Bye-Bye U.S., Hello Exit Tax!
If you are a U.S. citizen thinking about relinquishing your U.S. citizenship, or if you are what is defined as a “long-term” green card holder and thinking about giving it up, you may be in for a surprise. The U.S. has a sinister parting gift for you, called an “exit tax,” the effect of which can be extremely costly, so much so that it will make you think twice before you leave.
The Exit Tax is calculated as though you sold all of your assets on the day before you expatriated, and had to pay tax on all the gain — even though you are not selling your assets.
Who does the exit tax affect?
If you are a U.S. citizen and were considering relinquishing your citizenship for any reason (e.g., to be with family overseas, to reduce your taxes, to escape the long-arm of the U.S. tax code and compliance regime), you may be subjected to the exit tax upon your relinquishment.
Alternatively, if you a “long-term” green card holder, defined as holding a green card for at least 8 of the last 15 tax years ending with the year of expatriation, then you may also be subject to the exit tax upon ceasing to be a lawful permanent resident of the U.S. It is important to note that expiration of green card is not considered expatriation. Permanent residence status can be relinquished by filing Form i-407.
However, if you do not have citizenship and have not held a green card for at least 8 years, then the exit tax will not apply to you.
Triggering the Exit Tax
If the exit tax applies to you, then there are three ways you can trigger it. If even one of the three ways has been triggered, you will be regarded as a “covered expatriate” and the exit tax will apply, unless a special exception exists.
To be a covered expatriate, an individual must meet just one of the three tests:
- Net Income Tax Liability Test: Your average annual net income tax liability for the 5 taxable years ending before the date of expatriation is greater than $124,000 (currently, indexed for inflation at $178,000). NIIT taxes and self-employment taxes do not get computed into this calculation. Moreover, if you are married, there is no way to divide the tax liability; thus, if you file jointly, it makes no difference.
- Net Worth Test: Your global net worth is $2 million or more.
- Tax compliance: You fail to certify that you have (substantially) complied with all US federal tax obligations for the 5-year period preceding expatriation.
An individual will not be considered a covered expatriate if he or she relinquished their citizenship prior to turning 18.5 years old and was a US tax resident for no more than 10 taxable years before the date of relinquishment.
Covered Expatriate Status
If an individual is regarded as a covered expatriate, there are income tax consequences and transfer tax consequences.
Regarding the income tax consequences:
- There will a deemed disposition on certain tax-deferred accounts like IRAs, although there will no early distribution penalties as a result.
- There will be a tax on deferred compensation depending on whether it was “eligible” or “ineligible” deferred compensation. Eligible deferred compensation carries a 30% withholding from distributions, while ineligible deferred compensation is taxed as a deemed present value lump sum distribution.
- There will be a 30% withholding in a non-grantor trust, from the taxable portion of trust distributions when paid.
- There will be a deemed sale with recognized gains and losses for all other assets, with a certain amount forgiven in capital gains, indexed for inflation (currently $767,000).
Regarding potential estate tax consequences, there would be a tax in a situation where a covered expatriate made a gift or transfer to a U.S. recipient. This is known as Section 2801 tax liability. In these situations, the recipient is the one paying the taxes. The rules here are harsh. Normally, for example, if a non-US domiciliary made gifts of an intangible asset, there are no gift taxes. Similarly, a non-US domiciliary normally would be permitted to pay directly an unlimited amount for school and medical expenses. However, these transfers are immediately taxable if the person making the transfer is a covered expatriate.
Conclusion
There are some strategies to take advantage of well before an individual relinquishes their US status. Among these include gifting to a non-expatriating spouse, gifting assets using your lifetime exemption, and creating US irrevocable trusts prior to relinquishing your status.