EXPATRIATION TAX RULES: GREEN CARD HOLDERS BEWARE THE EXIT TAX
The curiously titled "Heroes Earnings Assistance and Relief Tax Act of 2008" became law 17 June 2008. This was the third major revision of expatriation rules in 12 years. While the Act provides laudable benefits to armed service veterans, Congress sought to pay for those benefits by changing the expatriation rules.
A "covered expatriate" now pays tax on market values of worldwide assets.
Subject to tax and net worth thresholds, the new rules apply to: (1) expatriating US citizens (those who renounce US citizenship), and (2) "long-term permanent residents", defined as those holding a Green Card for eight out of the 15 years prior to expatriation, including the year of expatriation. (Holding a Green Card for one day counts as a whole year of permanent residency). Apparently, a non-resident alien here for eight years under a visa, rather than a Green Card, is not considered a "long-term permanent resident" and is therefore not subject to these new rules.
This new tax regime is severe and is intended to discourage or deter "wealthy" US citizens and Green Card holders from expatriating to avoid paying tax on worldwide income. The Act defines a "covered expatriate" as: (1) a US citizen, and (2) a "long-term permanent resident" with a net-worth of USD$2 million, OR having an annual net income tax for the five previous years greater than USD$155K and adjusted for inflation. As discussed below, an expatriate with less net-worth then the threshold amount will be subject to the Act's penalties absent certain affirmative action by that person.
Green Card holders (covered expatriates) might choose to expatriate for any number of non-tax related reasons. There are those who are US citizens only because their parents were or are citizens, or they just happened to have been born here now and have decided to go back "home". A Green Card holder may wish to expatriate for family reasons, or to marry, or as a result of illness, or for a foreign-based business opportunity, or to run for Office in his/her home country. In any case, the covered expatriate will be subject not only to the Exit Tax but also to severe estate and gift tax burdens should there be US beneficiaries.
Covered Expatriates: Exceptions
The Act drastically limits the available exceptions to the new rules for US citizens with the threshold net-worth or tax history. The exceptions apply only to US citizens, and Green Card holders are not allowed any exceptions.
The exceptions available to US citizens are:
- The expatriate holds US citizenship solely by reason of birth, and is also a citizen of another country where he/she pays taxes at the time of expatriation, AND (and not "or")
- Such citizen has not been a US resident under the "substantial presence" test (183 days in any one year or by formula over three years) for more than 10 years out the previous 15 years.
- A US citizen who expatriates before the age of 18½.
THE EXIT TAX:
The expatriation rules have always been rather complex, but until 2004 it was possible to apply to the IRS for a private ruling that expatriation was not for tax avoidance purposes. The Act now provides a "bright line" test, and it eliminated the opportunity for an IRS favorable ruling. The 10-year forward US tax regime is also replaced by the new Exit tax. Covered expatriates are now be taxed as if they sold their assets at fair market value the day before expatriation, with a USD $668,000 (2013) exemption. The "mark to market" rules require that assets be valued at current market values, but the Act does not itself provide any other guidance for valuing assets. Foreign-based assets, which are covered by the Exit Tax, present substantial valuation issues, as foreign assets could be subject to different appraisal methods, tax regimes, and inheritance laws, all of which affect value.
Unlike US citizens, expatriating Green Card holders do get one advantage in that their tax basis on their assets are deemed to be the fair market value at the date US residency started; this could be a huge advantage, for example, to an immigrant who owned US properties before obtaining a Green Card.
Pre-planning Opportunities
Pre-planning before expatriation could be very beneficial, especially for Green Card holders. For example, the intended expatriate might gift assets to a family member to reduce the assets subject to the Exit Tax. Gift Tax issues must be considered, but the current large exclusions can make gifting attractive, especially with sophisticated estate planning. Cash and possibly hard assets, can potentially be removed from the exit tax assessment through a carefully constructed offshore but U.S. compliant "private placement" life insurance policy. If the policy cash value is owned or controlled by the expatriate, it would be considered as asset; therefore the policy might be owned by a Trust, or written to disallow early termination or have other limitations on control. There may be other planning opportunities.
Gift and Estate Tax Consequences
The Exit Tax is only the beginning of negative tax consequences to the expatriate. The Act imposes a new and quite punitive estate and gift tax regime. After expatriation, future direct and indirect gifts or bequests by the expatriate to US beneficiaries will be subject to tax at the highest applicable gift or estate tax rate. It must be noted that the estate and gift taxes for the purposes of the Act are imposed on the US beneficiaries. Gift taxes are normally the obligation of the donor, and estate taxes are normally assessed on the estate. One must wonder why Congress thought it important to penalize expatriates for an unlimited period after expatriation.
Enforcement would seem problematic. For example, is US beneficiary receiving a distribution from a foreign trust created directly or indirectly by an expatriate obligated to pay the gift tax? The US beneficiary is required to report the distribution from a foreign trust in excess of USD10,000, but the reporting form (3520) does not provide for identifying whether the Trust was established by an expatriate.
US Estate Tax is based on domicile, unlike Income Tax which is based on citizenship or residency. Therefore it is possible for a noncitizen permanent resident to have a foreign domicile which will exclude non-US assets from US Estate Tax. It appears that the long term resident who expatriates could lose this planning opportunity if his or her beneficiaries are US citizens.
An exception to the tax on gifts or bequests is that applicable charitable or marital deductions will apply. For example, if the beneficiary of the expatriate's estate is a US citizen spouse, the bequest should not be considered a "covered" gift or bequest. The US beneficiary can in any case deduct from Income Tax any tax paid on the distribution. The annual gift exemption tax exemption applies but not gifts for medical and educational expenses under Section 2503(e).
The Act imposes additional tax burdens on covered expatriates:
* All assets in a Grantor Trust are deemed sold at market value (mark to market).
* IRS or other tax deferred retirement accounts are deemed distributed; subsequent distributions are adjusted to account for taxes paid.
* Other IRS sections relating to extensions for tax are inapplicable.
* Future distributions from a domestic or foreign Non-Grantor Trust are subject to 30% withholding. (The IRS may find it difficult to enforce this rule against bona fide foreign Non-Grantor Trusts).
* With respect to the generation skipping tax (GST), the Act may preclude the tax free transfer by an expatriate of non-US property to, for example, grandchildren. Before this new law, non-US sited property was not subject to the GST.
Affirmative Action Required
The Act requires an affirmative action by any person expatriating, and not just by "covered expatriates". Each expatriate must sign a declaration under penalty of perjury they he/she has complied with all tax laws for five years prior to expatriation. Failure to do so, regardless of net-worth, will cause such person to be subject to the new tax regime including the Exit Tax. Form 8854 is also required, and additional required forms are likely.
Conclusion
Perhaps an unintended result of the Act is that it may discourage qualified foreign persons from taking long-term jobs in the US. While there are various visas available, the Green Card may be the only way to qualify for a long-term US assignment, and for the Investment Visa. In any case, a Green Card holder meeting the net worth threshold should at least consider limiting his or her US presence to less than eight years. Furthermore, the Act may negate the sources of revenue it was created to attract by discouraging high net-worth individuals from immigrating to the US.
Clearly, a foreigner with sufficient assets should carefully consider the consequences of applying for permanent US residency. If a Green Card is issued, permanent residency is measured from the date of the application. As is always the case when new tax rules penalize free mobility, pre-planning before expatriation is essential. Advance pre-immigration planning can be very effective to either eliminate or reduce both income tax and exit tax exposure.
