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Just how is the Expatriation Tax Calculated?

by Stephen M. Moskowitz, Esq. and Anthony V. Diosdi, Esq. 11. September 2012 18:34

Introduction

It has been all over the news lately, wealthy U.S. taxpayers, such as, Eduardo Saverin (a Facebook founder), Denise Rich (songwriter), and another eighteen hundred, or so, have forfeited their U.S. citizenship for U.S. tax reasons.    Federal law provides that some U.S. taxpayers who elect to renounce their U.S. citizenship must pay a so-called federal exit tax or expatriation tax. The computation of this tax is incredibly complex. Only by reviewing the originally enacted expatriation tax in 1966 and the intervening modifications to the expatriation tax law over a four decade period can one begin to understand how to properly compute the so-called “exit tax” regime.

In our International Tax Practice, we have found individuals seeking to learn how the Exit Tax came to be and some of the considerations commonly sought.   This article provides an overview of the federal law governing expatriation tax and the modifications to the law over the past four decades.

The Original Expatriation Tax Provision as Defined by the Foreign Investors Tax Act of 1966

The expatriation tax was introduced to U.S. tax law by the Foreign Investors Tax Act of 1966 (“FITA”). FITA introduced Sections 877, 2107, and 2501 to the Internal Revenue Code.

Section 877 imposed a tax, calculated at higher rates applicable to nonresidents who were not former U.S. citizens or at the rates applicable to U.S. citizens, on the U.S. source income of former citizens who expatriated for a principal purpose of tax avoidance for 10 years following expatriation. In order to correctly determine an individual’s expatriation tax rate, it was necessary to make two calculations known as the “alternative tax” regime.

U.S. source income for purposes of FITA was defined to include gains from the sale of exchange of property (other than stock or debt obligations) located in the U.S. as well as gains from the sale or exchange of stock or debt obligations issued by a domestic corporation or U.S. person. In addition, gains from the sale or exchange of property having a basis determined by reference to such property, in whole or in part was treated as U.S. source income for a 10 year period in order to capture gains from non-U.S. property.

Under Section 2107, added by FITA, if an expatriate subject to the alternative tax regime of Section 877 died within 10 years following expatriation, his or her U.S. estate was assessed the expatriation tax. The expatriation tax was also assessed shares held at the death of the individual comprising a 10 percent or greater direct or indirect interest in a foreign corporation considered to be owned by more than 50 percent by the decedent, directly, indirectly, or constructively, in portion to the foreign corporation’s underlying U.S. situated property. In addition, Section 2501(a)(3) was enacted by FITA. Section 2501(a)(3) provided that the normal gift tax exclusion did not apply for gifts made within 10 year period of expatriation.

For purposes of the expatriation tax, if the IRS was able to establish that it was reasonable to believe that a U.S. citizen expatriated with a principal purpose of tax avoidance, the burden of proof on this matter was placed on the expatriate or his estate to prove otherwise.

Amendments Made to the Expatriation Tax through Health Insurance Portability and Accountability Act of 1996

In 1996, Congress enacted changes to the rules governing expatriation tax through the Health Insurance Portability and Accountability Act (“HIPAA”). Under this act, the category of “covered expatriates” was expanded to include “long-term resident aliens,” defined as “lawful permanent residents” (green card holders) residents for expatriation tax purposes if the individual was a resident in the U.S. in eight of the prior 15 tax years. For purposes of HIPAA, expatriation was considered to have occurred at date stated for citizens under U.S. immigration law (the date of an expatriation act) and for long-term residents under tax residency rules.

HIPPA also introduced the notion of “presumptive tax avoidance purpose” based on a number of economic factors that pertained to the taxpayer seeking to expatriate. A tax avoidance motive was presumed if an individual’s net average U.S. income tax liability in the 5 years preceding expatriation was $100,000 or more (“income tax liability test”) or if his net worth at expatriation exceeded $500,000 (“net worth test”).

In addition, HIPAA significantly enlarged the categories of income considered to be U.S. source income. For example, income and gains derived from former controlled foreign corporations (“CFC”) were considered controlled by an expatriate if held within two years prior to expatriation and were considered to be U.S. source income for tax purposes.

Finally, HIPAA expanded federal tax law to require an expatriating U.S. citizen to provide an information statement, including a statement of net worth, to the Department of State when applying for expatriation.

The Impact of the American Jobs Creation Act of 2004 on the Expatriation Regime

The American Jobs Creation Act of 2004 (AJCA) adopted a number of changes to the tax laws governing expatriation. The AJCA removed the requirement that an individual have a principal tax avoidance purpose and changed the income tax liability test. The income tax liability test threshold was changed to “greater than” $124,000 (indexed annually), the net worth test standard was increased significantly to $2,000,000 (not indexed). In addition, the AJCA added a third test which provided that an expatriate certify that he has fully complied with all U.S. tax requirements for the five years preceding expatriation.

The AJCA also amended the expatriation gift tax rules to add a provision which imposes tax on gifts of a foreign corporation owned by the expatriating taxpayer ten years subsequent to the expatriation period.

In addition, AJCA added Section 7701(n) to the Internal Revenue Code which provides that an individual will continue to be treated as a U.S. citizen or long-term resident until he both gives notice of his expatriation to the Department of Secretary or Department of Homeland Security, and furnishes an information statement. Furthermore, the AJCA increased the information reporting rules requiring that an expatriate file an annual information statement for each of the ten post-expatriation years regardless of whether the expatriate had any U.S. source income for each year at issue. Expatriating taxpayers were now required to Form 8854 advising the Government of his or assets.

Finally, the AJCA added a new residency classification to the expatriation taxing regime. Under this new rule, an individual who has expatriated will suffer U.S. worldwide income tax if he or she is physically present in the U.S. for more than 30 days during any of the ten years preceding expatriation. Typically, a non-resident alien is permitted an average of 121 U.S. days per year without becoming a U.S. tax resident.

The Heroes Earning Assistance and Relief Tax Act of 2008 and the Impact of this act on Expatriation Taxation

Prior to Section 301 of the Heroes Earning Assistance and Relief Tax Act of 2008 (“HEART Act”), expatriates generally were subject to a ten year “alternative tax” regime on U.S. source income as discussed in FITA.

Section 877A replaces the former alternative tax regime on U.S. source income of “covered expatriates” with a mark-to-market tax on gains in excess of $600,000 (indexed for 2012 to $651,000) from a deemed sale of an individual’s worldwide assets on the day prior to the individual’s expatriation date. The term “covered expatriate” includes individuals who renounce or relinquish U.S. nationality or terminate their status as long-term permanent residents (i.e. green card holders for at least eight of the 15 taxable preceding expatriation) and whose average net income tax liability for the five years preceding exceeds $124,000 indexed for inflation (for persons expatriating in 2012, $151,000) 1 or whose net worth at the date of expatriation equals or exceeds $2 million (not indexed).

Under the provision, a covered expatriate can irrevocably elect, on an asset by asset basis, to deter the payment of the mark-to-mark tax attributable to an asset until the due date of the return in which such property is sold or exchanged. In order to make the election, a taxpayer must provide “adequate security” (including a bond conditioned on the payment of tax and interest) and irrevocably waive the benefit of any U.S. tax treaty that would preclude assessment of tax. The election will terminate as to any property not sold or exchanged when a taxpayer dies or when the IRS determines that security is no longer adequate. In addition, certain property, including deferred compensation items, “specified tax deferred accounts,” such as individual retirement accounts and health savings accounts are exempted from the mark-to-market tax.

Expatriation date is defined to mean the date that a citizen relinquishes U.S. nationality or a long-term resident alien ceases to be a lawful permanent resident. A citizen is considered to have relinquished U.S. citizenship at the earliest of the dates: 1) he renounces his nationality before a U.S. diplomatic or consular officer; 2) he provides a statement of voluntary relinquishment to the Department of State; 3) the Department of State issues the individual a Certificate of Loss of Nationality; or 4) a U.S. court cancels a naturalized citizen’s certificate of naturalization.

Finally, for purposes of the mark-to-market taxing regime, all nonrecognition deferrals and extensions of time for the payment of tax are considered terminated the day before expatriation.

The HEART Act added Section 2801 to the Internal Revenue Code. Section 2801 imposes a tax, at the highest applicable gift or estate tax rates on the receipt by a U.S. person of a “covered gift or bequest,” which is defined as a direct or indirect gift or bequest from a “covered expatriate” within the meaning of Internal Revenue Code Section 877A. The tax is assessed on, and intended to be paid by, the recipient of a covered gift or bequest. The succession tax will be reduced by any foreign gift or estate tax paid. The new succession tax does not apply to gifts covered by the annual exclusion of Section 2503(b), currently at $13,000 per done per annum. It also does not apply to gift or bequests entitled to a marital or charitable deduction.

Conclusion

Over the past four decades, the expatriation tax has evolved into an extremely complex taxing regime. In 2009, the Treasury and the Internal Revenue Service (IRS) promulgated Notice 2009-85 to provide limited guidance to determine an expatriating individual’s tax liability. Unfortunately, the Notice fails to provide any meaningful guidance regarding Section 877 and 2801. The failure to provide meaningful guidance in regards to the expatriation tax. This failure only makes determining the proper the expatriate tax more difficult than is necessary which can result in disastrous consequences. This is because the failure to properly compute an expatriation tax may result in a bar of re-entry of former citizens who to the U.S.

In 1996, the so-called “Reed amendment” was enacted as part of the Illegal Immigration Reform and Immigration Responsibility Act. Because of a number of statutory defects, the Reed Act has never been enforced. 2 Even though the statutory language of the Reed amendment may be flawed, The Department of Homeland Security has been working to develop regulations to implement the Reed amendment. If this project is to move forward, former citizens or long-term residents could discover that their re-entry to the U.S. is bared if they fail to fully comply with their expatriation tax obligations. Given the current climate Washington regarding individuals seeking to expatriate from the U.S. for tax purposes, it is not to difficult to imagine regulations being promulgated by the Department of Homeland Security barring ex-citizens from re-entering the U.S. for failing to comply with their expatriation tax obligations. This could disastrous for former citizens with families and economic interests in the U.S.

Given the foreseeable consequences of failing to properly compute an expatriation tax, individuals considering repatriation should consult with a tax attorney to determine how the exit tax will impact them.    We welcome your feedback and questions regarding this article and your tax questions.    You can learn more about our firm at www.moskowitzllp.com or by calling our firm (415) 394-7200. 

  1. Rev. Proc. 2011-52, 2011-45.
  2. The Reed amendment has the following statutory flaws: 1) it is unclear from the language of the statute if it encompasses all acts of expatriation; 2) it is uncertain if the Reed amendment violates the Constitutional Due Process rights of certain former citizens by barring them from reentering into the U.S.


Moskowitz LLP, A Tax Law Firm, Disclaimer:   Because of the generality of this blog post, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.   Prior results do not guarantee a similar outcome.   Furthermore, in accordance with Treasury Regulation Circular 230, we inform you that any tax advice contained in this communication was not intended or written to be used, and cannot be used, for the purposes of (i) avoiding tax related penalties under the Internal Revenue Code, or (ii.) promoting, marketing, or recommending to another party any tax related matter addressed herein.

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