Unsurprisingly, many taxpayers are confused about the tax results of expatriation. One of the most common questions is whether, after having expatriated, but before receiving the CLN, the individual is liable for US tax on his worldwide income. This question likely stems from the Department of State (DOS) policy that while issuance of the CLN is pending, the renunciant is still considered to remain a US citizen. This is why some US Embassies or Consulates return the US passport to the individual and cancel it only once the CLN has been sent by the DOS in Washington DC.
The Final Tax Filing – Dual Status Return
While “continued” US citizenship may be the case for US nationality and immigration purposes, for tax purposes, the individual’s final tax year is bifurcated into two separate portions. The first portion is the part of the calendar year the individual was a US citizen, commencing January 1 and ending on the day prior to the expatriation date. During this portion, the individual is liable for tax on his worldwide income and must file Form 1040 to report that income. For the balance of the year, which commences on the expatriation date and ends on December 31, the individual is treated as a nonresident alien and is liable for tax only on US-source income. The individual must file Form 1040NR with regard to this portion of the tax year.
He or she must also remember to file Form 8854 with the final years’ income tax returns. This is a critical Form, and failure to file it can cause the individual to be treated as a “covered expatriate” (CE), more fully discussed below. The failure to file Form 8854 can be corrected pursuant to a specific Internal Revenue Service procedure.
What is the Expatriation Date?
For US tax purposes, a US citizen will be considered to have relinquished his US citizenship on the earliest of the following dates:
- The date he renounces US citizenship before a diplomatic or consular officer of the United States (provided that the renouncement is subsequently approved by the issuance of a CLN by the DOS);
- The date he furnishes to the DOS a signed statement of voluntary relinquishment of US nationality confirming the earlier performance of an expatriating act (provided that this voluntary relinquishment is subsequently approved by the issuance of a CLN by the DOS);
- The date the DOS issues a CLN; or
- If the individual is a naturalized citizen, the date that a US court cancels the certificate of naturalization.
Be Prepared
What happens if the CLN is denied? I have not seen this happen, but it can and does happen. In guiding clients, the professional must make sure that the client is prepared for interview questions by the consular officer. The officer is tasked with ensuring that the renunciant has the specific intent to give up US citizenship, fully understands the implications and consequences of this irrevocable act and that he is acting voluntarily. These issues become far more complicated when the individual is younger or has diminished mental capacity (for example, due to aging when for example, estate tax planning is even more critical). More on this topic at my blog post here.
Who is Treated as a Covered Expatriate?
The current US “expatriation” tax rules are found in IRC Section 877A and apply only to certain US citizens or long-term residents (LTR) who have properly given up their US status. A LTR is an individual who has held a green card in at least 8 of the past 15 tax years. The tax regime applies only to so-called “covered expatriates” (CE). IRC Section 877A(g)(1) references IRC Section 877(a)(2) for the definition of a CE.
The US Expatriation Tax Regime
The 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 [This amount is indexed annually for inflation and is US$190,000 for 2023]. 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 [This amount is not indexed for inflation], 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.
Exit Tax / Mark-to-Market Taxation
A CE is subject to the “exit tax” or “mark-to-market” (MTM) 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. Various nuances apply that are not addressed in this post. For example, the MTM regime does not apply to certain assets such as the CE’s interest in trusts, pensions or deferred compensation. Those items get special tax treatment (and by special, don’t think it’s nice)!
Further, an exception for a certain amount of deemed 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 it does not apply to ownership in certain kinds of property. As such, professional guidance should be taken.
I have been working on expatriation matters for over 30 years and have assisted in numerous highly complex expatriations as well as those that are more straightforward. It is a complex area of law. Don’t be duped by tax pro’s who tell you it is easy. The IRS has a special audit campaign going for individuals who expatriate. Make sure things are done right.
Posted July 13, 2023
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