What Does the IRS Want From You When You Renounce?

What are the Tax Implications of Renouncing US Citizenship?

Tax Implications of Renouncing US Citizenship

When a U.S. Person renounces their US citizenship, there are two main legal components to be aware of. From an immigration perspective, the US person will no longer be considered a US citizen. They will no longer have a United States Passport and they will not receive the benefits of being a US Citizen. In addition, there are also the tax implications of renouncing US citizenship. When a person is a US citizen and they renounce their US citizenship, they may become subject to an exit tax at the time they expatriate if they are considered a covered expatriate and if they have certain types of income that fall into the different exit tax categories such as mark-to-market gains and specified tax-deferred accounts. The process of renouncing US citizenship can be very complicated. This article is designed to provide insight into the basics of each step in the renouncing process.

Tax Planning Before Renouncing

It is important to note that once a person renounces, they cannot take that step back. That is not to say they cannot become a US person at a later date, but from a tax perspective, the key point in time is the day before the US citizen formally expatriates. Thus, it is important for the taxpayer to do all the necessary tax legwork, analysis, and evaluation before formally renouncing. Generally, a US citizen renounces their US citizenship by going into a consulate in a foreign country, submitting the necessary Department of State paperwork, and completing the exit interview process.

Additional Citizenship is Required First

In order to renounce US citizenship, the US government requires the Taxpayer to already have received another country’s citizenship. This is because the U.S. Government will not authorize a renouncement unless the person can prove they already have citizenship in another country to avoid them being ‘Stateless”. Taxpayers who do not have second citizenship or lineage in a foreign country sufficient to quickly obtain citizenship may qualify for one of the Citizenship-by-Investment programs. There are several different programs. Here is a separate article about Citizenship-by-Investment programs

• • • Dual Nationality/ Statelessness

      • Persons intending to renounce U.S. citizenship should be aware that, unless they already possess a foreign nationality, they may be rendered stateless and, thus, lack the protection of any government. They may also have difficulty traveling as they may not be entitled to a passport from any country. Statelessness can present severe hardships: the ability to own or rent property, work, marry, receive medical or other benefits, and attend school can be affected. Former U.S. citizens would be required to obtain a visa to travel to the United States or show that they are eligible for admission pursuant to the terms of the Visa Waiver Program. If unable to qualify for a visa, the person could be permanently barred from entering the United States. If the Department of Homeland Security determines that the renunciation is motivated by tax avoidance purposes, the individual will be found inadmissible to the United States under Section 212(a)(10)(E) of the Immigration and Nationality Act (8 U.S.C. 1182(a)(10)(E)), as amended. Renunciation of U.S. citizenship may not prevent a foreign country from deporting that individual to the United States in some non-citizen status.

Pesky Department of State Forms (4079-4083)

At the time that a person formally renounces their US citizenship, they will have to submit several Department of State (DS) Forms. These are known as Department of State forms and they can generally be found on the Department of State website, forms 4079-4083. These are not tax forms but rather immigration-type forms about why a person wants to give up their US citizenship.

• • •  Requirement-Renounce All Rights and Privilege

      • A person seeking to renounce U.S. citizenship must renounce all the rights and privileges associated with such citizenship. In the case of Colon v. U.S. Department of State, 2 F.Supp.2d 43 (1998), the U.S. District Court for the District of Columbia rejected Colon’s petition for a writ of mandamus directing the Secretary of State to approve a Certificate of Loss of Nationality in the case because, despite his oath of renunciation, he wanted to retain the right to live in the United States while claiming he was not a U.S. citizen.

Making an Appointment to Renounce

As a result of Covid, making an appointment to perform a renunciation can be an exercise in futility. It could take several months to get an interview and it is important to note that some countries have restrictions. That is, in some countries it is easier to obtain an interview in another country than where the Taxpayer will ultimately reside. Likewise, some countries require the taxpayer to be a citizen of that actual country in order to use the local Embassy/Consulate of the country to renounce. In other countries, it is not as formal which is why some Taxpayers travel to other countries such as Panama in order to renounce their US citizenship — even if they are not a citizen of Panama and have no intent to reside there after they renounce.

• • • Elements of Renunciation

      • A person wishing to renounce his or her U.S. citizenship must voluntarily and with intent to relinquish U.S. citizenship: appear in person before a U.S. consular or diplomatic officer, in a foreign country  at a U.S. Embassy or Consulate; and sign an oath of renunciation Renunciations abroad that do not meet the conditions described above have no legal effect. Because of the provisions of Section 349(a)(5), U.S. citizens can only renounce their citizenship in person, and therefore cannot do so by mail, electronically, or through agents. In fact, U.S. courts have held certain attempts to renounce U.S. citizenship to be ineffective on a variety of grounds, as discussed below. Questions concerning renunciation of U.S. citizenship in the United Statespursuant to INA section 349(a)(6) must be directed to United States Citizenship and Immigration Services (USCIS) of the Department of Homeland Security.

Exit Taxes When You Renounce

One of the biggest headaches for US citizens when they renounce their US citizenship is the issue of the exit tax. We have authored several articles on all matters involving exit taxes, but we wanted to provide an introductory summary of some of the basic considerations to be aware of if you are considering renouncing your US citizenship. The most important thing to keep in mind is that the exit tax is not a wealth tax. In other words, while one person can exit the United States and be worth $50 million and have no exit tax, another person with a much lower net worth may have a significant exit tax. It is based on the type of potential exit tax income they will have to report in their final year, which we will go through below.

As provided by the IRS:

• • • Expatriation on or after June 17, 2008

      • If you expatriated on or after June 17, 2008, the new IRC 877A expatriation rules apply to you if any of the following statements apply. Your average annual net income tax for the 5 years ending before the date of expatriation or termination of residency is more than a specified amount that is adjusted for inflation ($162,000 for 2017, $165,000 for 2018, $168,000 for 2019, and $171,000 for 2020. Your net worth is $2 million or more on the date of your expatriation or termination of residency. You fail to certify on Form 8854 that you have complied with all U.S. federal tax obligations for the 5 years preceding the date of your expatriation or termination of residency. If any of these rules apply, you are a “covered expatriate.”

      • A citizen will be treated as relinquishing his or her U.S. citizenship on the earliest of four possible dates: the date the individual renounces his or her U.S. nationality before a diplomatic or consular officer of the United States, provided the renunciation is subsequently approved by the issuance to the individual of a certificate of loss of nationality by the U.S. Department of State; the date the individual furnishes to the U.S. Department of State a signed statement of voluntary relinquishment of U.S. nationality confirming the performance of an act of expatriation specified in paragraph (1), (2), (3), or (4) of section 349(a) of the Immigration and Nationality Act (8 U.S.C. 1481(a)(1)-(4)), provided the voluntary relinquishment is subsequently approved by the issuance to the individual of a certificate of loss of nationality by the U.S. Department of State; the date the U.S. Department of State issues to the individual a certificate of loss of nationality; or the date a U.S. court cancels a naturalized citizen’s certificate of naturalization.

      • For long-term residents, as defined in IRC 7701(b)(6), a long-term resident ceases to be a lawful permanent resident if: the individual’s status of having been lawfully accorded the privilege of residing permanently in the United States as an immigrant in accordance with immigration laws has been revoked or has been administratively or judicially determined to have been abandoned, or the individual: commences to be treated as a resident of a foreign country under the provisions of a tax treaty between the United States and the foreign country, does not waive the benefits of the treaty applicable to residents of the foreign country, and notifies the IRS of such treatment on Forms 8833 and 8854. IRC 877A imposes a mark-to-market regime, which generally means that all property of a covered expatriate is deemed sold for its fair market value on the day before the expatriation date.

      • Any gain arising from the deemed sale is taken into account for the tax year of the deemed sale notwithstanding any other provisions of the Code.  Any loss from the deemed sale is taken into account for the tax year of the deemed sale to the extent otherwise provided in the Code, except that the wash sale rules of IRC 1091 do not apply.

IRS Forms: 1040/1040NR/Sailing Permit/8854

In general, when a person renounces their US citizenship, they will have to file a final Form 1040 tax return for the year that they renounced. Accompanying Form 1040 may be several other US tax forms as well, such as a Form 1040-NR for the portion of the year that they are a non-US person, a Form 8854 which is the expatriation statement, and possibly a sailing permit.

Exceptions to Exit Tax

Not everybody who is a US citizen can even become subject to the exit tax, even if they would otherwise be a covered expatriate. That is because there are certain exceptions and limitations for some taxpayers who are dual citizens or otherwise meet one of the exceptions for not having to pay exit taxes.

As provided by the IRS:

• • • Exception for dual-citizens and certain minors.

      • Dual-citizens and certain minors (defined next) won’t be treated as covered expatriates (and therefore won’t be subject to the expatriation tax) solely because one or both of the statements in paragraph (1) or (2) under Covered expatriate applies. However, these individuals will still be treated as covered expatriates unless they file Form 8854 and certify that they have complied with all federal tax obligations for the 5 tax years preceding the date of expatriation as required in paragraph (3) (under Covered expatriate, earlier).

      • Certain dual-citizens. You can qualify for the exception described above if you meet both of the following requirements.  You became at birth a U.S. citizen and a citizen of another country and, as of your expatriation date, you continue to be a citizen of, and are taxed as a resident of, that other country.

        • You were a resident of the United States for not more than 10 years during the 15-tax-year period ending with the tax year during which you expatriated. For the purpose of determining U.S. residency, use the substantial presence test described in chapter 1 of Pub. 519. Certain minors. You can qualify for the exception described above if you meet both of the following requirements.

        • You expatriated before you were 181/2.

        • You were a resident of the United States for not more than 10 tax years before you expatriated. For the purpose of determining U.S. residency, use the substantial presence test described in chapter 1 of Pub. 519.

What Income Gets Taxed When You Exit

The exit tax calculation is complicated. That is because while most people presume that exit tax only involves potential mark-to-market gain on assets that grew in value while the person was a US citizen, there are various other categories of potential exit tax as well. This includes specified tax-deferred accounts — such as a traditional IRA, ineligible deferred compensation — such as foreign pension plans, and ownership of certain domestic and foreign trusts. In addition, if a person has restricted stock and other deferred compensation that is also grossed up into the value and potentially subject to exit tax even though the assets have not been fully vested. Let’s go through some of the basics of the different categories of income that may become subject to exit tax by using examples:

Mark-to-Market

David is a US citizen who has stock that he acquired for $500,000 — 20 years ago. At the time David is going to renounce his US citizenship, the value of the stock is worth $5 million. Noting, that although David has no intention of actually selling the stock, he will still have to pay an exit tax on the phantom mark-to-market and that would occur at the time he ‘pretend sells’ the stock. The sales price is based on the Fair Market Value the day before he formally expatriates.

Specified Tax Deferred Accounts

Michelle is a US citizen who has a significant amount of money in a traditional IRA. She is a covered expatriate and so the value of the traditional IRA account is included as income on her final tax return. If it was a Roth IRA instead of a traditional IRA, then it may not be subject to exit tax — presuming that the taxpayer meets the requirements for age and time in the investment.

Ineligible Deferred Compensation

Scott is a US citizen who worked overseas in a foreign country for many years. He has a significant amount of deferred foreign pension. Since the pension is not US based or otherwise qualified under US tax law it is considered ineligible deferred compensation. As a result, the value of the foreign pension is included as income on Scott’s final tax return, even if Scott does not receive the income at that time and even if Scott was to receive that income tax-free under the foreign country’s tax laws.

Eligible Deferred Compensation

Eligible deferred compensation such as a 401(k) is treated differently. While the value of the 401(k) is used to determine whether the taxpayer may meet the net worth test under the covered expatriate analysis, the taxpayer is not subject to an exit tax on eligible deferred compensation at the time she exits the United States. Rather, at a future date when she starts receiving distributions, she will have 30% taxes withheld from each distribution. At the time she formally expatriates, she must irrevocably waive the right to claim treaty benefits to reduce the withholding on those 30% taxes (Form 8854).

Trusts

If a taxpayer has an ownership interest in a US or foreign trust, the value of the trust is grossed up as part of the potential exit tax. Trust exit tax rules are very complicated and can be impacted by whether or not it is a grantor trust or a non-grantor trust.

Post-Expatriation Taxes

After a person formally renounces their US citizenship, they are no longer considered a US citizen or US person for tax purposes. Therefore, for tax purposes, they are treated as nonresident aliens (unless they again become a US Person, noting Taxpayers should be cognizant of the Substantial Presence Test rules). As a result, they only pay tax on their US-sourced income. ECI or Effectively Connected Income is taxed at progressive tax rates. FDAP Fixed, Determinable, Annual, and Periodic income is taxed at a straight 30%, although the taxpayer may be able to rely on a tax treaty — if one is available between the country the taxpayer lives or resides and the United States — that reduces or eliminates withholding. Likewise, the other non-resident alien tax rules also apply so that items such as Capital Gains and Interest are generally not taxable to a Non-Resident Alien.

Covered Expatriate Taxes

One other tax item to keep in mind for Taxpayers who renounce but are deemed as Covered Expatriates is that there may be additional tax implications after they expatriate. Not only do some tax treaties even limit the tax benefits for people who are considered covered expatriates but there are also gift/estate tax implications as well. For example, if a Covered Expatriate wants to give a gift or a bequest to a US person, the US person is required to file paperwork and pay tax on the gift. And, the US person reports the money on Form 708 — although that form has not actually been published yet.

Annual Expatriation Statement

When an expatriate still has certain US investments such as deferred compensation after they renounce their US citizenship, they may be required to continually file an annual Form 8854 and identify whether any distributions have been made to them — and other related issues.

Golding & Golding: About Our International Tax Law Firm

Golding & Golding specializes exclusively in international tax, and specifically IRS offshore disclosure and how the Substantial Presence Test works.

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