Not surprisingly over 1,000 individuals expatriated (gave up US citizenship or long term residency) in the third quarter of 2018. This is according to the most recent “Name and Shame” list published by the US Treasury in the Federal Register on November 19, 2018. Most likely the real number is higher, as the accuracy of the count on the US Treasury list has repeatedly been called into question.
How many of these individuals might be “covered expatriates”? The list does not provide any kind of information on that possible status, but hopefully, most persons will escape the “covered expat” taint.
Today’s post will examine a few items. First, it will briefly examine what it means to be a so-called “covered expatriate”, how you can get that status and what happens to you when you do. It will then look at a planning technique commonly used to avoid such status and how the recent tax reform has helped those wishing to divorce the US from being tarred with the “covered expatriate” brush.
Am I a “Covered Expatriate”?
Under the US expatriation rules, an individual will be treated as a “covered expatriate” if any one of the following tests apply:
- The individual’s average annual net income tax for the 5 years ending before the date of expatriation or termination of residency is more than a specified amount that is adjusted annually for inflation ($165,000 for 2018 and $168,000 for 2019). This is often called the “Tax Liability” Test. Simply put, it means that you look at the tax paid by the individual for each year over the 5 years prior to the “expatriation” year, add up the total of the tax paid for the 5 years and divide that total number by 5.
- The individual’s net worth is $2 million or more on the date of expatriation or termination of residency. This is often called the “Net Worth” Test.
- The individual fails to certify on Form 8854 that he or she has complied with all US federal tax obligations for the 5 years preceding the date of expatriation or termination of residency. Essentially this requires that you tell the US government you are completely up to date with your tax and information return filings and tax payments for the previous five years.
The tax certification requirement is usually the most troublesome provision for so-called “Accidental Americans” who reside outside the US, and are often blissfully unaware of their US tax filing duties until they learn of this very unpleasant surprise. While there are limited exceptions to treatment as a so-called “covered expatriate” for certain dual nationals and individuals expatriating prior to age 18.5 years, the exceptions are narrowly drawn, require limited physical presence in the United States during the prior 15 year period and in all cases, require tax compliance for the 5 years prior to expatriation.
What Happens To a “Covered Expatriate?”
In two words – NOTHING GOOD! In fact, not only does the “covered expatriate” suffer US tax consequences, but his family and friends will often be punished as well! More on this below, at “Special Transfer Tax”.
Under the “Exit Tax” or “Mark-to-Market” regime, generally, all property owned by the covered expatriate anywhere in the world is treated as if it was sold for its fair market value on the day before the expatriation date. This “pretend sale” results in “pretend gain”. This “pretend gain” is taken into account for the tax year of the deemed sale and subject to tax, usually at capital gains rates.
An exception for a certain amount of gain (which is adjusted annually for inflation) is provided in the tax law. On account of this exception, some individuals may not be impacted by the “Exit Tax”. The amount of gain that can escape tax is $713,000 for 2018 and $725,000 for 2019. See the Internal Revenue Service (IRS) announcements for inflation adjustments for 2019 in Revenue Procedure 2018-57.
In addition, a 3.8% “net investment income tax” will likely also apply to this deemed gain if certain modified adjusted gross income thresholds are met. The Exit Tax must be computed via one’s Form 1040 with the gain or loss being reported on the relevant part of the 1040 for the part of the year that the taxpayer is still considered a US person.
The tax burdens don’t stop there. For example, onerous tax rules apply to the covered expatriate’s deferred compensation plans and specified tax deferred accounts. These and other nuances are complicated and are not addressed in this post.
Special Transfer Tax
In addition to the Exit Tax, US recipients of any gift or bequest at any time in the future from the “covered expatriate” will be hit with a special tax upon receiving that gift or inheritance under Code Section 2801. It has been said that this is somewhat of an alternative way for the US to recoup US Gift or Estate taxes that it would otherwise have received (upon the making of lifetime gifts, or upon death) had the individual not given up his US status. Currently, the tax rate is 40% and the tax must be paid by the US recipient on the value of the gift or bequest from the covered expatriate (e.g., if the covered expatriate leaves a $1,000,000 bequest to his US citizen son, the son must pay $400,000 to the IRS pursuant to Section 2801. Ouch!).
US recipients of a gift or bequest from a former American should be ready for what appears will be an uphill battle with the IRS about the taxability of their gift or inheritance, since the burden of proving that the person was not a “covered expatriate” is firmly placed on the recipient. Do you know how to protect US recipients of your gifts/ bequests from a 40% take by the IRS? You should obtain expert advice on what should be done now in order to prepare for this likely scenario. I am available to discuss possible planning.
An Ounce of Prevention …..
Preventing “covered expatriate” status is possible in some cases, depending on the relevant facts. For example, if the individual does not have problems under the net worth or tax liability tests, but has not been US tax compliant for the five year period prior to expatriation, then bringing the taxpayer back into tax compliance (while probably a painful exercise), will solve the problem. The individual should obtain proper advice and see if he can use the IRS Streamlined Offshore Procedures to regain tax compliance without imposition of penalties.
Gifting (‘Tis the Season)
Many individuals seeking help in expatriation matters have a net worth exceeding US$ 2 million. Planning can be undertaken to reduce the individual’s net worth by the careful gifting of assets to reduce it below US$ 2 million.
One has to be careful with such planning and take into account the different rules that apply to US persons versus non-US persons. For example, a green card holder might not be a “resident” for purposes of the US gift tax and completely different rules will apply to such an individual. See my earlier blog post on this topic. Gifts made to US-citizen spouses, may be exempt from gift tax regardless of the amount. Gifts to non-US citizen spouses, however, are permitted only a limited spousal exemption each year. For calendar year 2018, the annual permitted amount is $152,000; for 2019 the amount is $155,000.
Aside from spousal gifting, US citizens and “residents” are permitted a very generous lifetime exclusion amount. This exclusion amount was substantially increased by the 2017 Tax Cuts and Jobs Act (TCJA). The exclusion amount permits an individual to make lifetime gifts without payment of US gift tax if the gifts do not exceed the exclusion amount threshold. Prior to TCJA, the exclusion amount was $5 million; it has increased to $10 million for tax years 2018 through 2025. The exclusion amount is indexed annually for inflation and for 2018 is worth a whopping $11.18 million; for 2019 it is worth $11.4 million. So, TCJA has provided a golden opportunity to those more wealthy individuals who are wishing to divorce the United States and give back their US passports or green cards! Happy gifting!
Make Sure You Get the Right Advice
Thanks to TCJA, careful use of the gifting provisions can allow wealthier individuals the opportunity to reduce their net worth, followed by a later expatriation. Individual circumstances must be carefully noted to ensure, for example, that the gifts are bona fide gifts, that they are properly documented as such, and that they are the type of gifts eligible for the aforementioned exclusions. Gifts of so-called “future interests” don’t qualify for the spousal deductions or for any other gift tax exclusions! In addition, safer, wiser counsel is that gifting programs should be completed no later than the calendar year prior to the expatriation year. There are many nuances that need to be addressed so this is definitely not an area a potential expatriate should attempt to tackle by internet resources!
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