Exit Tax – A Comment on Richardson / Zelinsky Debate on Citizenship Based Taxation

Recently, a debate took place on the merits of the United States’ income tax regime which is based on “citizenship”.  This lively debate was between the esteemed John Richardson (a US and Canadian attorney) and Professor Edward Zelinsky (a tax scholar and professor at Cardozo Law School in New York City).  You can watch the full debate by accessing the video embedded at the end of this blog post.

While there were many areas in this animated discussion that could be the subject of various blog posts, I have chosen to address Prof. Zelinsky’s comment on the so-called “Exit Tax” (At Minute 47.56).

Americans Abroad – “Doing Rather Well”?

Essentially, from what I can deduce overall, Prof. Zelinsky seems to be saying that the citizenship-based taxation model is justified and that Americans abroad are doing “rather well”, in part, because of the benefits conferred on them by certain provisions in the US Internal Revenue Code.  As examples, he highlights Section 911 (Foreign Earned Income Exclusion) and Section 877A (expatriation regime).

Specifically, with respect to the expatriation rules, he points to the provision permitting “covered expatriates” an exclusion of USD725,000 on capital gains taxation upon their “exit” from America and its US tax system. Prof. Zelinsky states that he must pay capital gains tax when he earns $1.00 of capital gain, yet the individual who is expatriating and who qualifies as a “covered expatriate” can get an exclusion for USD725,000 of capital gain before the Exit Tax is calculated.

Fake, Fake, Fake

Throughout the debate, John Richardson repeatedly called attention to the general problem of what he calls “fake income” – Subpart F, PFIC, Exit Tax.  Today, I choose to focus on the Exit Tax issue raised in the debate.

Exit Tax – Fake Income, but a Real Tax

I think there is a significant point that should be made. Unlike Prof. Zelinsky, who must generally make a conscious choice to dispose of his assets and who must sell or exchange them before capital gains tax is incurred, the “covered expatriate” will become liable for the tax even though he is not disposing of any assets whatsoever. The “covered expatriate” has not made a choice to sell anything.  For him, tax liability on capital gains arises at expatriation on account of a “deemed” or “pretend” sale or other dispostion of his worldwide assets. The gain is only a phantom one.

Thus, while Prof. Zelinsky will have received cash or something of value before capital gains tax is incurred, the “covered expatriate” has received nothing and will probably lack the cash with which to pay the tax.

Now, Prof. Zelinsky may possibly retort that the Internal Revenue Code in all its wisdom, has a “fix” for this particular problem of illiquidity. The “fix” is in the form of the provision permitting “deferral” of the Exit Tax. A follow-up blog post coming soon will address that fix, and will demonstrate that it is so cumbersome, it is not a realistic “fix” at all!

Foreign Pension Plan

What makes matters particularly worse for the “covered expatriate” having an interest in a foreign pension plan, is that he is deemed to receive the full value of that pension at expatriation. This number is a calculation based on actuarial principles/life expectancy.  He must include that full value in income and immediately pay tax on it.  Significantly, this “pretend” income is not eligible for the $725,000 exclusion.  Again, the expatriate has received nothing from his pension plan and in fact, he may not be eligible to receive his pension for many years after his actual expatriation. Yet the tax is due.

Justifiable in Theory

Prof. Zelinsky did point out in his debate with Mr. Richardson that reform may be needed in some areas where the US tax law is too complex for Americans abroad. This included the foreign pension problem mentioned before.  However, Prof. Zelinsky did not see the US citizenship-based tax model as one that was unjustified, at least not in theory.

For those of you who do not live in an ivory tower, what do you think?  Comments can be seen by scrolling down well to the end of the page.

Posted June 3, 2019

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