Breaking Up Is Hard To Do: A Quick Refresher on the U.S. Tax Implications of Expatriating

Ever since the advent of FATCA and related global tax transparency movements, U.S. individuals living abroad have likely become far too acquainted with the challenges posed by holding U.S. citizenship or residency. Perhaps now more than ever, U.S. individuals have been giving serious thought to formally cutting ties with the U.S. – a process known as expatriating. While the wave of expatriations has subsided in recent years, 2020 has brought things back in full force, with a recent Fortune article highlighting the record number of expatriations that have taken place so far in 2020. ¹  This may not be a coincidence, as clients may becoming increasingly concerned about the uncertainty surrounding the impending U.S. election, as well as other precarious circumstances that have presented themselves in the U.S. as a result of the COVID-19 pandemic.

Whatever a person's reasons, the decision to permanently exit the U.S., if not done correctly, can lead to some nasty U.S. tax outcomes. Indeed, a recent case brought by the Justice Department against a wealthy Russian expat highlights just how serious some of the issues surrounding expatriating can be, particularly for those individuals providing false information on IRS tax forms. ²

For tax purposes, an "expatriate" is any U.S. citizen who relinquishes citizenship, and any long-term resident of the U.S. who ceases to be a lawful permanent resident (i.e., a green card holder) of the U.S. A long-term resident is any individual who has held a U.S. green card in at least 8 of the last 15 years leading up to the expatriation. Accordingly, the act of expatriating is when a U.S. person relinquishes or renounces his or her U.S. citizenship or formally abandons his or her U.S. green card.

For tax planners, we know that being a mere "expatriate" is not necessarily enough to get someone into tax trouble. Rather, it's the status of being a "covered expatriate" that can produce U.S. tax consequences. Covered expatriate status is defined by three tests, and an individual need meet only one of the tests to be considered a covered expatriate. The three tests are summarized immediately below.

1. Tax Liability Test: Under the first test, commonly referred to as the "Tax Liability Test," an individual is a covered expatriate if his average annual net income tax liability for the five years preceding expatriation exceeds a specified threshold, which is indexed annually for inflation ($171,000 for 2020).
   
   
2. Net Worth Test: Under the second test, commonly referred to as the "Net Worth Test," an individual is a covered expatriate if his or her net worth as of expatriation is $2,000,000 or more.
   
   
3. Certification Test: Under the third test, commonly referred to as the "Certification Test," an individual is a covered expatriate if he or she fails to certify under penalty of perjury that he or she has complied with all federal tax obligations for the five years preceding the expatriation. This certification must be made on IRS Form 8854 and is filed with the covered expatriate's U.S. income tax return for the year of expatriation. ³
   
   

Exceptions exist for certain dual citizens and minors, but a discussion of those topics is beyond the scope of this article.

If an individual is classified as a covered expatriate, an "exit tax" is imposed whereby the individual is deemed to have sold all of his or her property on the day before the expatriation date for fair market value. Individuals pay tax on the net gain on the deemed sale at generally applicable U.S. tax rates based on the character and holding period of the asset. The amount of gain required to be recognized is reduced, however, by an exclusion amount, indexed annually for inflation ($737,000 for 2020).

In addition to this exit tax, covered expatriates, or perhaps more accurately their U.S. family members, must also deal with a special transfer tax. Under these rules, U.S. recipients pay tax at the highest gift or estate tax rate (currently 40%) on the receipt of so-called covered gifts or bequests – essentially, property received from a covered expatriate either during life via a gift or upon death via an inheritance. Importantly, unlike general U.S. transfer tax rules where tax is imposed on the donor (in the case of a gift) or the estate of the decedent (in the case of a bequest), the transfer tax imposed under the expatriation regime must be paid by the person who receives the property. ⁴

The decision to expatriate carries with it significant tax and non-tax consequences. Clients and their advisors should give the appropriate amount of consideration to the relevant planning implications well in advance of the decision to formally exit the U.S.

[1] See " Americans are renouncing their citizenship in record numbers," available at https://fortune.com/2020/08/07/americans-renouncing-citizenship-passport-2020/.
[2] See U.S., N.D. Cal., No. 4:19-cr-00489, indictment unsealed 3/5/20.
[3] In the case involving the Russian expat, Mr. Tinkov, one of the government's charges is that Mr. Tinkov willfully falsified his IRS Form 8854, reporting his total net worth well below its actual value.
[4] Advice in this area is somewhat challenging, because the IRS has not yet published the form (what will be IRS Form 708) for reporting and paying the tax due on covered gifts and bequests. Until then, the collection of the tax is not being enforced. The IRS has stated that it intends to issue Form 708 once it releases final regulations (regulations on the subject have been issued in proposed form since 2015). The IRS has also indicated that it will give recipients a "reasonable period of time" after final regulations are published to file IRS Form 708 and pay any tax due.