The new US exit tax scheme: breaking off a long-term relationship with Uncle Sam

Abstract

The US ‘alternative tax regime’ in place since 17 June 2008 captures both US nationals who renounce citizenship and long-term residents who give up their ‘Green Cards’. The scheme subjects their non-retirement assets to an immediate mark-to-market tax on unrealized gains and levies other immediate or deferred income taxes on retirement assets. Furthermore, there is a new inheritance tax on the recipients of certain gifts or bequests from an expatriate. Creative planning, however, can circumvent the taxes entirely or at least ameliorate their effect. The ‘expatriation trust’ is the primary vehicle for providing relief. For several decades, the US Government has imposed an ‘alternative tax regime’ on its citizens who relinquish their passports. In 1996, the regime was extended to certain non-citizens who give up their permanent resident cards, which are commonly referred to as ‘Green Cards’. Until 17 June 2008, this alternative tax regime merely expanded the items of US-sited property against which any other non-US persons would pay tax, whether income tax or various taxes on gratuitous transfers. For renunciations of citizenship and permanent resident status occurring on or after that date, however, the scheme is completely different and, for many unhappy expats, very expensive. The new scheme involves two immediate exit taxes, two further income taxes that may come due later, and an inheritance tax on subsequent transfers by the expatriate. Before addressing the specifics of these taxes, this article treats the threshold question of who qualifies as a ‘covered expatriate’ for purposes of exposure to the scheme. The article next addresses the various taxes under the headings of ‘immediate income taxes,’ ‘deferred income taxes’, and ‘inheritance tax’. The possibility of treaty relief is then considered. The article concludes with advice on legitimately avoiding the taxes. The ‘covered expatriate’ The new alternative tax regime ensnares certain nationals who renounce citizenship and long-term residents who turn in, or are deemed to have turned in, their permanent resident cards. In either case, they are considered to be ‘expatriates’. In order to qualify as a ‘covered expatriate’, the person must meet either a net worth test or a tax liability test. The new alternative tax regime ensnares certain nationals who renounce citizenship and *Michael J Stegman, JD, TEP, Kohnen & Patton LLP, PNC Center, Suite 800, 201 East Fifth Street, Cincinnati, OH 45202-4190, USA. Tel: þ1 513 381 0656. Email: mstegman@kplaw.com 1. Foreign Investors Tax Act of 1966, US Public Law No 89-809. ‘US Public Law’ is hereafter cited as ‘Pub L’. 2. Health Insurance Portability and Accountability Act of 1996, Pub L 104-191. 3. Internal Revenue Code, Title 26 United States Code, ss 871–77. The Internal Revenue Code is hereafter cited as ‘IRC’. 4. The new regime became law as part of the Heroes Earnings Assistance and Relief Tax Act of 2008, Pub L 110-245. The former regime still applies to expatriations before 17 June 2008. Trusts & Trustees, 2012 1 The Author (2012). Published by Oxford University Press. All rights reserved. doi:10.1093/tandt/tts008 Trusts & Trustees Advance Access published March 16, 2012 by gest on M arch 7, 2012 http://tandordjournals.org/ D ow nladed from long-termresidentswho turnin, orare deemed to have turned in, their permanent resident cards. In either case, they are considered to be ‘expatriates’ The net worth test is met if the fair market value of person’s worldwide assets, as of the expatriation date, equals or exceeds USD 2,000,000. The advisor must use ‘good faith estimates’ for hard-to-value assets. Furthermore, the scheme looks through beneficial interests in certain trusts and requires valuation of the interests. In order to value a beneficiary’s interest in a trust, there is a vague facts-and-circumstances analysis that takes into account the terms of the trust instrument, any letter of wishes, and historical patterns of distributions. If these factors fail to produce a reliable valuation, then the expatriate must consider the amount he or she would receive if the trust terminated and the rules of succession applied, as if the settlor died without a will in place. The rules on valuation of a beneficial interest in a trust will likely apply to an interest in a Stiftung. Pity the task of the expatriate’s advisor when the valuation rules do not produce a clear answer on whether to file with the Internal Revenue Service (IRS) as a covered expatriate or not. The tax liability test is more workable. It looks to the expatriate’s average US income tax liability over the previous five calendar years. If the average tax exceeds an inflation-adjusted threshold, the person is considered a covered expatriate. For expatriations occurring in 2012, the amount is USD 151,000. A non-compliant taxpayer will nonetheless be classified as a covered expatriate even if he or she does not meet the net worth test or the tax liability test. A further ‘certification test’ provides that if the taxpayer fails to certify under penalty of perjury that he or she is fully compliant with US tax obligations over the preceding five calendar years, the taxpayer becomes a covered expatriate. There are two very narrow exceptions to covered expatriate status for an otherwise qualifying US national. The more likely exception to apply aims to exempt persons who were born into dual citizenship. In order to be exempt, however, the person must never have been a resident of the United States for income tax purposes, must never have held a passport and, over the previous 10 years, must not have been present in the United States for more than 30 days. The other exemption involves minors with insubstantial connections to the United States. As for permanent residents who give up the Green Card (or are deemed to have done so) and who otherwise qualify as a covered expatriate under the net worth, tax liability, and certification tests, they will be classified as covered expatriates if they meet the 8-of-15 test. Under this analysis, the permanent resident must have held the Green Card for 8 of the previous 15 calendar years. The noteworthy trap in this regard is that any one day of permanent residence status during a calendar year counts as a full year. For example, if the date of issuance of a person’s Green Card is 31 December 2005 and the person subsequently renounces it on 1 January 2012, the unfortunate soul qualifies under the 8-of-15 rule. 5. IRC s 877(a)(2). The USD 2,000,000 threshold is not adjusted for inflation. 6. United States Internal Revenue Service (IRS) Notice 97-19, 1997-1 Cumulative Bulletin 394, Sec III. This Notice is subsequently cited as ‘Notice 97-19’. The ‘Cumulative Bulletin’ is hereafter cited as ‘CB’. 7. ibid. 8. ibid. 9. ibid. 10. See IRS Associate Chief Counsel (Passthroughs & Special Industries) Memorandum, AM 2009-012 (7 October 2009). 11. IRC s 877(a)(2). 12. IRC s 877A(a)(3); IRS Revenue Procedure 2011-52, 2011-45 Internal Revenue Bulletin. Revenue Procedure 2011-52 is subsequently cited as ‘Rev Proc 2011-52’. The Internal Revenue Bulletin is hereafter cited as ‘IRB’. 13. IRC s 877(a)(2). 14. ibid, s 877(c)(2). 15. If these persons have had little contact with the United States in the 10 years prior to reaching the age of majority (regardless of length of time spent in the United States during the first eight years of life), they will be exempt upon expatriation if certain criteria are met. IRC s 877(c)(3). 16. IRC s 877(e). 17. US Department of the Treasury Regulation s 301.7701(b)-1(b)(1). A Treasury Regulation is hereafter cited as ‘Treas. Reg.’ 2 Article Trusts & Trustees, 2012 by gest on M arch 7, 2012 http://tandordjournals.org/ D ow nladed from Although a permanent resident can ‘expatriate’ by the affirmative act of taking the Green Card to an American consulate and filling out a form, he or she can also expatriate inadvertently. In the case of a permanent resident who moves to a country that has an income tax treaty with the United States, the person is deemed to have expatriated simply by filing a US income tax return and taking advantage of the treaty, perhaps to achieve a lower rate of taxation on US-source dividends. Given the penalties for failure to file an expatriation return with the IRS and the interest due on unpaid taxes, the inadvertent mistake can make an already expensive tax all the more costly. And considering that the United States has income tax treaties with over 60 nations, the likelihood of inadvertence is not remote. The fairness of such a scheme is difficult to justify. Because American corporations need the talents of permanent residents, it remains an open question of policy as to why the US Congress would want to tax them when they determine to go back home, perhaps after many years of dedicated service. Others may have been awarded a Green Card, perhaps in the annual ‘lottery’, but have never settled in the States. Query the legitimacy of a regime that would tax them upon renunciation. Because American corporations need the talents of permanent residents, it remains an open question of policy as to why the US Congress would want to tax them when they determine to go back home, perhaps after many years ofdedicated service