By T.L. Fahring, Esq.
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.