Part 11 – Understanding “Exit Taxes”

John Richardson 20
S. 2801 of the Internal Revenue Code is NOT a S. 877A “Exit Tax”, but a punishment for the “sins of the father”

Updated September 12, 2015 – the IRS has issued “proposed rules”  governing the issue of “The sins of the father”.

The following was a comment on Part 9 of this “Exit Tax” series.

“I know many tax compliant, patriotic Americans who have renounced. Many have done so seeing the $2m threshold approaching, to protect their families and get on with their lives. All with heavy hearts.

You did not mention the additional burden on those who renounce who have US citizen relatives–the tax their relatives are supposed to pay on receiving a gift or bequest from a covered expatriate. More and more will be covered expatriates as the $2m gets smaller by reason of inflation and currency change. Although the IRS promises to give guidance on this unenforceable “succession” tax that punishes the children for the acts of their parents, so far, since 2008, we are still waiting for it. The reason for the delay is that there is probably no way of identifying those donors or deceased persons who were covered expatriates. Will the US take a FATCA approach and assume every foreign donor or deceased person is a covered expatriate unless the US recipient can demonstrate otherwise?? Certainly this law proves your point that an exit tax reflects the morality of a nation.”

Thanks for the comment. S. 2801 is NOT part of the “Exit Tax” Regime. The “Exit Tax” punishes “covered expatriates” for relinquishing U.S. citizenship. S. 2801 is to inflict further punishment after relinquishment on both the “covered expatriate” and his heirs. You will see that S. 2801 exists for one and only one purpose – the punishment of “expatriation”.

The definition of “covered expatriate” is covered in Part 3 of this series of Posts about the S. 877A “Exit Tax”.

Yes, this post will focus on Internal Revenue Code S. 2801 punishment for the “Sins of the fathers“.

Exodus 20:1-26

And God spoke all these words, saying, “I am the Lord your God, who brought you out of the land of Egypt, out of the house of slavery. “You shall have no other gods before me. “You shall not make for yourself a carved image, or any likeness of anything that is in heaven above, or that is in the earth beneath, or that is in the water under the earth. You shall not bow down to them or serve them, for I the Lord your God am a jealous God, visiting the iniquity of the fathers on the children to the third and the fourth generation of those who hate me, …

Part 1 – What does S. 2801 actually say?

Notice that this is a different section from the S. 877A “Exit Tax” rules. What S. 2801 says in this:

If a U.S. citizen, resident or U.S. trust receives a gift or bequest from a “covered expatriate” or from a “foreign trust” created by a “covered expatriate”, then

That U.S. citizen, resident of U.S. trust must pay a tax equal to the highest rate of tax – currently 40%.

There are certain exceptions and the rule is slightly more complicated than my summary above, but you get the point. The point is to ensure that a “covered expatriate” will NOT be inclined to make gifts to U.S. citizens after he/she relinquishes U.S. citizenship.

Note also that this rules applies only to gifts from “covered expatriates”. The stigma of being a “covered expatriate” is permanent. (More reasons to avoid being one.)

This rule produces results that are contrary to both the short and long term interests of the United States. Therefore, one can only conclude that the desire of Congress to impose punishment on “covered expatriates” exceeds all rationality. (They hate you because you don’t want to be one of them.)

If you haven’t figured this out, if you would be a “covered expatriate” upon renouncing and you want to make gifts to U.S. citizens, you should make the gift prior to renouncing. (Perhaps making the gift will reduce your wealth below the two million level solving your problem once and for all. But, that’s a topic for a future post.)

How the S. 2801 rules work – The creation of tax where none would have been paid.

Let’s assume a “covered expatriate” with 3 million dollars in cash. Let’s hypothesize two scenarios:

Scenario 1 – The “covered expatriate” wishes to make a present gift the $3,000,000 of cash to a U.S. citizen relative. The U.S. citizen relative will pay a 40% tax of 1,200,000. Therefore, it is unlikely that this $3,000,000 gift will be made to a U.S. citizen. In other words, the $3,000,000 will NOT be returning to the United States.

Phil Hodgen provides insightful commentary on this scenario as follows:

“Section 2801 may be one of the dumbest things in the Internal Revenue Code, and that’s saying a lot. It deliberately stops money from returning to the United States. It deliberately prevents assets from entering the tax system to generate income, gift, and estate tax.

Section 2801 gives our bloated plutocrat a reason to not leave the $50 million to his kids. The reason is a $20 million tax bill.

What happens in real life? Two possible results: Mr. Plutocrat gives nothing to his kids. “Let the Young Plutocrats make their own fortune and find their own baby seals to club to death!” Or–and this is what I see–the entire family chooses to expatriate. Bloated Plutocrat, Mrs. Plutocrat, and the Plutocrat offspring. Gone.

And as a result, $50 million of capital has permanently left the United States. The income tax generated on that capital has permanently left the United States. The jobs created by investing that capital–they don’t exist.

The money that wasn’t invested. The jobs that were not created. The entrepreneurial spirit and energy that blossomed and bore fruit outside the United States instead of inside the United States. This is the cost of Section 2801.”

Scenario 2 – The “covered expatriate” wishes to create a “foreign trust” to benefit future generations of U.S. citizens. The result of the S. 2801 rules is that the “covered expatriate” status will burden generations of U.S. citizens (including those who have not yet been born).

Patrick Martin provides excellent commentary on this situation in “The “Hidden Tax” of expatriation and its “Forever Taint“.

The application of Section 2801 requires anyone contemplating renouncing (or proving a prior relinquishment) of citizenship to strategically consider the long-term consequences to his or her family and friends.

For instance, trusts formed under the laws outside the U.S., which are funded by a “covered expatriate” that may benefit future generations, which include a U.S. citizen or resident, will have to pay the tax – currently 40%.  This tax lives on forever, as long as there are assets from the former U.S. citizen or LPR that have been funded or set aside for family or friends who are “U.S. persons” in the tax sense.

To demonstrate an extreme example, a husband/wife U.S. citizens who have $3M of cash (as their only assets) when they renounce citizenship, will have no “mark to market” tax to pay, as there will be no phantom income.  Cash has no unrealized gain.  However, if the former citizens then grow a successful business while living in their home country, such that all wealth of this business was created as non-U.S. persons outside the U.S., any future gifts or bequests to U.S. persons would be subject to a 40% tax at current tax rates.  For instance if this same person grows the company so he and his wife’s complete estate is worth US$10M at their deaths, and then bequeaths these assets to their three dual national (including U.S. citizen) children, the children will have to pay US$4M in taxes under current rates.  This is true even if none of the children live in the U.S.

This would be a very bad tax result, since if they had remained U.S. citizens, there would be no U.S. estate taxes to them under current law and the children would have received the US$10M free from all U.S. federal taxation.

Finally, this “forever taint” could live on for multiple generations.   For instance, in the above example, if the former U.S. citizens funded the US$10M in trust for the benefit  of their children, grandchildren and great-grandchildren, all of whom have dual citizenship (including U.S.), these descendents will be paying the tax under Section 2801, even if some of these family members are yet to be born on the date (i) the trust is funded, or (ii) the death of husband and wife.  This is the “forever taint.”

While the expatriate might be delighted they have no future U.S. income tax obligations during their lifetimes, if they have friends and family who will be beneficiaries of their estate, they should keep their eye on Section 2801 and its “forever taint”.

Conclusion …

The S. 2801 rules are important and need to be understood. They are unlikely to prevent “middle class” Americans abroad from renouncing citizenship. On the other hand, for high net worth individuals, the S. 2801 rules must be well understood and carefully considered.

Update – September 12, 2015

The following two tweets link to recent commentary on the IRS proposed rules:

The article referenced in the above tweet (see interesting comments at the American Expatriates Facebook group) includes:

Sec. 2801 imposes a tax, at the highest applicable gift or estate tax rates, on any U.S. person who receives a covered gift or bequest. A covered gift is defined as a direct or indirect gift from a covered expatriate within the meaning of Sec. 877A. The tax applies regardless of whether the property transferred was acquired by the donor or decedent covered expatriate before or after expatriation.

The article, by Kevyn Nightingale, referenced in the above tweet (see some very interesting comments at the American Expatriates Facebook group) includes:

Some of the people in this category, who exited after June 16, 2008, will be “covered expatriates”. There are some unpleasant tax consequences for these individuals. And remember, once you’re a covered expatriate, you’re one forever (assuming you don’t return to live in the United States).

One of these consequences is that transfers made to Americans (US citizens and tax residents) are subject to an excise tax of 40%. Writ large, a transfer is a lifetime gift or a bequest on death. Since the expatriate is no longer subject to US jurisdiction, it is the recipient who is subject to the tax.

The expatriation rules were legislated in 2008 as part of the HEROES Act. But it is taking a long time for the regulations to be put in place. Well, the Department of the Treasury has finally proposed regulations on this item just now (September 10, 2015). It plans a public hearing in January, and comments afterwards. Eventually, we will see final regulations (these new rules are not applicable until then).

Original Post By:  John Richardson

Next:  Part 12 – Understanding “Exit Taxes” – “The two kinds of U.S. citizenship: Citizenship for “immigration and nationality” and citizenship for “taxation” – Are we taxed because we are citizens or are we citizens because we are taxed?”

The Reality of U.S. Citizenship Abroad

My name is John Richardson. I am a dual citizen. I am a lawyer – member of the Bar of Ontario. This means that, any counselling session you have with me will be governed by the rules of “lawyer client” privilege. This means that:

“What’s said in my office, stays in my office.”

I am also a member of the American Citizens Abroad Professional Tax Advisory Council (PTAC). This is an advisory panel focused on assisting American Citizens Abroad in an FBAR and FATCA world.

The U.S. imposes complex rules and life restrictions on its citizens wherever they live. These restrictions are becoming more and more difficult for those U.S. citizens who choose to live outside the United States.

FATCA is the mechanism to enforce those “complex rules and life restrictions” on Americans abroad. As a result, many U.S. citizens abroad are renouncing their U.S. citizenship. Although this is very sad. It is also the reality.

One comment

  1. sheridan vernon says:

    excellent post thank you

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