“Expatriation: Sometimes, the cure is worse than the disease (1st of 2 parts)” by Ken Meissner (October 10, 2011)

Business World (10/10/2011)

(First of two parts)

In the classic American folk tale, Bre’r Rabbit and the Tar Baby, Bre’r Rabbit finds out that, having once touched the Tar Baby, it’s just about impossible to let go.

A sticky situation that is perhaps akin to what a US citizen or long-term resident who wishes to cease being a US taxpayer is likely to feel when dealing with the US Internal Revenue Service (IRS).

Section 877A of the US Internal Revenue Code (IRC) imposes an “exit tax” on people who cease being US taxpayers on or after June 17, 2008.

Anyone subject to exit tax is treated as if they had sold virtually everything they owned one day before losing or giving up US citizenship or residence.

Gains generated by this hypothetical sale are taxed on the expatriate’s final resident income tax return.

Losses are allowed only if an actual loss would have been deductible on an actual sale in a normal tax year.

Who pays the exit tax?

The exit tax applies to “covered expatriates.”

That means almost anyone who (1) ceases being a US citizen (no matter how long he has been a citizen), or (2) ceases being a permanent US resident or Green Card holder after having been a permanent resident in at least eight of the previous 15 years.

There are exceptions for people of modest income and moderate wealth, provided they file certain paperwork.

Other exceptions cover some dual citizens and minors, provided they have not spent too much time in the US.

There is no exit tax unless the hypothetical sale described above would generate substantial profits.

Finally, certain property rights (some deferred compensation, some special tax deferred accounts, and benefits provided under certain trusts) are not included in the hypothetical sale, but are subject to special rules. Details of these exceptions, thresholds, and exclusions are described below.

Deferral of exit tax

An expatriate may postpone paying tax on the hypothetical asset sale if he or she agrees to post a bond or security and agrees to pay the tax when his or her assets are actually disposed of. The election may cover all of the tax or only the tax on certain assets.

When an asset is disposed of and deferred exit tax is paid, interest must be paid as well.

There is no exit tax for anyone whose income and assets fall below certain thresholds and who files certain required paperwork. To qualify, an expatriate must meet each of the following three criteria:

• For 2011 expatriates, average US income tax liability must be less than $147,000 during the five-year period 2006-2010. (The threshold for this criterion is adjusted each year for inflation.);

• The expatriate’s net worth must be below $2 million; and

• The expatriate must certify under penalty of perjury that he or she has complied with all US tax requirements for the five-year period ending on the expatriation date, and must provide satisfactory proof of compliance if the IRS asks for it.

In practice, this third requirement means a former citizen or resident must submit a timely US form 1040 for the expatriation year. The 1040 must include IRS form 8854.

Form 8854 requires disclosure of detailed information, including a balance sheet and income statement, computation of hypothetical gains, a waiver of rights in some instances, plus a description of the steps the expatriate took to notify appropriate government agencies, such as the US State Department or the Department of Homeland Security of the expat’s status change.

Exception for dual citizens and minors

The exit tax also does not apply to someone who:

• Was born a dual citizen, keeps the non-US citizenship (or residency for tax purposes) he or she was born with, and hasn’t been a US resident for more than 10 taxable years during the 15-taxable-year period ending on the expatriation date.

• Was an expatriate before turning 18 years old, and has not been a US resident more than 10 taxable years during the 15-taxable-year period ending on the expatriation date.

Exclusion for people whose gains are not substantial

In calculating hypothetical exit-year gains, an expatriate is allowed an exclusion amount. For 2011, the exclusion amount (adjusted each year for inflation) is $636,000. Only gains that exceed the exclusion are taxable. If hypothetical gains are below the exclusion amount, there is no exit tax. The exclusion is allocated among all built-in-gain assets in proportion to those gains.

Basis step-up

An expatriate who is taxed on hypothetical gains may later be taxed again if a hypothetical-gain asset is actually sold in a later year.

This could happen, for example, to someone who owns US real estate and sells it after they expatriate.

To minimize double taxation, the tax basis of assets included in the hypothetical sale is stepped up to each asset’s fair market value on the date of the hypothetical sale. In other words, if I have an appreciated asset that is worth $100,000 the day before I expatriate, any taxable gain on a subsequent actual sale of that asset will be computed for US purposes as though the asset had cost me $100,000.

In the second part of this article, we will cover the other areas covered by IRC 877A, and the specific details that should be noted by affected individuals.

(Ken Meissner is a Tax Senior Director of SGV & Co.)

This article was originally published in the BusinessWorld newspaper. It is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.