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Part 3 – Understanding “Exit Taxes”



“The “Exit Tax” affects “covered expatriates” – what is a “covered expatriate”?”

In a FATCAesque world, where “relinquishments” are becoming a form of “self defense”, it’s important that you understand:

Issue A – Who is affected by the Exit Tax? What is a “covered expatriate”? Only “covered expatriates” are subject to the “Exit Tax”

1. What are the sections of the Internal Revenue Code that govern the Exit Tax?

2. Who is subject to the “Exit Tax” and why?

3. What are the consequences of being subject to the Exit Tax?

Issue B – Okay, I’m a “Covered Expatriate” How am I affected by the Exit Tax?

4. How the Exit Tax is calculated in general – what is subject to the “Exit Tax” – to be discussed in Post 4

5. How the Exit Tax is likely to affect Americans abroad – Five scenarios – to be discussed in Post 5

Please note that this discussion assumes that one has relinquished U.S. citizenship under the “Immigration and Nationality Act” after June 16, 2008 (the date that the Exit Tax provisions became law). Different rules can apply to expatriations prior to June 16, 2008. See this summary which comes from the IRS site:

irs.gov/Individuals/International-Taxpayers/Expatriation-Tax

Let’s begin our journey.

Issue A – Who is affected by the Exit Tax – What is a “covered expatriate”? Only “covered expatriates” are subject to the “Exit Tax”

1. What are the sections of the Internal Revenue Code that govern the Exit Tax?

The provisions of the Internal Revenue Code that matter are:

– S. 7701(a)(50) which means that one is a U.S. citizen until one satisfies the requirements of S. 877A(g)(4)

– S. 877A which provides the framework for the Exit Tax

– S. 877(a)(2) which defines the meaning of “Covered Expatriate”

– S. 2801 which imposes taxes on the recipient of a gift or bequest from a Covered Expatriate

2. Who is subject to the “Exit Tax” and why?

Those relinquishing U.S. citizenship are either “expatriates” (who are NOT subject to the Exit Tax provisions) or “covered expatriates” who are subject to the Exit Tax provisions.

The key question is what triggers “covered expatriate status”. The answer depends on whether you were born ONLY a U.S. citizen or whether you were born a “dual citizen” and are a resident of and subject to taxation in your country of residence/second citizenship. Those who relinquish before the age of 18 1/2 receive preferred treatment.

There appear to be four categories of people who “relinquish” U.S. citizenship and become “expatriates”:

(i) Born ONLY a U.S. citizen and relinquish over the age of 18 1/2:

You will be a “covered expatriate” if you meet any one of the following three tests:

– Too much income – based on your U.S. tax liability (average of approximately $155,000 (which is indexed to inflation) per year for the preceding five years;

– Too many assets – net worth of only 2 million (which is NOT indexed to inflation) U.S. dollars. Note that through inflation or fluctuations in the U.S. exchange rate, people will become “covered expatriates”

– Tax compliance test – not U.S. tax compliant (meeting the requirements of Title 26) for each of the 5 years preceding the year of relinquishment

Conclusion: Hang on for the ride. You will see how the “Exit Tax” has its most disastrous effects on those born in the U.S., are older than 18 1/2, are NOT born dual citizens, and who left the U.S. to make a life elsewhere. The longer you live outside the United States the worse the “Exit Tax” is likely to be.

(ii) Born a U.S. citizen who relinquishes prior to the age of 18 1/2:

You will be a “covered expatriate” only if you fail to certify that you have been U.S. tax compliant for the 5 years preceding your relinquishment AND you have lived in the United States for not more than 10 years.

Conclusion: Nice to keep in mind for your children. This is extremely important for children who are the beneficiaries of wealth (often trusts). This is probably a good reason for wealthy children to be “whisked out of the United States” at a very young age. Saving the “family fortune” may depend on it.

(iii) Born a U.S./Canadian dual citizen and living in Canada, who has NOT lived in the U.S. for more than 10 of the 15 years preceding the year of “relinquishment” (or substitute your country of second citizenship):

You will be a “covered expatriate” only if you fail to certify that you have been U.S. tax compliant for the 5 years preceding your relinquishment

Conclusion: It pays to have had the good luck to have been born a dual citizen (which is nothing but an accident of location of birth or citizenship of your parent(s)). “Oh Canada, my home and native land …”

(iv) Born a U.S./Canadian dual citizen, who is over the age of 18 1/2, and who is NOT living in Canada on the date of the relinquishment

You will be a “covered expatriate” and treated as one who was born ONLY a U.S. citizen who is over the age of 18 1/2. In other words the same as category (i) above.

Conclusion: Dual citizens who plan to relinquish U.S. citizenship should consider where they are residing when they relinquish. Some people return home to die. Some people return home to relinquish U.S. citizenship.

3. What are the consequences of being subject to the Exit Tax?

There are three consequences:

– you will be subject to the Exit Tax rules and will have to pay the United States a tax (in addition to taxes costs of U.S. tax compliance and the $2350 renunciation fee charged by the U.S. government to renounce U.S. citizenship)

– any gift that you give to a “U.S. person” will be subject to a 40% tax payable by the recipient of the gift (in other words you can’t give or will anything to an American relative)

– you will carry the stigma of being a “covered expatriate”. There are a number of U.S. politicians who do NOT like “covered expatriates” and have threatened punitive legislation.

For example:

About 10,000 people in the last ten years have renounced their citizenship.  Not a single one has been penalized. They will be.

– Sen. Chuck Schumer

Original Post By:  John Richardson

Next: Part 4 – Understanding “Exit Taxes” – You are a “covered expatriate” How the “Exit Tax” is actually calculated

Avatar

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.

2 thoughts on “Part 3 – Understanding “Exit Taxes”

  1. Avatar Steve says:

    “About 10,000 people in the last ten years have renounced their citizenship. Not a single one has been penalized. They will be.” —– my question is WHY are US citizens being compelled to give up citizenship AND THEN be punished for doing so?

  2. Avatar Marnie says:

    How confusing! Would you still be a “covered expat” if you relinquish US citizenship and were born a dual US/Canadian citizen but are a long term resident of a European country where you are also a citizen? Or would I have to return to live in Canada in order to be able to renounce?

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