What is Expatriation?
An act of expatriation is whenever an individual permanently departs from a country.
For example: A U.S. citizen who renounces citizenship or a U.S. lawful permanent resident “green card holder” who has held that status for eight or more of the last fifteen calendar years and decides to formally relinquish the green card by filing USCIS Form I-407.
Exemptions from the Exit Tax:
- A dual citizen from birth not residing in the U.S. and has not met the substantial presence test for eleven or more of the last 15 calendar years, including the current year of intended expatriation (exempt from the covered expatriate analysis and thus exempt from the exit tax)
- Minor – if you are under the age of 18 ½ and have been a resident no more than ten years since birth, you are exempt from the covered expatriate analysis and thus exempt from the exit tax.
Covered expatriate is an expatriate who is deemed by the IRS to be “covered” under the U.S. tax code — and therefore may become subject to exit tax at the time of expatriation.
Not all taxpayers who formally give up their U.S. Status are considered expatriates. Not all expatriates are considered “covered.” An expatriate is a U.S. person who is either a U.S. citizen or Long-Term Lawful Permanent Resident, which means that they have been a lawful permanent resident for eight of the last fifteen tax years — excluding any year in which they claimed Form 8833 treaty benefits to be treated as a foreign resident.
An expatriate is considered covered when they fall into one of the two categories identified above, and they meet any of the three covered expatriate tests below.
The three (3) tests are as summarized below (only need to meet one of the tests to be considered “covered”):
- Net-Worth Test: Net worth is more than $2,000,000 (does not adjust for inflation);
- Net-Income Tax Liability Test: Net income tax liability is more than prior five-year allowable average ($171,000 for 2020; adjusts for inflation); or
- Noncompliance with Taxes: Unable to prove tax compliance for the past five years.
Calculating Exit Tax (Sec 877A) Exposure
Exit tax only applies to built-in gains on worldwide assets, and the first $737,000 of the gain is excluded.
For U.S. citizens, adjusted basis is determined by adding the purchase cost and any permitted basis adjustments. While this is also true for noncitizens in ordinary circumstances, in the context of the Exit Tax, it is different. The basis in worldwide assets for a naturalized citizen or a long-term lawful permanent resident “green card holder” is the fair market value of the assets on the date the individual first arrived in the U.S. unless the individual elects out of this default rule under 877A(h)(2).
What Happens if you are Covered?
If a person is considered a covered expatriate, they may become subject to Exit Tax. In determining the amount of Exit tax, the main (and most complicated) part is to conduct a mark-to-market analysis of the realized but unrecognized capital gains. In addition, they must determine if there are any deemed distributions. One very important takeaway is that just because a person is covered does not mean they owe any exit tax — here are two examples:
No Exit Tax
- Georgina is a U.S. Citizen who is going to expatriate.
- She has a net worth of $150,000,000, all of which is cash. She has no retirement plans, trusts, or tax-deferred investments — Clearly, Georgina needs an investment advisor!
- At the time Georgina expatriates, she will oweno exit tax because there is no mark to market gain on the cash.
- Miranda has been a U.S. Permanent Resident for the last 10-years.
- She has stock worth $4 million that she purchased after becoming a U.S. person.
- Her basis in the stock is only $50,000. Therefore, based on the mark-to-market gain on the realized but unrecognized gains, she will presumably have an exit tax consequence; however, additional information will be required to determine the exact amount of the unrealized gain related to her period U.S. residency.
Why is Being Covered Bad?
The main deterrent in being covered is that certain transactions the nonresident alien covered expatriate has with a U.S. person (after the expatriation date) are still taxable. This is no truer than in situations involving covered gifts and bequests to a U.S. person — which may result in an immediate tax consequence at a rate upwards of 40%. Those rules fall under Internal Revenue Code 2801 and Form 708 — only the proposed regulations for section 2801 are still proposed — and Form 708 has yet to be published.
Exit Tax Planning to Avoid/Minimize Expatriation Exit Tax
In conclusion, when a U.S. person is planning to expatriate, careful analysis should be undertaken to avoid the covered expatriate status. Sometimes, it is just not possible to avoid covered expatriate status. In these situations, the expatriate may be able to perform some pre-exit tax planning to minimize or avoid exit tax, which, to be effective, needs to be done before the act of expatriation is completed (relinquishing permanent residents or renouncing citizenship).
Contact a member of Withum’s International Tax Team to help address your business challenges.