New Rules for Expats
Leaving America with dignity.
DAVID A. LIFSON, CPA, is a partner at Hays & Company LLP (Globally: Moore Stephens Hays LLP), New York, and a member of the AICPA’s Tax Legislation and Policy Committee. His e-mail address is dlifson@haysco.com . PETER E. BENTLEY, Esq., is a manager at Hays & Company LLP. His e-mail address is pbentley@haysco.com .
ongress has debated the merits of various tax measures for expatriates for more than 20 years. The most straightforward approach is an exit tax on all untaxed asset appreciation on departure. Fortunately, this complex tax policy has been constrained by civil rights concerns of those who view exit taxes as inappropriate barriers to free population movement, historically used by totalitarian-style regimes to detain their oppressed inhabitants. In spite of this controversy, several enlightened governments, notably Canada and Australia, have recently adopted this approach, with mixed results. The United States uses another approach…for now.
The world is going global, and the U.S. tax system is keeping up with the times. The American Jobs Creation Act of 2004 (the “Jobs Act”) established special rules for individuals emigrating from the United States, including all traditional expatriates—people giving up citizenship—and even certain aliens relinquishing permanent residency. They subject the wealthy to at least 10 years of stricter reporting, and monitor and tax certain postdeparture income. The less-wealthy are allowed to leave with minimal fuss, but must report their departure to claim U.S. tax freedom.
The U.S. tax system is unique in its global approach to taxation. U.S. citizens always are required to pay income tax on their worldwide income from all sources, subject to various credits, exemptions and exceptions, and any gifts they make or estates they leave are generally subject to U.S. transfer taxes.
Enhanced disclosure requirements, an intent-driven tax regime and the inclusion of long-term residents in the antiavoidance regime tightened these rules in 1996. The chink in the armor in the 1996 revisions was the focus on the taxpayer’s intent to trigger the full antiavoidance tax system. Determining intent has proven nearly as costly and elusive as the daunting task of determining the fair value of unsold assets at departure.
NEW LEGISLATION, NEW RULES
The new rules apply to all departing expatriates retroactively from June 3, 2004. In addition to the 10-year postexpatriation self-assessment and reporting system, the net-worth threshold also has been increased, exempting more of the “less-than-wealthy” from continuing tax payment and return filing obligations. This will allow those individuals to move freely with no special postdeparture U.S. taxes or reporting responsibilities after an initial filing. Expensive and time-consuming letter ruling requests no longer are required. When citizens (or long-term residents) move to locations where there is a U.S. tax treaty, those provisions also must be considered in determining the individual’s U.S. tax reporting obligations.
| Emigration on the Rise Recent census data show traditional emigration is trending upward, to about 300,000 Americans a year. |
An expatriate continues to be a U.S. resident for tax purposes, and liable for U.S. tax on worldwide income, until the formal acts of expatriation and associated reporting are complete. Under the new law, all citizens and long-term residents remain U.S. residents until the later of the day they perform an expatriating act (give up citizenship or green card status) or file an information return with the IRS documenting their expatriation and financial status.
FITTING INTO THE TAX SYSTEM
The United States taxes noncitizens (“aliens”) based on their U.S. activities. If an alien’s presence in the United States is casual, only U.S. source income is taxable and transfer taxes (on estates and gifts) apply only to specific classes of U.S. assets. The tax profile of aliens changes significantly when they become U.S. residents. For income tax purposes, this is objectively based on immigration status (the green card test for those that obtain lawful permanent residence) or physical presence (the substantial presence test). For estate and gift tax purposes, residence is based on domicile. An alien who becomes a resident is subject to the same income tax rules as any U.S. citizen.
Most resident aliens can change their residence status freely, leaving the United States at will, with few U.S. tax repercussions. However, resident aliens who hold green cards for 8 of the 15 prior years generally are taxed at departure identically to citizens who relinquish their citizenship. These departing long-term green card holders, and citizens relinquishing their citizenship, are described collectively in the tax rules as “expatriating individuals.” CPAs will want to obtain detailed calendars and client case histories for at least five years, and in some cases 15 or more years, when evaluating the potential consequences of expatriation.
Using 2005 thresholds, expatriating individuals (a) who have been tax-compliant for at least five previous years and attest to such fact, (b) whose net worth is less than $2 million dollars and (c) who have paid federal income tax (indexed annually) of less than an average of $124,001 (about $400,000 of adjusted gross income for an average taxpayer) for the five years prior to expatriation are exempt from the alternative tax regime. That means they are exempt from the enhanced U.S. source rules, the 10-year requirement and most of the restrictions on return visits to the United States that lead to tax “as if a resident” postexpatriation. To obtain the exemption, they must file form 8854 with the IRS to document the expatriation and provide information about their recent tax history, income and assets.
Caution: A termination of U.S. residency during the calendar year requires maintenance of a “closer connection” to another country based on general U.S. tax law or a particular U.S. tax treaty with that foreign country, or absence from the United States for all but 30 days in the postexpatriation calendar year and no reentry as a U.S. resident for three tax years postexpatriation.
Certain expatriating individuals are exempt: dual citizens and minors. These exemptions are very narrowly defined, but will be useful to those who are U.S. citizens through an “accident of birth” but have no significant U.S. connections. Provided they follow the required filing and other formalities in relinquishing citizenship, regardless of their financial circumstances, they are permitted to expatriate without the complications described below. A strict rule for these two categories of expatriates is that they may not have been in the United States for more than 30 days in any year during the 10-year period prior to expatriation. Additionally, “dual citizens” must never have been resident based on physical presence and never held a U.S. passport. Minors relinquishing citizenship may not have had U.S. citizen parents at birth and must expatriate prior to turning 181¦2.
WEALTHY EXPATRIATES
Wealthy expatriating individuals are subject to taxation of U.S. source income under the “alternative tax regime” that modifies the traditional rules for U.S. income, gift and estate taxation of aliens. They must file form 8854 to start the expatriation process, and annually for 10 years after their departure to document their status. They also may become subject to tax as resident aliens on their worldwide income if they spend any significant time in the United States—more than 30 days per year in most cases and another 30 days on qualified business trips—in any of the 10 tax years postdeparture. If any tax is due in a postdeparture year, they also must file form 1040 or 1040NR to report income and calculate the tax.
Note: A careful projection of an individual’s travel and lifestyle plans and alternatives is required to evaluate the tax risks of expatriation. CPAs should document client expectations to help monitor their actual activities and advise them during the sensitive 10-year postdeparture window.
To terminate their responsibilities to pay U.S. tax on worldwide income and to set the clock running on the 10-year period, wealthy expatriates must demonstrate they have been tax-compliant for at least five previous years and file an information disclosure statement with the IRS, describing their act of expatriation and providing financial information. They then become subject to the postexpatriation alternative tax regime for 10 calendar years.
In summary, the alternate tax regime
Subjects the expatriate to enhanced U.S. sourcing rules so that certain foreign transactions with U.S. connections are taxable as U.S. income.
Requires annual filings for 10 years post-expatriation.
Imposes expanded estate and gift tax obligations.
The wealthy expatriating individual must remain in compliance with the strict physical presence limitations to continue to be taxed solely on enhanced U.S. source income, rather than worldwide income.
VISITS TO THE UNITED STATES
Expatriates, in order to avoid being taxed on worldwide income, must sever physical ties with the United States, which is evidenced by presence in the United States for no more than 30 days in each year in the 10-year period after expatriation. A daily calendar with third-party evidence of all travel is essential to prove this. Annual copies of passports also are useful.
The 30-day requirement now is absolute, save for one narrow exception: Expatriates who are fully taxable citizens or residents of the country in which they, their spouse or either of their parents were born and are traveling on business for a company that is not owned by their family are allowed an additional 30 days per year.
There are no general exceptions to the physical presence restriction, and the repercussions of inadvertent U.S. residency could be catastrophic. Additional days due to medical emergencies, transit delays, diplomat status or for students and teachers no longer are allowed. An expatriate suffering a heart attack while in international transit at a U.S. airport could now confront the eternal question, “Your money or your life?” It might even be wise to consider a hospital jet out of the country.
INCOME TAX
Some expatriates are subject to taxes on an expanded base of U.S. source income and gains for a 10-year period following expatriation. The principle behind this is that they are taxed on income and gains from assets located in the United States even where general source rules would look to the non-U.S. residence of a nonresident. This prevents them from avoiding U.S. taxes by waiting until after they leave to realize built-in gains on U.S. assets. Once the taxable income has been determined under the alternative tax regime, it is taxed at the graduated rates applicable to U.S. citizens (unless withholding tax for nonresidents results in a higher liability). Any liability may be offset by foreign tax credits.
Generally, a nonresident noncitizen is subject to U.S. estate tax only where U.S. property is held at the time of death. The Jobs Act expanded the estate tax in two important ways. First, under the new objective tests, a wider pool of “wealthy” expatriates is expected to report taxable estates during the 10 years after expatriating. Second, where expatriates have the misfortune of dying in a year in which they exceed the 30-day physical presence test, they will be taxed as U.S. residents, so that their gross estate will include all U.S. and other assets, wherever held. Think of the expatriate who suffers a heart attack in transit through a U.S. airport. A 31-day hospitalization followed by his death would subject his worldwide estate to U.S. taxes. Departing expatriates should review their U.S. and global estate plans carefully with their CPAs to accommodate these new rules.
GIFT TAX
Changes to the gift tax rules parallel the new estate tax provisions, with the added inclusion of additional persons as expatriating individuals, and the imposition of gift tax on transfers of stock of certain closely held foreign corporations, based on a “look-through rule” that considers underlying U.S. assets. Accordingly, gifts made by expatriates during the 10-year post-expatriation period must be monitored.
The look-through rule expands the definition of U.S. property to include property located in the United States that is indirectly held through certain foreign corporations. When an expatriate gifts stock during the 10-year look-back period, the taxable gift will comprise the pro rata share of U.S. property held by any foreign corporation in which the expatriate owns a 10% or larger interest of the total combined voting power, and in which the expatriate directly or indirectly owns more than 50% of the total combined value of the stock.
For example, let’s assume an expatriate gifts 60% of a foreign corporation that has a fair market value of $5 million, of which 40% is represented by assets in the United States. In calculating the taxable gift, $1.2 million ($5 million x 60% x 40%) is included, representing the proportionate share of the closely held foreign corporation’s U.S. assets.
WINNERS AND LOSERS
The largest group of winners under the new law is the expanded group of near wealthy who will be able to expatriate more easily. The most fortunate winners are the select few wealthy individuals who qualify under the narrow fairness exceptions for expatriating individuals who were accidental taxpayers with virtually no U.S. connections. Any of these people now may expatriate with minimal further consequences, and have been relieved of the burden to file protective letter ruling requests on exit.
Losers will fall into several groups. The largest likely will be those without good U.S. tax advice, wealthy or not, who leave without satisfying the reporting requirement. The 10-year reporting period starts only when the taxpayer reports the departure. Particularly likely to err under the new rules are former long-term residents who may be ignorant of the scope of U.S. taxation and uninformed about the exit rules. As technology improves, it’s conceivable that years or even decades later, a former green card holder will be stopped at a U.S. airport and informed of years of delinquent past returns with overdue tax, penalties and interest on worldwide income for the intervening period. Foreign executives who have spent extended periods in the United States on green cards are among those most likely to find themselves unwittingly shackled to the U.S. tax system.
In dollar terms, the biggest losers will be those who have genuine reasons to leave and strong connections with another country, but do not meet any of the exceptions. Another group who will be unable to satisfy the new tests are those with strong connections with another country, but also U.S. ties that compel them to visit here.
LEAVING AMERICA WITH DIGNITY
The new rules both expand the categories of income of expatriating individuals subject to U.S. tax and create additional classes of persons subject to such tax. The law’s focus and strict exemptions will make administration and enforcement easier and more objective. Leaving America will be easier and more straightforward, but also will involve significantly more paperwork and postdeparture monitoring for the expatriates and for the CPAs who advise them.
U.S. Source of Income—General Rules
Nonresident aliens (NRAs) must pay U.S. income tax on
The new rules state that expatriating individuals also must pay U.S. income tax for the next 10 years on
For estate and gift tax purposes, NRAs must pay U.S. taxes on the transfer of
Expatriates also must pay U.S. estate and gift tax for 10 years on foreign corporate stock where the foreign corporation owns U.S. personal property.
