IRC 877A & Expatriation

IRC 877A

Tax Responsibilities of Expatriation with Examples

Expatriation is the process in which 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. Let’s walk through the basics of 877A.

Mark-to-Market

One of the key components for taxpayers who are considered to be covered expatriates is that they have to conduct a mark-to-market analysis to determine whether they will have any recognition of gain as part of the exit tax exercise. If a Taxpayer is not considered a covered expatriate then they do not have to worry about any exit tax.

• • • Example: Jennifer is a covered expatriate who has $2,000,000 worth of stock. This is the only assets that she owns because she rents the property that she lives in and the remainder of her assets are in cash and pension plans. Therefore, since Jennifer is a covered expatriate she must look at the basis of the assets (which is generally going to be the value she purchased them for) and then subtract the basis from the Fair Market Value (FMV) on the day before expatriation to determine whether there is any gain or loss. If there is gain, she is entitled to a certain exclusion amount which we will discuss further in the summary.

Exclusion for Gain and Adjustment for Inflation

A certain portion of the gain that would otherwise be recognized as part of the mark-to-market cell is excluded for exit tax purposes.

• • • Example: Jennifer the covered expatriate who has $2,000,000 worth of stock has a $1,500,000 million cost basis in the stock as well. Therefore, the total gain would be $600,000. Since the stock is the only asset that Jennifer has, she can apply the full amount of the exclusion to this single asset (otherwise the exclusion is spread amongst the different mark to market assets). As a result, in this situation Jennifer would not have any exit tax on the mark-to-market gain because the total amount of recognized gain would be less than the exclusion amount.

Election to Defer Tax

Taxpayers who may otherwise have an exit tax may qualify to defer the amount of tax to a later date. The main problem with deferring tax is that it requires a taxpayer to obtain a bond or something similar and typically they can be very expensive so it may not be cost-effective for the Taxpayer to elect to defer the tax if at all possible. Some Taxpayers will sell some of their assets instead of ‘pretending to sell’ the assets to apply those funds toward any amount of extra tax that would be due.

Exception for Certain Property

It is also important to note that the mark-to-market gain portion of the exit tax is only one aspect of the exit tax period there are various other components that apply to exit tax as well and are treated differently. These types of exit tasks are not eligible for the exclusion amount edified for the mark-to-market gain category.

 Other categories in addition to the mark-to-market gain comma include:

• • • Deferred compensation (eligible and ineligible)

    • Specify tax-deferred accounts

    • Nongrantor trusts

Treatment of Deferred Compensation Items

When it comes to deferred compensation items, the two main categories are eligible deferred compensation and ineligible deferred compensation. The two categories are treated differently for exit tax purposes.

Withholding of Eligible Deferred Compensation

A common example of eligible deferred compensation is a 401K. When it comes to a 401K, the amount in the 401K is not deemed distributed at the time that the person expatriates. However, at a later date when the taxpayer begins receiving 401K distributions the administrator will withhold 30% since the taxpayer will be a non-resident alien at that time and the income is categorized as FDAP (also, at the time the person expatriates, they irrevocably waived the right to claim treaty benefits at a later date to reduce the withholding). The Taxpayer must be sure to let the payor know that they are covered (W-8CE) and the IRS takes the position it must be submitted within 30 days from the date of expatriation.

• • • Example: At the time of expatriation, Michelle was a covered expatriate who had $700,000 in her 401K. At the time she expatriated, she did not have to pay any extra tax on the 401K. Later, when she begins receiving distributions from her 401K, the administrator will withhold 30% for tax and Michelle cannot rely on a treaty between the country she resides and the United States to reduce the withholding.

Ineligible Deferred Compensation

 The rules for ineligible deferred compensation are different and unfortunately more harsh. When a person is a covered expatriate and they have ineligible deferred compensation, such as a foreign pension plan, the amount of deferred compensation is deemed distributed at the time the person expatriates and grossed up into their income tax return so that they are paying tax as if the income had been distributed, even though it has not yet been distributed.

Treatment of Specified Tax Deferred Accounts 

A specified tax-deferred account (such as a traditional IRA) is also deemed distributed at the time of expatriation. Even though the distribution is at the time of expatriation and can be considered ‘early’, there is no early distribution tax.

Nongrantor Trusts

 Nongrantor trusts also receive negative tax treatment at the time of expatriation. The Trustee will withhold 30% of the taxable portion of the distribution and there may be tax implications that result in recognizing gains.

IRC 877A Key Definitions

Here are some of the key definitions for Section 877A:

Covered Expatriate

A covered expatriate is generally going to be an expatriate who is either a U.S. citizen or a Long-Term Lawful Permanent Resident and meets one of the three tests: net worth test; net income average tax liability test; or the five-year tax compliance test.

Exceptions

Even if a person isn’t covered expatriate, they may qualify for an exception as either a dual citizen or minor – noting, that each of these exceptions has very specific requirements.

Expatriation Date

Depending on whether the Taxpayer is a U.S. Citizen or a Long-Term Lawful Permanent Resident will help determine what their expatriation date is. When the Taxpayer is a citizen, it is generally going to be the date that the taxpayer renounces their U.S. nationality at a consulate in a foreign country. Noting, that even though it may take several months for the taxpayer to receive their DS-4083 loss of nationality, the expatriation date will usually relate back to the date that they were announced at the consulate. For Long-Term Lawful Permanent Residents, it is generally going to be the day that the taxpayer ceases being a lawful permanent resident which usually occurs when the taxpayer submits form I-407 to the USCIS. Likewise, even though it may take USCIS months to process the I-407, the date will typically relate back to the date the I-407 was submitted presuming that the I-407 was processed and accepted.

Offshore Disclosure with Expatriation

When a person is either considered a U.S. citizen or a Long Term Lawful Permanent Resident (LTR), the formal process of either renouncing US citizenship or relinquishing a green card is referred to as expatriation. When a taxpayer expatriates from the United States there are various tax and immigration requirements that they must be aware of to ensure that the process goes smoothly. One of the biggest hurdles for some taxpayers is that they are not in IRS tax compliance for the five prior years at the time that they expatriate. As a result, this may lead to the taxpayer having to pay an exit tax when they may have avoided attacks if they had been tax-compliant at the time that they expatriated. Let’s look at four common issues involving offshore disclosure with expatriation.

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