Expatriation Tax Planning: Long-Term Residents & US Citizens (Examples)

Expatriation Tax Planning for Long-Term Residents & US Citizens (with Examples)

Expatriation Tax Planning for Long-Term Residents and U.S. Citizens 

One of the most common questions our international tax lawyers receive each year when U.S. Taxpayers get ready to renounce their U.S. citizenship or terminate their Lawful Permanent Resident status is whether or not they will have to pay an exit tax when they leave the United States. It is important to note, that not all individuals who expatriate from the United States will owe an exit tax. 

• • • First, there are two categories of individuals who may be subject to an exit tax — U.S. Citizens and Long Term Lawful Permanent Residents.

    • If a Taxpayer falls into one of these two categories, he must first determine whether or not he is considered to be a covered expatriate to determine if he may even become subject to exit taxes.

    • If the Taxpayer is a covered expatriate, then he may have an exit tax — but it is important to note that the exit tax it is not a wealth tax. Rather, it is a U.S. tax based on whether income or gains have accumulated while the Taxpayer was a U.S. person but has not been recognized/realized yet.

Let’s briefly examine some examples of when a taxpayer may or may not owe an exit tax.

*For all examples, please note that the Taxpayers are U.S. persons for tax purposes who have not made any treaty elections to be treated as a Non-Resident Alien (NRA). Also, these examples are for illustrative purposes only and Taxpayers should consult with a Board-Certified Tax Law Specialist if they have specific questions about their reporting requirements and not rely on this article for legal advice.

First, What is IRC Section 877A?

Expatriation is when a U.S. Citizen or Long Term Lawful Permanent Resident gives up their U.S. person status and exits the U.S. tax system. There are two main components to expatriation: there is the immigration aspect of formally renouncing U.S. Citizenship or terminating Long-Term Lawful Permanent Resident Status and then there are the tax responsibilities of expatriation and filing a final U.S. person tax return (Form 1040). The tax responsibilities of expatriation for Taxpayers fall under Internal Revenue Code section 877A. For some Taxpayers who are considered to be either U.S. Citizens or Long-Term Lawful Permanent Residents and are considered to be covered expatriates — and do not meet any of the exceptions — they may be subject to exit taxes when they expatriate. In addition, they may have subsequent tax issues involving gifts and other matters in future years. 

Net Worth vs Exit Tax

It is very important to note that when a Taxpayer is covered, it does not mean that they will have an exit tax when they leave the United States — even if they have a high net worth.  There generally has to be some type of unrealized income such as mark-to-market gain with stock (or other equities), ineligible deferred compensation that accrued while the taxpayer was a U.S. Person and is deemed distributed at exit, etc.

Let’s look at two different examples to illustrate the concept:

• • • Example 1: Michelle is a U.S. Citizen who owns stock worth $4M. She acquired the stock for $1M. When Michelle expatriates from the United States, she may have an exit tax based on the mark to market gain in the stock.

    • Example 2: Dylan is a U.S. Citizen who has $50M in cash. While Dylan will be considered a covered expatriate, he would not have any immediate exit tax because his assets are all cash.

Mark-to-Market Gains

The most common type of exit tax is based on mark-to-market gains. In an all-too-common situation, the Taxpayer may have purchased stock while they were a U.S. person, and that stock value has gone up significantly so that if the stock was sold on the day before the person expatriated there would be a gain. Noting, that there is an exit tax exclusion which may eliminate MTM exit taxes for some Taxpayers (currently, it is $821,000 and adjusts each year for inflation).

• • • Example 1: Peter is a U.S. Citizen who purchased stock worth $600,000 several years ago and now the stock is worth $1.3M. If this is the only mark-to-market asset that Peter has, then the exclusion amount should cover any gain so that there would not be any exit tax when Peter expatriates.

    • Example 2: Daniel is a U.S. citizen who purchased stock worth $600,000 seven years ago and now the stock is worth $3.8M. Even if Daniel applies the exclusion amount, he will still have to pay a significant exit tax on the Long Term Capital Gain for the difference between the fair market value on the day before he expatriates and the adjusted basis.

    • Example 3: Michelle is a Lawful Permanent Resident who purchased stock before she became a Lawful Permanent Resident for $300,000. On the day she became a Lawful Permanent Resident the stock was worth $800,000 and on the day before she expatriates, it is worth $1.2M. Due to the step-up value that Michelle would receive on the day which became a Lawful Permanent Resident, if this is the only mark to market asset Michelle has she may be able to avoid MTM exit taxes on this particular asset.

Eligible Deferred Compensation

When it comes to Eligible Deferred Compensation (such as 401K), Taxpayers generally do not have to pay any exit tax at the time they expatriate. In the future, if they were covered, they may have to pay tax on the distributions. While no exit tax may be due when they expatriate, they may have to irrevocably waive the right to treaty benefits when they receive distributions.

Ineligible Deferred Compensation

When a person is covered and has ineligible deferred compensation, they may be required to pay an exit tax on the ineligible deferred compensation as if it had been distributed. This type of exit tax is especially unfair, especially in light of the fact that oftentimes ineligible deferred compensation is just a foreign retirement plan that receives tax-deferred treatment in the foreign country where the pension plan is situated — similar to a 401K in the United States.

If the taxpayer has a step up, it may serve to reduce any exit taxes.

• • • Example 1: Mindy is a Long Term Lawful Permanent Resident who previously earned pension while living overseas as a green card holder. She is a covered expatriate and has a $1.5M pension (with no U.S. tax basis), all of it which was received while she was a U.S. person. No taxes have been paid on the pension and therefore the full amount of the pension may become subject to exit tax.

    • Example 2: William is a U.S. Citizen who has been on different assignments throughout the globe for many years but always maintains an international pension plan overseas that is not considered qualified in the United States. It is now worth $3.2M dollars and no taxes have been paid. The full amount of the pension plan may become taxable.

    • Example 3: Jennifer is a Long-Term Resident who has $2M in foreign pension. She is a covered expatriate, but she only became a green card holder nine years ago. Before she became a green card holder from marriage, she did not have any U.S. person status. When she first came to the United States and became a green card holder the foreign pension was worth $1.6M. Therefore, Jennifer may be able to take the position that only ~$4M of the amount of pension may be taxable because of the step-up.

Specified Tax Deferred Accounts

Another common category of exit tax is specified tax-deferred accounts. A common example of a specified tax-deferred account may be a traditional IRA — which may be impacted based on whether the IRA is an employment IRA or an investment IRA. In general, the IRS takes the position that the IRA loses its tax-deferred status and becomes deemed distributed at the time of expatriation. However, if it is a Roth IRA and if the Taxpayer meets the requirements for longevity and age of the taxpayer, it may avoid exit tax.

• • • Example 1: Frank is a U.S. citizen who has $700,000 in his IRA. It is a non-employment traditional IRA which has no tax basis since it is all pre-tax dollars. Therefore, since Frank is a covered expatriate, when he expatriates he may have to pay exit tax on that $700,000.

    • Example 2: Denise is a U.S. citizen who has $500,000 in a Roth IRA and she is also a covered expatriate. Denise is 71 years old and has had her Roth IRA for more than 20 years. Therefore, Denise may be able to avoid exit taxes on her Roth IRA.

Can Gifting Avoid Exit Tax For High-Net Worth Expatriates?

For many U.S. Taxpayers, the main reason they may be considered a covered expatriate at the time that they expatriate from the United States is because they meet the net worth test. Surprisingly, unlike the net income average tax liability test, the net worth test does not adjust annually for inflation. As a result, many U.S. Taxpayers who may not necessarily be high-income earners but acquired assets many years ago such as stock in companies such as Apple or Tesla — or purchased a home before the recent bubble – may unexpectedly meet the $2M net worth test. Especially for Taxpayers who may have acquired property in northern or southern California many years ago, the value of their home may have increased exponentially, and the ~$900,000 exclusion amount will not be sufficient to avoid exit tax on the mark-to-market gain. Therefore, they may consider ‘gifting‘ assets to avoid meeting the net worth test — although several limitations may apply.

The ’3-Year Gift  Pull-Back’

The three-year pullback rule can apply to Taxpayers at expatriation as well as death. Thus, if the Taxpayer gives gifts within three years before expatriating, the value of those gifts is still considered part of the estate — even though the asset was gifted to another person. In other words, those gifts are pulled back into the estate so that Taxpayers cannot quickly give gifts to reduce the value of their estate. However,  Taxpayers may be able to avoid this harsh outcome when issuing gifts to spouses.

The Tip of the Iceberg

This article aims to help clarify some of the basics of exit taxes. Being tax compliant when a person expatriates is very important and exit taxes in general can be very complicated, especially when it involves additional items such as foreign life insurance policies, foreign corporations, foreign partnerships, and transactions between U.S. persons and foreign companies. Taxpayers should try to stay in compliance if they are already in compliance or should consider getting into compliance if they have not properly filed the necessary reporting forms if for no other reason than the fact that the IRS has made offshore compliance a key enforcement priority and has been issuing fines and penalties for non-compliance. 

Late Filing Penalties May be Reduced or Avoided

For Taxpayers who did not timely file their FBAR and/or other international information-related reporting forms, the IRS has developed many different offshore amnesty programs to assist Taxpayers with safely getting into compliance. These programs may reduce or even eliminate international reporting penalties.

Current Year vs. Prior Year Non-Compliance

Once a Taxpayer missed the tax and reporting (such as FBAR and FATCA) requirements for prior years, they will want to be careful before submitting their information to the IRS in the current year. That is because they may risk making a quiet disclosure if they just begin filing forward in the current year and/or mass filing previous year forms without doing so under one of the approved IRS offshore submission procedures. Before filing prior untimely foreign reporting forms, Taxpayers should consider speaking with a Board-Certified Tax Law Specialist who specializes exclusively in these types of offshore disclosure matters.

Avoid False Offshore Disclosure Submissions (Willful vs Non-Willful)

In recent years, the IRS has increased the level of scrutiny for certain streamlined procedure submissions. When a person is non-willful, they have an excellent chance of making a successful submission to Streamlined Procedures. If they are willful, they would submit to the IRS Voluntary Disclosure Program instead. But, if a willful Taxpayer submits an intentionally false narrative under the Streamlined Procedures (and gets caught), they may become subject to significant fines and penalties. 

Need Help Finding an Experienced Offshore Tax Attorney?

When it comes to hiring an experienced international tax attorney to represent you for unreported foreign and offshore account reporting, it can become overwhelming for Taxpayers trying to trek through all the false information and nonsense they will find in their online research. There are only a handful of attorneys worldwide who are Board-Certified Tax Specialists and who specialize exclusively in offshore disclosure and international tax amnesty reporting.  *This resource may help Taxpayers seeking to hire offshore tax counsel: How to Hire an Offshore Disclosure Lawyer.

Golding & Golding: About Our International Tax Law Firm

Golding & Golding specializes exclusively in international tax, specifically IRS offshore disclosure. 

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