New Taxation Rules for Expatriated Americans

It is well-known that the United States is one of the few countries in the world that taxes its citizens and residents on their worldwide income and assets irrespective of their physical presence or the actual source of income and assets.  Due to this taxation of persons who no longer live in the United States, and who don’t make earn income in the U.S., many of these taxpayers often decide to cut the ties that continue to link them to the United States.

The U.S. government of course has a vested interest in discouraging tax avoidance by “expatriation”. The Internal Revenue Service is involved in a never-ending process of closing actual or perceived loopholes and taking measures of discouraging any form of tax avoidance.  The result is an unmanageable tax code riddled with pitfalls.

Initially the IRS took the stance that if a US citizen renounced citizenship with tax avoidance as a goal, that person would be subject to harsher income tax reporting for the next ten years, as well as more punitive special gift and estate tax rules.

In 1995, the IRS took steps to abandon the existing system and to replace it with a so-called exit tax, similar to that of other countries. Taxpayers (now including green card residents as well as U.S. citizens) now bear the burden of proving the motivations behind expatriation. Under the new rules, a taxpayer had to continue to report for the next ten years.  The reporting applied to every citizen or long term resident that expatriated that had either $500,000 in net worth or an average income tax in excess of $100,000.

In order to avoid a substantial tax hit, the taxpayer had to get a ruling from the IRS, that tax avoidance was not a principal reason for expatriation.

In 1999, an exit tax was once again considered and abandoned.  The issue of intent was subsequently removed. Reasons behind expatriation are no longer relevant. The thresholds were adjusted to $124,000 of tax or $2,000,000 of net worth and an additional requirement was added that those under the thresholds also had to certify under penalty of perjury that they had complied with all tax laws for the previous 5 years.

The conduct by the Revenue Service was egregious. Merely renouncing your citizenship, which is governed by the U.S. State Department, is no longer enough.  The Revenue Service now added the requirement of having to provide notice to the IRS or the taxpayer will continue to be deemed a citizen and the 10 year period doesn’t begin until the reporting requirement has been met.

The changes implemented by the IRS had created a situation where people, like Green Card holders, are going home to their countries with no thought of the tax implications, and no intention to violate rules that they are unaware of, now are officially “tax cheats”…

Now let’s put the shoe on the other foot. Imagine a US citizen working for a US company relocated to Germany or Japan or China for 10 years. Now he’s retiring and going home. Wouldn’t it seem a bit unfair that for the next ten years, he would have to comply with a complex reporting regime and pay tax to a country that he is no longer working in and has severed all ties with?

There is also another group of affected persons, those that I refer to as “accidental citizens”. These are persons who have lived their lives in countries other than the US but are citizens either because their parents were citizens or because the best obstetrician at that critical moment was in the US.

Many foreign women give birth unexpectedly in the US. Many more appreciate the quality of US healthcare and come here to have their children. These children go through life with the scarlet letter A on their chest. Not for Adulterer, but for American.

After 2004, even if you had never permanently lived in the US (unless you had also never had a passport, never exceeded the substantial presence test and hadn’t exceeded 30 days in the US in any of the last 10 years), regardless of the fact that your abandonment of citizenship had nothing to do with taxes, you would still have to at least do 5 years of taxes before giving up your citizenship and another 10 years thereafter under the old rules.

Beginning as of June 18, 2008, expatriates will now be subject to an exit tax, and then except for certain specific items, be done with their US reporting requirements.  This onetime tax should be much easier to enforce and much easier to comply with. However, it may be harder to avoid and or plan around.

The other major change is a loosening of the limitations on the above referenced “accidental citizens”. Now instead of the 30 day residency limitation, the expatriate only needs not to have violated the substantial presence test in 10 of the last 15 years to be out of the tax regime. This provides a much broader exemption.

The revised rules now  apply to anyone who expatriates after June 16, 2008.  The general provisions provide that anyone who is a “Covered Expatriate” is deemed to have sold all their assets on the date of expatriation for fair market value. A Covered Expatriate is any citizen or long term resident, who:

·        gives up or loses his/her status,
·        has a net worth in excess of $2,000,000, or
·        an average annual income tax liability in excess of $139,000 (inflation adjusted) for the five years preceding expatriation, or
·        fails to certify compliance with the code for the five years preceding expatriation.

This last requirement is a remaining trap for the unwary because, regardless of your economic circumstances or actual compliance history, if you don’t do the paperwork you will be considered a Covered Expatriate.

Notwithstanding the foregoing, certain persons are excluded. This includes individuals who are born U.S. citizens and  citizens of another country (and remain  dual citizens), and who for 10 of the 15 years (or less if under 18) preceding expatriation have not been in the US in excess of the amount provided for substantial presence test (oversimplified analysis…less than 120 days per year on average).

Special rules also apply for deferred compensation items and other tax deferred items. Special exceptions apply to the special rules in the case of Covered Expat’s that subsequently become subject to tax as a citizen or resident in the future.

In the estate and gift tax arena, the new rules turn the US tax system on its head with the creation of Section 1208. Under §1208 any direct or indirect gift or bequest from a Covered Expat to a U.S. person is subject to tax at the highest applicable rate. The tax is reduced by any estate or gift taxes paid. The tax is paid by the recipient.

Many expats under these rules, will be relieved from the burdens of the expatriation tax and long term reporting requirements.  The new reverse inheritance tax will not affect those expatriates whose natural objects of bounty are non-U.S.  Temporary residents returning home with not too much net worth increase should feel little pain.

On the other hand, those high net worth individuals who made their fortunes while in the United States, will bear a high exit tax.  Also negatively impacted will be the American descendants and loved ones of expatriates.

One thought on “New Taxation Rules for Expatriated Americans

  1. Rocco_R

    Thanks, the article is clear. I read the IRS webpage on this topic and a summary or two at other websites but yours is the one that made it clear that expatriation for “non-covered” individuals is a one-time deal and that the long-term reporting requirements for such individuals have been eliminated.

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