According to the Treasury Department, the number of Americans renouncing their U.S. citizenship hit an all-time high in 2016. However, before severing ties with the U.S., it is important to evaluate the tax implications, specifically the “Exit Tax,” which may apply to individuals who relinquish their U.S. citizenship or Green Card. The Wolf Group has outlined some of the major considerations below:
What is the Exit Tax?
Where the Exit Tax applies, the covered expatriate is required to calculate the taxable gain on all worldwide assets as if those assets were sold on the day before expatriation and pay an Exit Tax on the gain above a certain exclusion amount ($693,000 for 2016). Additional taxes – such as inheritance tax and tax on deferred compensation may also apply.
Who is subject to the Exit Tax?
A long-term resident is one who has held the Green Card for at least eight years during the 15-year period before their residency ends. Generally, the Exit Tax may be imposed on U.S. citizens or long-term residents who relinquish U.S. citizenship or long-term residency status in addition to meeting one of the following parameters:
- The individual’s annual net income tax liability for the prior five years exceed a certain threshold ($161,000 for 2016), or
- The individual’s net worth (including the present value of any pension) on his/her expatriation date is $2,000,000 or more, or
- The individual fails to certify that he/she has met U.S. tax law requirements (i.e., filing tax returns, Foreign Bank Account Report, etc.) for the prior five-year period. This certification is done by filing IRS Form 8854.
Should the expatriate fail to meet one of the tests, he/she is considered a covered expatriate and the Exit Tax may be imposed.
Failure to Meet the Five-Year Compliance Test
The compliance test is one of the more common tests that taxpayers fail. Taxpayers assume that because they have filed their tax returns every year, they will meet this test. If a tax return is missing significant international informational reports, foreign gross income, etc., it may be deemed substantially incomplete by the IRS under audit thus, the taxpayer may fail the compliance test.
For example, one such informational report is the Foreign Bank Account Report (FBAR). Failure to submit or accurately file the FBAR imposes significant IRS penalty implications. It is important to work with a tax professional who is well-versed in the foreign taxation subject area as there are tax professionals that do not understand the reporting requirements for this filing, the proper method for converting currency, or the interaction of the FBAR with other tax forms (such as Form 8938 and Schedule B) on the U.S. tax return.
Performing an independent audit or review of the tax returns and foreign financial reporting by an experienced international tax advisor can uncover issues that can be resolved through one of the many IRS amnesty programs currently available to taxpayers. By voluntarily resolving these issues, taxpayers can retain peace of mind that they are in full compliance with all IRS filings and reporting during the five-year period.
Timing is Critical
From a tax perspective, there may be events when it is more advantageous to remain a U.S. resident or citizen. These events include receiving deductions for mortgage interest or being able to report carry-over losses from rental properties. On the other hand, there are events when it makes more sense from a tax perspective to be a non-U.S. resident. These events include transactions such as the receipt of bonuses, pension distributions, and the execution of stock sales and real estate sales.
One can also plan the timing strategically to avoid failing the income tax liability test. Should the taxpayer’s tax liability from the prior five years exceed the stated threshold, one may consider deferring the timing of expatriation. With the additional time available, one should aim to minimize the tax liability for the years prior to expatriation to bring the average down to below the threshold.
Accordingly, it is critical for one to understand the significance of timing with respect to making the decision to expatriate. Additionally, it should be noted that expatriating on a random date can wreak havoc on the final filings with the IRS for U.S. tax preparers. Working with an experienced tax advisor can help the expatriate time the event perfectly while minimizing tax liability.
Other Tax Planning Considerations and Strategies
There are significant ramifications related to gift and estate taxes for covered expatriates and their heirs. The general U.S. estate tax regime is not applicable to covered expatriates; instead, a tax is imposed on U.S. citizens or residents who receive a gift or bequest from a covered expatriate. The tax could be as high as 45% of the value of the gift or bequest. It is important to work with a practitioner who is familiar with both – the Exit Tax and Estate Tax planning – so that the ramifications of these two tax provisions are most ideally optimized for the taxpayer.
There are additional concerns for taxpayers who have filed tax returns in foreign jurisdictions. Should a foreign jurisdiction change or amend the foreign tax due, consideration should be given to the foreign tax claimed on the U.S. tax return, to ensure proper compliance with U.S. tax law.
Whether you are subject to the exit tax or not, the IRS requires all individuals that are expatriating to list the net value of their assets as of the day before they expatriated on Form 8854. Individuals may find the exercise of understanding what assets to value and how to value them somewhat perplexing. To confuse the matter further, items such as deferred compensation (think annuity, simplified retirement plan, foreign pension, etc.) and specified tax deferred accounts (think 529 Plan, ESA Coverdell, HAS, etc) have special valuation rules. Finally, even after proper valuations are completed, there may be certain withholding forms (W-8CE) that are required. This is an area that should not be overlooked or shortchanged due to IRS audit risk.
Seek an Experienced Tax Advisor in Advance for Proper Expatriation Planning
Exit Tax planning, if done correctly, should assist the taxpayer with optimizing taxes, clearly understanding each test, how the calculations are completed, the potential risks, and proper timing. In essence, these services should provide full transparency to the taxpayer so that informed decisions can be made with respect to how to move forward (or in some cases not move forward) with expatriation.
The Wolf Group is experienced in assisting individuals with all facets of U.S. international and domestic tax issues, including Exit Tax planning and estate planning. For more information about our Exit Tax planning services, please click here. To get started, contact The Wolf Group’s New Client Lead, Fan Chen, CPA, at firstname.lastname@example.org or (703) 502-9500 x137.