Every few years, it seems, there’s a story about someone giving up his or her U.S. citizenship or legal residency to save on U.S. taxes. Given the peculiarities of the U.S. tax system, expatriation may make sense, sort of the ultimate opt-out. But there are some hassles involved.
The United States is unique as virtually the only country to use citizenship as a basis for taxation. Generally, the federal income tax is imposed on the worldwide income of U.S. citizens (and certain resident aliens) regardless of whether such persons currently live in the United States. Nonresident aliens are subject to tax only on U.S.-source income and income effectively connected with a U.S. trade or business.
And the discrepancy in tax treatment between citizens and nonresident aliens doesn’t end with the income tax. For instance, the U.S. estate tax defines the gross estate of a citizen or resident alien to include all property held at death wherever situated, while the gross estate of a nonresident alien includes only property situated in the United States. Citizens and certain resident aliens also may be required to report foreign bank accounts and assets to the United States, while nonresident aliens are not subject to those requirements.
So there are reasons why expatriating may seem like a good idea.
But here’s where the hassles come in. Since 1966, Congress has implemented several regimes to dissuade citizens from tax-motivated expatriation. The most recent regime is found principally in Section 877A of the Internal Revenue Code. Section 877A makes the renunciation of U.S. citizenship or the cessation of long-term lawful permanent residency by certain covered expatriates into a taxable event. A “covered expatriate” means any expatriate:
(1) whose average net income tax for the period of 5 taxable years ending before the date of loss of U.S. citizenship is greater than $124,000;
(2) whose net worth as of such date is $2,000,000 or more; or
(3) who fails to file a Form 8854 certifying under penalty of perjury that he or she has met the requirements of Internal Revenue Code for the five preceding taxable years or fails to submit such evidence of such compliance as may be required.
The above amounts are subject to a cost-of- living adjustment for years after 2004. However, the definition of a covered expatriate does not include any individual who was born a citizen of both the United States and another country, continues to be a citizen of and taxed as a resident of this other country as of the expatriation date, and has not been a resident of the United States for more than 10 taxable years during the 15-taxable year period ending with the expatriation date.
Section 877A treats all property of a covered expatriate (subject to certain narrow exceptions) as having been sold at fair market value on the day before the expatriation date. All gains and losses from this deemed sale are recognized and included in the expatriate’s gross income for the taxable year of the deemed sale to the extent that this aggregate includible amount exceeds $600,000 (subject to a cost-of- living adjustment for years after 2008).
A covered expatriate may elect to defer payment of tax on any property deemed to have been sold until after he or she actually disposes the property if he or she provides the United States with adequate security for the deferred tax (as well as applicable interest) and waives any right under any treaty that would prevent the assessment or collection of the tax imposed by Section 877A. Expatriates who elect to defer also must file a Form 8854 every year after expatriation until the tax imposed by reasons of Section 877A (as well as applicable interest) is paid off.
It’s no picnic after expatriation either. For starters, an expatriate has to make sure not to be present in the United States a sufficient number of days to qualify as a U.S. resident under the substantial presence test in Section 7701(b) of the Internal Revenue Code, or subject again to U.S. tax on a worldwide basis. In addition, Section 2801 of the Internal Revenue Code, with certain exceptions, imposes a succession tax at the highest applicable rate on U.S. citizens and residents who receive from a covered expatriate gifts or bequests exceeding the federal gift tax annual exclusion for any given year.
Then there are the non-tax hassles associated with expatriation. For instance, Section 6039G of the Internal Revenue Code requires the names of all persons who have lost U.S. citizenship in each calendar quarter to be posted in the federal register. In addition, a former citizen may be barred from reentering the United States if it is determined that the renunciation of citizenship was tax-motivated. However, this latter provision does not seem to have ever been enforced.
The primary I.R.C. tax statute is set forth below:
26 U.S. Code § 877A.Tax responsibilities of expatriation
(a) General rulesFor purposes of this subtitle—
(1) Mark to market
(2) Recognition of gain or lossIn the case of any sale under paragraph (1)—
(3) Exclusion for certain gain
(A) In general
The amount which would (but for this paragraph) be includible in the gross income of any individual by reason of paragraph (1) shall be reduced (but not below zero) by $600,000.
(B) Adjustment for inflation
(i) In generalIn the case of any taxable year beginning in a calendar year after 2008, the dollar amount in subparagraph (A) shall be increased by an amount equal to—
If any amount as adjusted under clause (i) is not a multiple of $1,000, such amount shall be rounded to the nearest multiple of $1,000.
(b) Election to defer tax
(1) In general
If the taxpayer elects the application of this subsection with respect to any property treated as sold by reason of subsection (a), the time for payment of the additional tax attributable to such property shall be extended until the due date of the return for the taxable year in which such property is disposed of (or, in the case of property disposed of in a transaction in which gain is not recognized in whole or in part, until such other date as the Secretary may prescribe).
(2) Determination of tax with respect to property
For purposes of paragraph (1), the additional tax attributable to any property is an amount which bears the same ratio to the additional tax imposed by this chapter for the taxable year solely by reason of subsection (a) as the gain taken into account under subsection (a) with respect to such property bears to the total gain taken into account under subsection (a) with respect to all property to which subsection (a) applies.
(3) Termination of extension
The due date for payment of tax may not be extended under this subsection later than the due date for the return of tax imposed by this chapter for the taxable year which includes the date of death of the expatriate (or, if earlier, the time that the security provided with respect to the property fails to meet the requirements of paragraph (4), unless the taxpayer corrects such failure within the time specified by the Secretary).
(A) In general
No election may be made under paragraph (1) with respect to any property unless adequate security is provided with respect to such property.
(B) Adequate securityFor purposes of subparagraph (A), security with respect to any property shall be treated as adequate security if—
(5) Waiver of certain rights
No election may be made under paragraph (1) unless the taxpayer makes an irrevocable waiver of any right under any treaty of the United States which would preclude assessment or collection of any tax imposed by reason of this section.
An election under paragraph (1) shall only apply to property described in the election and, once made, is irrevocable.
For purposes of section 6601, the last date for the payment of tax shall be determined without regard to the election under this subsection.
(c) Exception for certain propertySubsection (a) shall not apply to—
(d) Treatment of deferred compensation items
(1) Withholding on eligible deferred compensation items
(A) In general
(B) Taxable payment
For purposes of subparagraph (A), the term “taxable payment” means with respect to a covered expatriate 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 citizen or resident of the United States. A deferred compensation item shall be taken into account as a payment under the preceding sentence when such item would be so includible.
(A) the payor of such item is—
(4) Deferred compensation itemFor purposes of this subsection, the term “deferred compensation item” means—
(6) Special rules
(A) Application of withholding rules
Rules similar to the rules of subchapter B of chapter 3 shall apply for purposes of this subsection.
(B) Application of tax
Any item subject to the withholding tax imposed under paragraph (1) shall be subject to tax under section 871.
(C) Coordination with other withholding requirements
Any item subject to withholding under paragraph (1) shall not be subject to withholding under section 1441 or chapter 24.
(e) Treatment of specified tax deferred accounts
(2) Specified tax deferred account
For purposes of paragraph (1), the term “specified tax deferred account” means an individual retirement plan (as defined in section 7701(a)(37)) other than any arrangement described in subsection (k) or (p) of section 408, a qualified tuition program (as defined in section 529), a qualified ABLE program (as defined in section 529A), a Coverdell education savings account (as defined in section 530), a health savings account (as defined in section 223), and an Archer MSA (as defined in section 220).
(f) Special rules for nongrantor trusts
(2) Taxable portion
For purposes of this subsection, the term “taxable portion” means, with respect to any distribution, that portion of the distribution which would be includible in the gross income of the covered expatriate if such expatriate continued to be subject to tax as a citizen or resident of the United States.
(3) Nongrantor trust
(4) Special rules relating to withholdingFor purposes of this subsection—
(g) Definitions and special rules relating to expatriationFor purposes of this section—
(1) Covered expatriate
(A) In general
(B) ExceptionsAn individual shall not be treated as meeting the requirements of subparagraph (A) or (B) of section 877(a)(2) if—
(i) the individual—
(C) Covered expatriates also subject to tax as citizens or residents
In the case of any covered expatriate who is subject to tax as a citizen or resident of the United States for any period beginning after the expatriation date, such individual shall not be treated as a covered expatriate during such period for purposes of subsections (d)(1) and (f) and section 2801.
(2) ExpatriateThe term “expatriate” means—
(3) Expatriation date The term “expatriation date” means—
(4) Relinquishment of citizenshipA citizen shall be treated as relinquishing his United States citizenship on the earliest of—
(5) Long-term resident
The term “long-term resident” has the meaning given to such term by section 877(e)(2).
(6) Early distribution tax
The term “early distribution tax” means any increase in tax imposed under section 72(t), 220(f)(4), 223(f)(4), 409A(a)(1)(B), 529(c)(6), 529A(c)(3), or 530(d)(4).
(h) Other rules
(1) Termination of deferrals, etc.In the case of any covered expatriate, notwithstanding any other provision of this title—
(2) Step-up in basis
Solely for purposes of determining any tax imposed by reason of subsection (a), property which was held by an individual on the date the individual first became a resident of the United States (within the meaning of section 7701(b)) shall be treated as having a basis on such date of not less than the fair market value of such property on such date. The preceding sentence shall not apply if the individual elects not to have such sentence apply. Such an election, once made, shall be irrevocable.
(3) Coordination with section 684
If the expatriation of any individual would result in the recognition of gain under section 684, this section shall be applied after the application of section 684.
The Secretary shall prescribe such regulations as may be necessary or appropriate to carry out the purposes of this section.