Expatriation And Exit Tax
Many individuals who previously took on United States citizenship as a second nationality or obtained a green card are now regretting this decision. Some individuals often incorrectly assume they can give up the US citizenship or the green card without adverse US tax consequences.
Under the so-called “expatriation” tax rules, harsh tax consequences will result if the individual giving up his US citizenship or “long-term” green card (generally, held for 8 out of the past 15 years) is a so-called “covered expatriate”. Only “covered expatriates” will suffer the onerous tax consequences. One is a “covered expatriate” if the individual has either a net worth of US$2 million at the time of expatriation; or, if he has a certain average income tax liability over the past 5 years prior to expatriation. One is also automatically treated as a “covered expatriate” if the person fails to notify the IRS that he has expatriated and satisfied all of his tax liabilities for the past five years even if he did not meet the aforementioned dollar thresholds.
In these cases, imposition of an “Exit Tax” (among other harsh tax results) will occur when one gives up his US citizenship or “long term” green card. Under the Exit Tax provisions, the individual is subject to tax on the net unrealized gain on all of his world wide assets as if such property were sold for its fair market value on the day before the expatriation date. Thus, the individual must pay US income tax on gain that he is “deemed” to have earned by operation of the Exit Tax rules, when in fact, the individual has not sold anything and is without any cash in hand with regard to the deemed sale. Naturally, this raises the issue of how the individual will fund payment of the Exit Tax.
Deferral Of The Exit Tax – Complicated And Burdensome
If a “covered expatriate” has liquidity concerns, he may make an election to defer the exit tax on a particular piece of property until it is actually disposed of (e.g., by gift, by sale etc), or even at the time the covered expatriate dies. Even if the individual makes the deferral election, he can still pay off any tax deferred together with accrued interest, at any time.
To date, not many (if any) deferral elections have actually been made. My telephone queries to the Treasury Department officials in Washington DC have been met with the equivalent of verbal blank stares. Here’s what we do know about the deferral election:
The deferral election is irrevocable. Once made, there is no turning back.
The election can be made on what is called an “asset-by-asset” basis (thus, the individual can pick and choose which properties will be covered by the election).
Interest will be charged on the deferred tax and this interest is compounded daily, starting from the due date of the return for the tax year that includes the day before expatriation. So if an individual expatriated in say, February 2013, and if the due date for his tax return would be April 15 2014, interest would start to run from that date. Since it is compounded daily, the amount can quickly escalate.
The conditions for obtaining approval for the deferral are rigorous. More on this follows below.
Adequate Security And Tax Deferral Agreement
Certain conditions must be met before a covered expatriate will be permitted to make a deferral election. Most importantly, a bond, or other security (including a letter of credit) must be provided for the tax liability. This security will be updated and monitored periodically so that the Internal Revenue Service (“IRS”) can make sure that it remains “adequate” to cover the tax debt. A big problem lies in the fact that there is really no guidance as to what constitutes “adequate security”.
A tax deferral agreement between the individual and the IRS must be signed and periodically renewed according to the terms provided in the agreement. Notice 2009-85 at Appendix A contains a template of the deferral election agreement one would have to sign with the IRS.
If the agreement is not renewed within the time frame as specified in the agreement, the collateral will be applied to the Exit Tax liability and interest. If the security is deemed inadequate at any time, the Exit Tax will become due immediately. A U.S. agent must be appointed for the limited purpose to receive communications from the IRS. Finally, all benefits under any relevant tax treaty that may affect the IRS’ ability to collect the Exit Tax must be waived.
While the immediate financial consequences of the Exit Tax may be very harsh, making the tax deferral election brings on its own set of unique problems. There is no guarantee that the covered expatriate will be permitted to enter into a tax-deferral agreement with the IRS, since this is completely discretionary with the IRS. It is very important to note that the IRS’ acceptance or rejection of an individual’s application to defer the tax would not be known until after the individual has already expatriated. So, an individual could be stuck having to pay all the Exit Tax if the IRS rejected his application and it would already be too late, since the individual will have expatriated and therefore already be liable for Exit Tax. Further, when tax-deferred property is finally disposed of, the capital gains tax rate may be higher than under current law. All this, in combination with the continuous accrual of interest on the Exit Tax that is owed and the requirement to maintain adequate security, may result in an extremely difficult financial burden.