Americans tend to be a relatively patriotic group, even when life’s journey takes them overseas to live. However, as many Americans become settled over time in a new country, it is only natural that they adapt to the culture, the language, the environment, etc. and adopt a new country as their “home.” Many of our expat clients acquire dual citizenship after spending significant time in a new residence country, or are able to acquire a second passport even faster due to the nationality of their parents or grandparents.
Unfortunately, and quite unfairly, the retention of U.S. citizenship often then becomes a special burden to them, because of the unique laws of the United States that base income tax residency on citizenship, not on actual residency. Accordingly, the U.S. “dual national,” who may feel the ties to the U.S. ever fading, is also a “dual tax resident,” meaning that they are also subject to income taxation on worldwide income, from all sources, in both their new “home” country and the United States. Moreover, should they choose to gift wealth during their lifetime, or bequeath their wealth to others at death, the gift, estate and/or inheritance tax laws of both countries may stake a claim to tax these wealth transfers.
Complications for Long-Term U.S. Residents
There is another, larger group of U.S. taxpayers that may find themselves in this same situation: long-term U.S. residents. These are noncitizens that held a U.S. green card and lived in the United States for eight years in any fifteen-year period. Once you become a long-term resident, U.S. tax residency permanently follows you when you leave the United States, whether the long-term resident returns to their home country or elsewhere. They may let their green card expire, but the tax residency is not so easily shed.
Severing Ties with U.S. Tax Residency
There is a way out for both the U.S. citizen abroad and the U.S. long-term resident abroad that wants to sever ties with their burdensome U.S. tax residency: Formal expatriation, first through immigration filings renouncing long-term resident status (Form I-407) or citizenship (State Department Form 4079, Form 4080, Form 4081, and Form 4082), followed thereafter in a final U.S. tax resident form 1040 filing, accompanied with special expatriation tax filing form IRS Form 8854 (the Expatriation Statement).
As a financial advisor who has had many client and prospective client discussions regarding the tax consequences, formal tax process, and tax-minimization strategies concerning expatriation, I will focus on the tax aspects of expatriation rather than get into the less familiar weeds of the surrendering of green cards or passports. I have only one point to emphasize on initiating the process through an expatriating act (Form I-407 or Forms 4079-4082): Do NOT go through with this until you have worked out the details of the tax filings and statements associated with expatriation, discussed below, and conclude that this is the right time to set this process into motion.
Form 8854 and “Covered Expat” Status
Form 8854 is, essentially, a declaration of the expatriate’s complete balance sheet as of that day before they formally expatriated (the “valuation date”). It must include all the items that would be considered to be in their taxable estate if they were to have died on the day before she formally expatriated. Valuations of assets ranging the gamut, including real estate, art and jewelry, private business ownership interests, etc. must be attested to by licensed appraisers, while pensions, retirement accounts, brokerage accounts must be listed and provide their market values as of that same date. In addition to itemized valuations as of the valuation date, cost basis information must also be provided, for reasons that will be made clear below. Moreover, the expatriating individual must also make an attestation that they made full, complete and accurate tax filings to the U.S. Department of Revenue for the last five years.
The expatriation statement, tax returns over the preceding five years, and personal attestation of complete transparency and accuracy will help determine the most critical element of expatriation, namely, whether the expatriating individual will be deemed to be a covered expatriate. This status will largely determine the financial and consequences of expatriation, now and into the future. If covered expat status is avoided, the expatriating individual will pay their last U.S. federal tax bill as a tax resident (reporting worldwide income) for the year (or partial year) before expatriating and then, thereafter, would only be liable for U.S. taxes on U.S. source income, and subject to the U.S. tax withholding rules that apply to non-U.S. persons.
However, should the circumstances trigger the key status as a covered expatriate, additional financial obligations ensue. First, the covered expatriate will owe an exit tax, above and beyond ordinary income tax obligations, in the year of expatriation. More details of the exit tax may be the subject of an article focussing on this particular subject, but, to summarize briefly:
- The exit tax is calculated as if the expatriating individual sold all of their assets provided on Form 8854 the day before expatriating, meaning that all unrealized gains at that time are now, in-fact, realized. This is subject to a special exemption on the first $737,000 of realized gains (2020, adjusts annually); and
- For retirement accounts, the exit tax is calculated as if the expatriating individual took full distribution of the pension, deferred compensation plan, retirement plan or IRA account. As this is ordinary income to the expatriate, the capital gains exemption above does not reduce taxes owed from these implied distributions. For qualified retirement plans like 401(k)s, but not IRAs, there is an ability to defer the tax from this implied distribution to when actual distributions are made, subject to special conditions, including application of the 30% withholding tax on each distribution and the waiver of the future right to reduce this withholding rate by tax treaty.
The burdens do not stop with the exit tax, either. Additionally, the covered expat will be deterred in the future from gifting or bequeathing assets to U.S. tax residents, such as family members that do not expatriate. Gifts and bequests from a covered expatriate are not entitled to a gift or estate tax exemption, and are taxed at the maximum tax rate by law on the entirety of the gift or bequest (currently 40%, or even 80% on generation-skipping gifts or bequests). This tax is actually paid by the beneficiary/recipient U.S. tax resident.
Covered Expat Status “Test”
By now, given the punitive taxation that accompanies the covered expat status, it is obviously critical to understand the test for acquiring this unfortunate status and the exceptions that otherwise prevent the triggering of covered expat status. Basically, the covered expat status is triggered by any one of three tests – fail any of the there following tests, and the expatriating individual shall be deemed a covered expat:
- The Compliance Test – As mentioned above, the expatriating person must certify they have been compliant with federal tax laws over the past five years. Failure to certify and/or failure to submit adequate evidence to substantiate compliance will result in covered expat status. Expect extra scrutiny of these tax forms during the process.
- High Income Tax Liability Test – Looking at those past five years of tax returns, the expatriating individual will be deemed a covered expatriate if their average federal income tax liability over the five-year period exceeds $172,000 (2021, adjusted annually). Do not confuse this with annual income or adjusted gross income – the standard is an actual tax liability on average per year exceeding $172,000, which implies high earnings and/or significant capital gains realization during part or all of those five years.
- High Net Worth Test – Looking at the balance sheet of the individual taxpayer, as submitted in Form 8854, including substantiation of the valuation of assets and liabilities, if the expatriating person’s net worth on the valuation date exceeds $2 million, the expatriate shall be deemed a covered expat. Remember, joint assets should be apportioned between individuals, so this is an individual net worth threshold, not a joint threshold. Unlike the high income tax liability test, the $2 million threshold does not adjust to account for inflation.
It should come as little surprise that this third test, high net worth, is more often the test that triggers covered expat status, especially considering that net worth covers each and every item that would fall within the expatriating person’s taxable estate. However, getting around either of those tests’ thresholds may be a matter of timing, or, especially in case of the high net worth test, a matter of strategically repositioning family wealth among family members.
There are a couple of important exceptions for those that would otherwise fail the covered expat tests:
- Dual nationals from birth (oftentimes considered “accidental Americans”), who have lived in the U.S. less than 10 of the previous 15 years prior to the year of expatriation, who continue to be citizens and tax residents of that other country for which they hold citizenship; and
- Citizens who expatriate before the age of 18 ½ , who were resident of the United States for less than 10 years.
Remember that all expatriating persons must still file Form 8854 and go through the tax process of expatriation, even though these two groups may do so without fear of being deemed a covered expatriation.
Conclusion: A Complex Process Demands Upfront Professional Planning
To generally recap the tax rules regarding expatriation – the procedure for eliminating tax residency on the basis of citizenship or long-term residency status – the expatriating person must commit an expatriating act and complete the tax filing and certification process outlined above. For the citizen, this will involve forms and procedures to formally terminate citizenship, e.g., surrendering of the U.S. passport. For a long-term tax resident, this might involve voluntarily surrendering your green card. Letting a green card expire without renewal, by itself, may not be an expatriating act. Therefore, the completion of Form I-401, entitled “Record of Abandonment of Lawful Permanent Resident Status,” is critical to establish intent to expatriate for long-term residents. This will then trigger the obligation to complete Form 8854 and certify compliance with U.S. federal tax laws.
During this tax process to conclude expatriation, a critical factor determining the real cost to get out of U.S. tax residency will be whether covered expat status is triggered. Because the consequences of that status can be so punitive in the present (exit tax) and thereafter to the American beneficiaries or heirs, it seems only logical to suggest that the expatriating person get some meaningful tax and financial advice well in advance of committing the expatriating act. In particular, if there is any real possibility that the three tests for covered expatriation could be met, and the two exceptions for covered expats will not apply, then developing and implementing a comprehensive strategy for expatriation with experienced financial and tax professionals may prove pivotal to navigating this process without creating unnecessary tax burdens for the expatriating person and their American families.
How We Can Help
At Walkner Condon, our international team of financial advisors is here to help guide clients that want to consider the possibility of expatriation. The first step of the process may be to determine what real tax advantage would flow from successfully expatriating. This requires an analysis of both U.S. and resident country tax laws and whatever tax treaties or compacts may factor in the distribution of tax payments by the client to each country.
If there may be financial relief to be gained through expatriation, then an evaluation of whether the client would meet the covered expat criteria, or, importantly, whether there are steps necessary prior to expatriation to either (a) avoid covered expatriate status, (b) at least reduce the exit tax consequences, or (c) modify estate plans to reduce the gift and/or estate tax consequences flowing from the decision to expatriate.
Ultimately, if a general strategy map toward expatriation is formulated, we’ll make sure that clients also get the tax and legal expertise needed to successfully implement that strategy and successfully navigate the complex rules of formal expatriation. It begins with a conversation, and we’re here to provide knowledge, support and advice that is helpful and impactful.