Expatriation: Deferring Payment of the Exit Tax

I recently blogged about the debate between Prof. Edward Zelinsky and John Richardson as it pertained to the Exit Tax imposed on so-called “covered expatriates”.  This was in the broader context of the US income taxation model which is based on one’s “citizenship” rather than one’s residence.

The thrust of my earlier blog post concerned the point emphasized by Prof. Zelinsky that unlike the American who is not expatriating, 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.  Prof. Zelinsky points out, for example, that he must pay tax on even $1.00 of his capital gains, without the benefit of any exclusion.  According to Prof. Zelinsky, the “covered expatriate” is in a sense, “well off” in this regard when compared to Prof. Zelinsky. My blog post took issue with this on grounds that for the “covered expatriate”, the gains are merely phantom gains, or “pretend income”, deemed to arise by operation of law, regardless of the fact that the expatriate has not sold or disposed of any assets at all.

Since nothing has been sold, the “covered expatriate” would likely be hard-pressed to come up with the cash to pay the exit tax. That is, while the income earned upon expatriation is all “pretend”, the tax itself is very real.  I imagined that Prof. Zelinsky might point to the provision in the expatriation rules permitting a deferral of the exit tax as the magic fix for this scenario.

Today’s post looks more closely at the tax rule permitting a deferral of the exit tax payment.  As you will see, it’s certainly not a fix!  First, a bit of background.

Expatriation and Exit Tax

Many individuals who previously took on US citizenship as a second nationality or obtained a green card are now regretting this decision.  Some individuals often incorrectly assume they can give up the US citizenship or the green card without adverse US tax consequences.

Under the so-called “expatriation” tax rules, harsh tax consequences will result if the individual giving up his US citizenship or a green card held for 8 out of the past 15 years (often called a “long-term resident”) qualifies as a so-called “covered expatriate”.  Remember, only “covered expatriates” will suffer the onerous tax consequences. 

Who is a “Covered Expatriate”?

One is a “covered expatriate” if the individual meets any one of three possible tests. 1) He has a net worth of US$2 million at the time of expatriation; or, 2) he has a certain average income tax liability over the past 5 years prior to expatriation.  This test looks at the average income tax he has paid over the 5-year period. For 2019, if the “average annual net income tax” for the five taxable years prior to expatriation is more than $168,000, the individual will be a “covered expatriate”.

The third test is a bit more nuanced.  One is treated as a “covered expatriate” if he fails to notify the Internal Revenue Service (IRS) that he has expatriated and satisfied all of his tax liabilities for the past five years. This harsh result applies even if the individual did not meet the aforementioned dollar thresholds.  So, one can be a pauper but still qualify as a “covered expatriate”.

Exit Tax

“Covered expatriates” will suffer imposition of an “Exit Tax” (and, as an aside, their US family members and close friends etc. will suffer along with them when they receive a gift or inheritance from the “covered expatriate” at any time in the future).  Under the Exit Tax provisions, the individual is subject to tax on the net unrealized gain on all of his world wide assets as if such property were sold for its fair market value on the day before the expatriation date. 

While there is an exclusion amount available, it is not as simple to figure out as many assume. The exclusion amount is indexed for inflation and can reduce the amount of Exit Tax owed.  The exclusion amount must be allocated according to special rules on an asset-by-assest basis, making application a bit complicated.  The excess above the exclusion allocation is taxed. In a nutshell, the individual must pay US income tax on gain that he is “deemed” to have earned by operation of the Exit Tax rules, when in fact, the individual has not sold anything.  The taxpayer may be without any cash in hand with regard to the deemed sale. Naturally, this raises the issue of how the individual will fund payment of the Exit Tax.

Deferral of the Exit Tax – Complicated, Expensive and Burdensome

If a “covered expatriate” has liquidity concerns, he may make an election to defer the exit tax on a particular piece of property until it is actually disposed of (e.g., by gift, by sale etc), or even at the time the covered expatriate dies. Even if the individual makes the deferral election, he can still pay off any tax deferred together with accrued interest, at any time.

To date, not many (if any) deferral elections have actually been made. My telephone queries to the Treasury Department officials in Washington DC have been met with the equivalent of verbal blank stares. Here’s what we do know about the deferral election:

The deferral election is irrevocable. Once made, there is no turning back.

The election can be made on what is called an “asset-by-asset” basis (thus, the individual can pick and choose which properties will be covered by the election).  

Interest will be charged on the deferred tax and this interest is compounded daily, starting from the due date of the return for the tax year that includes the day before expatriation.  So if an individual expatriated in say, February 2016, and if the due date for his tax return would be April 15, 2017,  interest would start to run from that date.  Since it is compounded daily, the amount can quickly escalate. So, deferral is going to be expensive!

The conditions for obtaining approval for the deferral are rigorous. More on this follows later.

Pension Plans — Not Eligible for Deferral

Deferral of the Exit Tax is possible only with respect to assets that are deemed “sold” under the expatriation rules contained in Code Section 877A(a).  Pension plans are not deemed to be “sold” under these rules and thus, expatriation tax due on any pension plan in which the covered expatriate has an interest, will not be eligible for deferral under this rule. While a bit beyond the scope of today’s post, suffice to say that the expatriation regime taxes pensions in a special way and it is not a warm and fuzzy way, either. 

Some US plans (called “eligible deferred compensation” plans), however, do fare better than foreign plans (called “ineligible deferred compensation” plans).  With “eligible deferred compensation” plans you may not have to pay the Exit Tax on the value of the plan at expatriation.  Instead, assuming you file the correct paperwork in a timely fashion, US tax will be assessed as distributions are made out of the plan (generally at a flat 30% withholding rate, and you cannot claim a treaty benefit to reduce the tax). 

Due to the complexity and harshness of these rules, many covered expatriates with pensions will be left in the lurch.  The situation will be more dire for a covered expatriate having a foreign pension plan.  Such an unlucky character will be deemed to receive the full value of that foreign 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, as mentioned in my earlier post, this “pretend” income is not eligible for the $725,000 exclusion and tax due on this pretend income is also not eligible for deferral.  Even though the expatriate has received nothing from his foreign pension plan (and in fact, he may not be eligible to receive his pension for many years after his actual expatriation), the tax is due and it cannot be deferred.

Adequate Security and Tax Deferral Agreement

Certain conditions must be met before a covered expatriate will be permitted to make a deferral election. Most importantly, a bond, or other security (including a letter of credit) must be provided for the tax liability. This security will be updated and monitored periodically so that the IRS can make sure that it remains “adequate” to cover the tax debt. A big problem lies in the fact that there is really no guidance as to what constitutes “adequate security”.

A tax deferral agreement between the individual and the IRS must be signed and periodically renewed according to the terms provided in the agreement. Notice 2009-85 at Appendix A contains a template of the deferral election agreement one would have to sign with the IRS.  It can be accessed here.

If the agreement is not renewed within the time frame as specified in the agreement, the collateral will be applied to the Exit Tax liability and interest. If the security is deemed inadequate at any time, the Exit Tax will become due immediately. A U.S. agent must be appointed for the limited purpose to receive communications from the IRS.  Finally, all benefits under any relevant tax treaty that may affect the IRS’ ability to collect the Exit Taxt must be waived. 

Practical Problems

While the immediate financial consequences of the Exit Tax may be very harsh, making the tax deferral election brings on its own set of unique problems.  There is no guarantee that the covered expatriate will be permitted to enter into a tax-deferral agreement with the IRS, since this is completely discretionary with the IRS. It is very important to note that the IRS’ acceptance or rejection of an individual’s application to defer the tax would not be known until after the individual has already expatriated. So, an individual could be stuck having to pay all the Exit Tax if the IRS rejected his application and it would already be too late, since the individual will have expatriated and therefore already be liable for Exit Tax. Further, when tax-deferred property is finally disposed of, the capital gains tax rate may be higher than under current law.  All this, in combination with the continuous accrual of interest on the Exit Tax that is owed and the requirement to maintain adequate security, may result in an extremely difficult financial burden.  

Posted June 13, 2019


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