US Recipients of Gifts or Inheritance from a Former American: The Importance of Record-Keeping to Avoid Transfer Tax Liability

Did someone you know and love give up their US citizenship or a green card held for a significant time?  If so, that former US individual may at some point in the future, give you a gift or leave you an inheritance.  If you are a US person here’s what you need to know to avoid paying 40% of that gift or bequest over to Uncle Sam.

“Expatriation” is a significant life decision that more and more individuals are making.  Expatriation is fraught with US tax issues, whether it’s done by giving up a green card held for eight or more tax years or relinquishing US citizenship.  It’s crucial for expatriates to understand the potential implications of being categorized as “covered expatriates” for purposes of the transfer tax imposed under IRC Section 2801.  Expatriates may unknowingly subject US recipients of gifts or bequests to transfer tax obligations. To avoid this situation, the expatriate must ensure loved ones have access to comprehensive records to demonstrate that the former American was not a “covered expatriate”, thereby enabling US recipients of their later gifts or bequests to meet the burden of proof imposed on them by the US tax rules.

Understanding “Covered Expatriate” Rules

A covered expatriate is a term used to describe individuals who have relinquished their US citizenship or long-term residency and meet specific criteria outlined by the Internal Revenue Code (IRC). The designation is based on factors such as net worth, tax liability, and compliance with tax obligations.

Covered expatriates are subject to various tax consequences such as the so-called exit tax and imposition of special tax hits on deferred compensation. In addition, US recipients of gifts or bequests from a covered expatriate are punished by imposing on them a transfer tax (currently at 40% of the value of the gift or bequest).   My blog post here provides more detail on the curse of the covered expatriate.

The Burden of Proof

When a US person receives a gift or bequest from a foreign person or foreign estate, the US individual must report its receipt on Form 3520 if certain dollar thresholds are met.  This puts the Internal Revenue Service (IRS) on notice.

Under the IRS proposed regulations discussed in my blog post, the burden of proof lies with the US recipient of gifts or bequests to establish that they did not receive the assets from a covered expatriate. This places a significant responsibility on the shoulders of recipients, who must furnish evidence demonstrating the assets were not received from a covered expatriate.  Failure to provide sufficient proof will result in the imposition of the Section 2801 transfer tax, potentially causing financial burdens and complications.

While the regulations have been proposed, they are not adopted.  However, the IRS has recently listed the Section 2801 regulations as an important project on its “to do” list.  (See Point 10 on page 11 of the IRS 2022–2023 Priority Guidance Plan).  I expect we will see some action on this soon.

The Importance of Record-Keeping

To mitigate the transfer tax liability risk for their US recipients, all expatriates should maintain meticulous records that establish their non-covered expatriate status. Family members (the likely recipients of gifts or bequests) should understand the importance of these records and where to find them (for example, copies should be kept with the individual’s will).  If a family attorney is involved I suggest keeping these important documents with the attorney as well.  Documentation and records play a vital role in substantiating an individual’s tax status and can serve as evidence in cases of future gifts or bequests.

Here are some important records expatriates should consider keeping:

Proof of Tax Compliance: Maintain copies of tax returns and records that demonstrate consistent compliance with US tax obligations for the 5 year period preceding the expatriation. This includes filing annual tax returns and any required foreign information returns, reporting foreign financial accounts, and fulfilling any outstanding tax liabilities.

Expatriation Documents: Retain copies of relevant expatriation forms such as those issued by the Department of State. Very important is the IRS Form 8854 that must be filed by all expatriates (“covered” or not).  This form provides critical information about the individual’s expatriation status, net worth and prior tax liability and the date and manner of expatriation.  Full details about the Form 8854 are at my blog post here. Failing to file the form can result in covered expatriate status even if the individual did not meet the net worth or tax liability thresholds at the time of expatriating.  If you have expatriated and not filed this form, all is not lost.  The situation can likely be handled, but it must be carefully done.

Financial Statements: Maintain comprehensive financial statements, including bank account records, investment statements, and records of assets and liabilities, to showcase net worth and financial status before and after expatriation.

Gift and Bequest Documentation: Keep records of any gifts or bequests made to US recipients, including documentation of the source of the funds, transaction details, and any relevant legal or financial agreements.

Professional Guidance: Seek professional guidance from tax advisors or attorneys specializing in expatriation and transfer tax matters. They can provide valuable advice on record-keeping requirements and ensure compliance with relevant regulations.

In a Nutshell

Unfortunately, most people who expatriate think “OK, done and dusted”.  Nothing can be further from the truth.  Tax professionals are often overlooking the importance of diligently explaining the need for such recordkeeping to their clients who have expatriated.

For individuals who choose to expatriate and want to safeguard their US recipients from potential transfer tax liabilities, maintaining thorough and accurate records is of utmost importance. By retaining documentation that demonstrates their non-covered expatriate status, expatriates can relieve the burden of proof on their recipients and help ensure a smoother transfer of gifts or bequests. Being proactive and diligent in record-keeping can prevent unnecessary tax complications and provide peace of mind for both expatriates and their beneficiaries.

Listen to the podcast with John Richardson – we discuss the various aspects of the transfer tax and how to gather proof that you are not subject to it.

Posted June 29, 2023

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