As a tax practitioner I have assisted many taxpayers for decades with expatriation issues (i.e., relinquishing US citizenship or a green card held for at least 8 tax years). In the best case scenario, the taxpayer can avoid being treated as a “covered expatriate” (CE). Sometimes tax planning, correcting tax returns or submitting delinquent international tax information filings must be undertaken in order to achieve this.
The Internal Revenue Service (IRS) is currently facing a terrible backlog of unprocessed tax returns. The filing of the tax return is the starting point to determine if the taxpayer has filed timely, if the statute of limitations has commenced, it impacts refund claims, and whether the taxpayer is subject to delinquency penalties.
Unprocessed returns may not be reflected on the taxpayer’s tax transcript, despite the fact that the taxpayer has in fact filed the return. This poses a conundrum for the taxpayer who wishes to expatriate and wants to make sure he has been tax compliant for purposes of the CE test. Does a filed but unprocessed tax return satisfy the so-called “tax compliance” requirement to avoid CE status? Let’s take a brief look at the expatriation regime before we delve into this particular issue.
US Expatriation Tax Rules in a Nutshell
The US “expatriation tax” provision rules apply only to certain US citizens or long-term residents who have given up their U.S. status. Long-term residents are generally those holding a green card for eight of the past 15 years and have properly ended their U.S. resident status for tax purposes.
Under the expatriation rules contained in IRC Section 877(a)(2) an individual will be treated as a CE if any one of the following tests applies (quoting the statutory text):
- (A) the average annual net income tax (as defined in section 38(c)(1)) of such individual for the period of 5 taxable years ending before the date of the loss of United States citizenship is greater than $124,000 [VLJ Notes: US$172,000 for 2021; US$178,000 for 2022. This means income tax paid by the individual, not his or her income],
- (B) the net worth of the individual as of such date is $2,000,000 or more, or
- (C) such individual fails to certify under penalty of perjury that he has met the requirements of this title for the 5 preceding taxable years or fails to submit such evidence of such compliance as the Secretary may require.
If any one of these tests is triggered, the individual is a CE. A CE is subject to the “Exit Tax” or “Mark-to-Market” regime which generally means that all property owned by the CE worldwide is treated as sold for its fair market value on the day before the expatriation date. This “pretend” gain is then 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”, but the exception is calculated a very specific way and professional guidance should be taken. Special tax rules apply, for example, to certain deferred compensation items and to trust distributions; the exception for a certain amount of gain does not apply to these items.
In addition to the Exit Tax, US recipients of any gift or bequest at any time in the future from the CE must pay a special transfer tax. This tax is currently 40% of the value of the gift or inheritance.
If you get the idea that it’s complicated, you would be correct! Make sure you get the best tax advice before expatriating. “Fixing things” after expatriation has occurred becomes far more difficult and will never be free of risks.
Unprocessed Tax Returns and Expatriation
So, let’s return to the main question which is the subject of this post. Does a filed but unprocessed tax return satisfy the so-called “tax compliance” requirement to avoid CE status? According to the IRS (IRS Notice 2009-85), a taxpayer must certify, under penalties of perjury, compliance with all US Federal tax obligations for the five taxable years preceding the taxable year that includes the expatriation date.
My answer (which is not legal or tax advice): the filed but unprocessed tax return should provide the taxpayer with solid ground for meeting the “tax compliance” requirement, provided the return meets the so-called Beard test, and is treated as “delivered” to the IRS. These issues are discussed below.
In Beard v. Commissioner, 82 T.C. 766 (1984), aff’d, 793 F.2d 139 (6th Cir. 1986), a document is to be treated as a tax return for purposes of the tax statute of limitations if: (1) there is sufficient data to calculate a tax liability, (2) the document purports to be a return, (3) there is an honest and reasonable attempt to satisfy the requirements of the tax law, and (4) the taxpayer executed the document under penalties of perjury. Id. at 777.
Even before COVID-19, it was not that uncommon for the IRS to fail to process returns taxpayers submitted either electronically or in paper format. In Willets v Commissioner of Internal Revenue, 19160-19S (U.S.T.C. Nov. 22, 2021) which was a summary opinion issued by the Tax Court (cannot be cited as precedent), it was held that the IRS’ failure to process a return did not mean the taxpayer had failed to file the return. The legal distinction between processing a return and filing it is very significant, especially in the contest of expatriation. When IRS fails to process a tax return it does not mean the unprocessed return was not in fact filed. The Willets court discussed the Beard test and quickly came to the conclusion that the taxpayers’ Form 1040 satisfied Beard. In conclusion, the Willets court noted, “a valid return is deemed filed on the day it is delivered, regardless of whether it is accepted by the Commissioner.”
Timing is Everything – “Delivered”
The general rule is that a tax document is considered filed only when it is actually delivered to the IRS. What does it mean for a tax return to be delivered? What if the taxpayer is living abroad and faced with unreliable mail or courier options? My blog post here gives you all of the details on this thorny subject of “delivery” and explains how registered and certified mail and the use of specially IRS-designated Private Delivery Services can help. Other “timing” considerations arise for expatriation, meeting the tax compliance test and signing the Form 8854. My earlier blog post does a deep dive into that topic.
Posted May 12, 2022
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