Recently, U.S. taxpayers have displayed increased anxiety relating to a number of issues, not the least of which is the growing uncertainty concerning U.S. income and estate taxes. President Obama’s recent holiday gift to affluent families (through The Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act) will indeed make it both easier and less expensive for clients to transfer wealth to their descendants. The new law severely diminishes estate and gift taxes for the vast majority of U.S. citizens by way of higher exemptions. However, this law as it relates to estate and gift taxes remains in effect only through 2012. Some of this anxiety over our tax regime is also evidenced at U.S. embassies across the globe as U.S. citizens renounce their citizenship in growing numbers. While the number of expatriates is certainly not alarming, it appears to be growing.
In 2010, Time magazine published an article entitled “Why More U.S. Expatriates Are Turning In Their Passports.” The author of the article explains how citizens are growing increasingly discontent with the U.S. tax system to the point that cutting ties with their homeland is not only a realistic option, but one that is being pursued more frequently.
The thought of no longer being subjected to the U.S. tax system is certainly enticing. However, U.S. citizens and green card holders must consider a number of issues before they seriously contemplate renouncing their U.S. status.
Heart-burn For Expatriates
In 2008, the Heroes Earnings Assistance and Relief Tax Act of 2008 (the “HEART Act”) was signed into law by President Bush. Among the provisions contained in the legislation was a new code section that fundamentally changed the tax consequences to “covered expatriates.”
A “covered expatriate” generally refers to a U.S. citizen or long-term U.S. resident (i.e., a person who has held a green card for 8 of the last 15 taxable years) who terminates U.S. residency provided he/she satisfies certain income or net worth thresholds, or fails to certify that he/she is in compliance with all U.S. federal tax obligations for the past five taxable years.
The HEART Act changed the tax treatment for covered expatriates in two fundamental ways. First, such persons became subject to a new exit tax, and second the new regime imposed a special transfer tax on certain gifts and bequests made to U.S. persons.
Exit Tax: Don’t Let The Door Hit You On The Way Out
The exit tax for expatriates can be viewed as both good and bad. As a positive, it provides expatriates with a degree of certainty regarding the tax implications of expatriation that the previous regime did not. As a negative, it can truly be a costly proposition, depending on the appreciation in the assets owned by the expatriate at the time of expatriation.
Essentially, the expatriating individual is deemed to have sold all of his or her assets for their fair market value the day prior to the expatriation. Gain from the deemed sale is included as income to the extent the gain exceeds $600,000 (as adjusted for inflation).
The critical issue here, particularly for long-term U.S. residents who may have assets located abroad, is that “all property” of the covered expatriate is treated as being sold at fair market value on the day before expatriation. Apart from some exceptions for deferred compensation arrangements, tax deferred accounts and interests in nongrantor trusts, this is a very broad provision with potentially adverse implications for persons owning property outside the U.S.
For example, if an expatriate’s worldwide assets include real estate in a foreign country that is appreciated, then the deemed sale of the real estate upon expatriation could trigger a U.S. income tax. Under normal circumstances, the sale of foreign real estate would typically be subject to a foreign tax thus generating a foreign tax credit. However, under the expatriation rules (as modified), a U.S. tax generated with respect to the foreign real estate may not be creditable under some U.S. tax treaties thereby making an actual sale of certain property preferable for tax purposes.
It should be noted that an election to defer payment of the tax with respect to gain on certain property may be available provided the expatriate is able to posted adequate security as collateral and satisfy other conditions.
Inheritance Tax: Oh, By The Way
The special tax on gifts and bequests is particularly troublesome for expatriates who may transfer property to U.S. citizens or residents at some point after expatriating. Generally, U.S. transfer taxes on gifts and bequests are imposed on the transferor. However, the expatriation rules provide that future transfers to U.S. residents from “covered expatriates” will apply at the highest estate or gift tax rates applicable at the time of the transfer, to the extent the transfer exceeds approximately $13,000.
The tax applies to both direct and indirect gifts, and the recipient is responsible for payment of the tax (although where trusts are involved the trustee may have obligations to make the payment).
These provisions could significantly impact the number of expatriations, particularly since many expatriates are likely to have children who are U.S. citizens or residents. For the determined, however, pre-expatriation planning will be necessary to minimize the effect of this transfer tax on future gifts or bequests.
Anyone considering a change to his or her U.S. status must be mindful of these tax issues and work closely with his or her counsel.