint Committee on Taxation’s commentary to the HEART Act expressly states this rule.18 Notwithstanding this rule, the exit tax as applied to grantor trusts also must be coordinated in many instances with the possible “outbound migration” of the trust, which may result in gain recognition. Under §684, the outbound migration of a U.S. trust triggers gain (but not loss) recognition in the trust’s assets, if the trust is not a grantor trust subsequent to the migration. Because grantor trust status is limited in application to non-U.S. persons, in many circumstances trusts other than revocable trusts will cease to be grantor trusts upon the grantor’s expatriation.19 If gain is recognized as a result of the outbound migration, that gain is taken into consideration prior to the application of the exit tax, so the gain is only taxed once.
Second, the assets of a “nongrantor trust,” though excluded from the exit tax base, are subject to special provisions under the expatriation regime.20 In the case of a distribution (directly or indirectly) of any property from a nongrantor trust to a covered expatriate, the trustee is required to deduct and withhold from such distribution an amount equal to 30 percent of the “taxable portion” of the distribution. The “taxable portion” of a distribution is the portion of the distribution that would be includible in the gross income of the covered expatriate if the covered expatriate were to continue to be subject to tax as a U.S. citizen or resident. The taxable portion is also subject to tax provisions that apply generally to the taxation of non-U.S. residents.21 If the fair market value of the property distributed in kind exceeds the trust’s basis in the property, the trust is required to recognize gain as if the property were sold to the covered expatriate. The covered expatriate is also treated as having waived any right to claim a reduction in withholding under any U.S. tax treaty unless otherwise agreed by the IRS. Even though a trust of which someone other than the covered expatriate is treated as the owner would be a “nongrantor trust” under the exit tax definition, a distribution from such a trust should not be subject to the 30 percent withholding tax because, if the expatriate were subject to tax as a U.S. citizen or resident, such a distribution would not result in taxable income.
• Computation of Tax — For purposes of computing the exit tax, assets are valued under general transfer tax valuation rules. IRS guidance also provides that the transfer tax special valuation rules (§§2701 through 2704) apply as if the covered expatriate were transferring property to family members. However, there is no authority disallowing valuation discounts such as lack of marketability discounts, lack of control discounts, or fractional interest discounts. As discussed below, this means that many traditional estate planning techniques can be implemented as part of pre-expatriation planning to reduce a covered expatriate’s exit tax exposure.
A covered expatriate is permitted to exclude up to $651,000 of gain (for calendar year 2012, adjusted annually for inflation).22 The exclusion is allocated pro rata among the expatriate’s assets subject to the exit tax on the basis of the amount of gain recognized with respect to each asset. This pro rata allocation is intended to prevent the covered expatriate from allocating the exclusion amount to ordinary income assets and other assets taxed at higher rates, such as collectibles.
• Exceptions — There are two important exceptions from the exit tax base for “eligible deferred compensation items” and for certain “tax deferred accounts.”23 Rather than being subject to the exit tax, eligible deferred compensation items are subject to 30 percent withholding at the source of payment. The withholding is imposed on the “taxable payment,” meaning any payment to the extent it would be includible in the gross income of the covered expatriate if such expatriate continued to be subject to tax as a U.S. citizen or resident. The exit tax also provides that “tax deferred accounts,” such as individual retirement accounts and tax-preferred education and medical savings accounts, are treated as being distributed in their entirety to the covered expatriate on the expatriation date. No early distribution taxes apply.
• Deferral of Exit Tax — Because the deemed gain triggered by the exit tax will not have corresponding liquidity, the expatriation regime permits deferral of the tax payment, subject to an interest charge.24 If the covered expatriate so elects, the pro rata portion of the exit tax associated with a particular asset can be deferred until its actual disposition. As part of the election, the covered expatriate is required to provide “adequate security” for the payment of the tax, which generally means a bond conditioned on the payment of tax. Any covered expatriate making the election must also irrevocably waive any rights under any U.S. income tax treaty with respect to the collection of the exit tax. The liquidity issues associated with expatriation are often difficult ones, as covered expatriates rarely wish to continue ties with the IRS during the deferral period, but may lack the liquidity to make an immediate tax payment.
• Timing Challenges — In addition to liquidity, the timing of the gain recognition may pose a significant obstacle to expatriation. The exit tax causes an acceleration of gain, offending the maxim that tax later is always better than tax now. The time value of money calculations force consideration of the potential holding period in the expatriate’s assets, the anticipated rate of return in those assets, and the potential tax rate that might apply if the expatriate remains in the United States and sells assets at a later date. This is further complicated by market fluctuations that may prove unfavorable for the potential expatriate. Because the tax is triggered at expatriation date values, the actual day of expatriation may have a significant impact on the amount of tax. Thus, the timing of this gain recognition is often simply a function of the date of the visit to the U.S. diplomatic or consular office, which is something that cannot be controlled with precision. This creates tax risk for potential expatriates holding volatile assets. It also highlights another risk — that assets may actually decrease in value after expatriation. The result is that not only does the tax become due immediately, the total tax liability may be greater than had the covered expatriate remained in the United States. Timing must also be taken into consideration with foreign tax credits. The deemed U.S. tax recognition event may not correspond with a taxable event in a non-U.S. jurisdiction where the potential expatriate may reside. If that is the case, there may be U.S. tax liability without a corresponding non-U.S. liability against which the credit can be used. So, the covered expatriate may pay tax twice on the same gain without the benefit of foreign tax credit or treaty relief.
The Succession Tax
Under the U.S. expatriation regime, a U.S. person who receives a gift or bequest from a covered expatriate (referred to as “covered gift or bequest”) is generally subject to a special succession tax.25 The tax is equal to the value of the covered gift or bequest multiplied by the highest marginal estate tax rate in effect on the date of the receipt. Notably, the tax is imposed on the recipient instead of the covered expatriate. Certain exclusions apply from treatment as a covered gift or bequest. If the transferred property is otherwise subject to U.S. estate or gift tax, then the succession tax does not apply. The statute also excepts transfers that would have qualified for a marital or charitable deduction had the covered expatriate been a U.S. person. Additionally, the succession tax allows a credit for foreign taxes paid with respect to the covered gift or bequest.
• Annual Exclusion — Recipients of covered gifts or bequests are permitted an annual exclusion from the succession tax.26 In determining the value of transfers subject to the succession tax, a recipient is permitted to exclude an amount equal to the gift tax annual exclusion amount ($13,000 for calendar year 2012, adjusted annually for inflation). Although, the statutory language is ambiguous as to the application of this exclusion, the statute should apply to all transfers received during a calendar year by one recipient from one covered expatriate. Because the succession tax is computed on a transfer-by-transfer basis, as opposed to aggregating the total amount of covered gifts or bequests the recipient received during the calendar year, this interpretation is appropriate.
• Transfer to Trusts — The succession tax includes special provisions for transfers to trusts.27 When a covered gift or bequest is made to a U.S. trust, the succession tax applies as if the trust were a U.S. citizen, and the trust is liable for the succession tax. When a covered gift or bequest is made to a non-U.S. trust, the succession tax is imposed on any distribution attributable to the covered gift or bequest, whether from income or principal, made to any U.S. citizen or resident. If any amount of the distribution is included in the recipient’s gross income, which may be the case under standard rules of trust taxation or under the “throwback rules,”28 then the transferee is entitled to an income tax deduction for the succession tax. A non-U.S. trust may elect to be treated as a U.S. trust solely for purposes of the succession tax.
• GST Tax Provisions — Notably absent from the succession tax is any provision regarding how a covered gift or bequest should be treated for generation-skipping transfer (GST) tax purposes. Importantly, under the statutory definitions of a GST, an estate tax or a gift tax is a prerequisite to the imposition of a GST tax. Because a “direct skip” is any transfer to a skip person that is subject to an estate or gift tax, a covered gift or bequest transferred directly to a skip person would not appear to be a direct skip. Similarly, in the case of a U.S. expatriate, the current GST tax regulations, as promulgated under the pre-HEART Act expatriation regime, impose a GST tax on taxable distributions and taxable terminations only to the extent the initial transfer of property was subject to U.S. estate or gift tax.29 In the case of a covered gift or bequest to a domestic trust, the initial transfer would be subject to the succession tax, which is not a U.S. estate or gift tax. In the case of a covered gift or bequest to a foreign trust, the initial transfer is not subject to any U.S. transfer tax. Thus, it would seem that there can be no GST tax event in the case of a distribution from a non-U.S. trust that constitutes a covered gift or bequest.
Several traditional planning techniques may be available to minimize the tax exposure facing a potential covered expatriate. Of course, these should be considered only after thoroughly evaluating whether the covered expatriate can avoid being “covered” altogether. This sometimes can be achieved through gifting, thereby reducing net worth for the net worth test, or by postponing gain recognition for several years, thereby reducing income tax liability for the tax liability test. Assuming covered expatriate status cannot be avoided, the following techniques can be considered.
• Valuation Discounts — Because the exit tax is based on the fair market value of the property, traditional estate planning techniques designed to create valuation discounts will reduce the amount of gain recognized upon expatriation. Accordingly, the formation of a family limited partnership (or similar entity) to hold assets may be an attractive option. Claiming valuation discounts for exit tax purposes may be susceptible to some of the same arguments levied against valuation discounts for transfer tax purposes, especially because of the incorporation of §2031 valuation principles into the exit tax computation. A “well-seasoned” family limited partnership is, thus, advisable in order to produce the intended results. Additionally, the use of fractional interest discounts, most often achieved by splitting real property among several trusts, can produce significant discounting.
• Pre-expatriation Trusts — Potential covered expatriates should also be advised to use all of their remaining unified credit before expatriating if potential U.S. beneficiaries are being left behind. Once a covered expatriate becomes a non-U.S. citizen and non-U.S. domiciliary, the unified credit is no longer available, either for succession tax purposes or for standard estate and gift taxation (except for the possibility of a $13,000 estate tax credit). The most efficient use of this credit is likely to be through transfers to a “pre-expatriation” trust, which can be structured as a standard irrevocable gifting trust. Careful consideration should be given as to whether the trust should be structured as a grantor trust or nongrantor trust and also whether expatriation will cause the trust to become a non-U.S. trust, thereby triggering §684 gain and potential throwback tax in future years.
• Crummey Planning — A pre-expatriation trust can continue to be utilized post-expatriation. If standard Crummey provisions are included in the trust, the covered expatriate can make annual exclusion gifts. These gifts are not subject to the succession tax. Additionally, there should be no need to allocate GST exemption to the transfer (as in a traditional life insurance trust). The transfer by the covered expatriate is not a transfer subject to the estate or gift tax, thereby taking it outside the scope of the GST tax. These annual exclusions gifts can then be utilized to purchase life insurance on the covered expatriate as in a traditional life insurance trust, with the result that the death benefits payable upon the covered expatriate’s death pass into trust for the U.S. beneficiaries without ever incurring succession tax.
• Sales to Trust — The pre-expatriation trust also can be used in a manner similar to a traditional gift-sale technique. Although the pre-expatriation trust would most likely not qualify as a grantor trust subsequent to the grantor’s expatriation, the technique can still be beneficial. If the covered expatriate sells appreciated property to the pre-expatriation trust, there may be gain recognition in the covered expatriate’s place of residence. However, the covered expatriate is likely to have chosen a no- or low-tax jurisdiction, so the gain recognition may be irrelevant. The pre-expatriation trust can purchase the property from the covered expatriate using a traditional promissory note with interest payable at the applicable federal rate. If structured properly, the interest payable on the note will qualify as “portfolio interest” and the covered expatriate will not have U.S. taxable interest income.30 The only significant inefficiency in comparison to a traditional gift-sale is that the covered expatriate would not be able to pay the trust’s income taxes without such payment being subject to the succession tax.
Although U.S. expatriation may produce tax savings for potential expatriates, handing in a U.S. passport or green card is not guaranteed to do so. The complexity of the U.S. expatriation regime, timing of expatriation, citizenship and residency of potential beneficiaries, and the possibility of successfully implementing planning techniques all need to be considered carefully as part of the decision to expatriate.
1 See Andrew M. Katzenstein & Scott A. Bowman, Facebook’s Saverin Left U.S. as a Taxpayer, Not a Traitor, Bloomberg News, May 24, 2012, available at http://www.bloomberg.com/news/2012-05-24/facebook-s-saverin-left-u-s-as-a-taxpayer-not-a-traitor.html.
2 See Immigration and Nationality Act of 1965 §212(a)(10)(E), as enacted by the Illegal Immigration Reform and Immigrant Responsibility Act of 1996 (Pub. L. 104-208).
3 Expatriation Prevention by Abolishing Tax-Related Incentives for Offshore Tenancy Act, §3205.
4 Heroes Earnings Assistance and Relief Tax Act of 2008 (Pub. L. 110-245).
5 Unless otherwise noted, all citations are to the I.R.C. of 1986, as amended (the Code), and to the Treasury Regulations promulgated thereunder.
6 I.R.C. §§877A(g)(2) and 877A(g)(4).
7 I.R.C. §§877A(g)(5) and 877(e)(2).
8 I.R.C. §7701(b)(6) (flush language).
9 I.R.C. §877A(g)(3).
10 I.R.C. §§877A(g)(1) and 877(a)(2).
11 Notice 2009-85, 2009-45 IRB 598, citing Notice 97-19, 1997-1 CB 394.
13 I.R.C. §§877A(g)(1)(B) and (E).
14 I.R.C. §877A(a).
15 Notice 2009-85.
16 See I.R.C. §§2033-2046.
17 See I.R.C. §877A(f)(3). Ordinarily the term “nongrantor trust” would refer to a trust taxed as a simple trust under I.R.C. §§651 and 652 or as a complex trust under I.R.C. §§661 and 662.
18 J. Comm. on Tax’n, Technical Explanation of H.R. 6081, JCX-44-08 at 43 (May 20, 2008).
19 See I.R.C. §672(f).
20 I.R.C. §877A(f)(3).
21 See I.R.C. §871.
22 I.R.C. §877A(a)(3).
23 See I.R.C. §§877A(d) and 877A(e).
24 I.R.C. §877A(b).
25 I.R.C. §2801.
26 I.R.C. §2801(c).
27 I.R.C. §2801(e)(4).
28 See I.R.C. §§665 through 668.
29 Treas. Reg. §26.2663-2(b).
30 See I.R.C. §871(h).
Scott Andrew Bowman is an attorney at Proskauer in Boca Raton. He practices in the areas of domestic and international estate planning. He received his J.D. and LL.M. (taxation) from the University of Florida Levin College of Law. He is the vice chair of the International Tax Planning Committee of the Real Property, Trust and Estate Law Section of the American Bar Association.
This column is submitted on behalf of the Tax Section, Michael Allen Lampert, chair, and Michael D. Miller and Benjamin Jablow, editors.