“You are a “covered expatriate” – How the “Exit Tax” is actually calculated”
How the Exit Tax is calculated in general – what is subject to the “Exit Tax”?
Remember that a person who relinquishes U.S. citizenship does not actually sell his assets or realize income from his assets. The Exit Tax is designed to ensure that the U.S. collects tax on assets as if they were sold OR as if generated an income stream (even though there is no sale). This means that one is forced to pay a massive tax when has not realized income to pay that tax!
The General Theory:
What if you left the U.S. and then sold your assets or started living from your pension? What would the taxable income have been if you had still been a U.S. citizen when the “realization event” took place? The Exit Tax calculates the tax the and makes you pay that tax as the price of relinquishing U.S. citizenship. Note that you are required to pay the “Exit Tax” without having realized any income to pay the tax.
This theory is expressed in S. 877A of the Internal Revenue Code – “Tax Responsibilities of Expatriation”. This section describes both (1) What asset is NOT subject to the “Exit Tax” and (2) what assets are subject to the “Exit Tax”.
(1) What assets are NOT subject to the “Exit Tax”?
The only assets that are NOT subject to the “Exit Tax” are pensions that were built up PRIOR to your becoming a “U.S. person” and property that you owned PRIOR to becoming a “U.S. person”.
This rules are described in S. 877(d)(5) S. 877(h)(2) as follows:
… shall not apply to any deferred compensation item to the extent attributable to services performed outside the United States while the covered expatriate was not a citizen or resident of the United States.
Solely for purposes of determining any tax imposed by reason of subsection (a), property which was held by an individual on the date the individual first became a resident of the United States (within the meaning of section 7701 (b)) shall be treated as having a basis on such date of not less than the fair market value of such property on such date. The preceding sentence shall not apply if the individual elects not to have such sentence apply. Such an election, once made, shall be irrevocable.
This is interesting.
– pensions earned OUTSIDE the U.S. BEFORE becoming a U.S. citizen or Green Card holder are NOT subject to the “Exit Tax”.
– pensions earned OUTSIDE the U.S. AFTER becoming a U.S. citizen or Green Card holder ARE subject to the “Exit Tax”.
– for the purposes of the “mark to mark” rules, the cost basis will be deemed to be the value of the property on the date the person became a U.S. resident. In other words, the Exit Tax will apply ONLY on the increase in value in the property after the person became a U.S. resident.
Notice that the U.S. tax system is based on jurisdiction over the person regardless of where the “person” or “property” exists.
Theoretical underpinnings of “citizenship taxation”: The basic premise of “citizenship taxation” assumes that a country has a “property interest” in the individual. Once a citizen, you owe “allegiance” to the U.S., and are (in effect) the property of the U.S. government. Because YOU are U.S. government property, all of YOUR property becomes the property of the U.S government.
The 1924 U.S. Supreme Court decision Cook v. Tait confirms, the fact that the person or property exists outside the United States is irrelevant. The decision in Cook v. Tait also reveals the court’s thinking on what “citizenship” was understood to mean in 1924.
Justice McKenna writing for the court ruled that:
“The contention was rejected that a citizen’s property without the limits of the United States derives no benefit from the United States. The contention, it was said, came from the confusion of thought in “mistaking the scope and extent of the sovereign power of the United States as a nation and its relations to its citizens and their relations to it.” And that power in its scope and extent, it was decided, is based on the presumption that government by its very nature benefits the citizen and his property wherever found, and that opposition to it holds on to citizenship while it “belittles and destroys its advantages and blessings by denying the possession by government of an essential power required to make citizenship completely beneficial.” In other words, the principle was declared that the government, by its very nature, benefits the citizen and his property wherever found and, therefore, has the power to make the benefit complete. Or to express it another way, the basis of the power to tax was not and cannot be made dependent upon the situs of the property in all cases, it being in or out of the United States, and was not and cannot be made dependent upon the domicile of the citizen, that being in or out of the United States, but upon his relation as citizen to the United States and the relation of the latter to him as citizen. The consequence of the relations is that the native citizen who is taxed may have domicile, and the property from which his income is derived may have situs, in a foreign country and the tax be legal — the government having power to impose the tax.”
What was the U.S. Homelander attitude toward “citizenship taxation” in 1925? Thanks to Google, I was able to find an article written by Albert Levitt – a law professor during the time. He expressed his view of the decision in Cook v. Tait and “citizenship taxation” as follows:
“The decisions of the United States Supreme Court is fully supported by reason and authority. The writer is glad that this is so. There was, and is, entirely too strong a tendency on behalf of selfish citizens of the United States to call loudly for their rights to protection when abroad and at the same time to seek by legal and illegal means to evade their responsibilities and duties as citizens. A citizen who demands protection from his government should be compelled to pay for the maintenance of that protection.
Albert Levitt – Washington and Lee Law School – June 1925
(2) What assets are subject to the “Exit Tax”?
First: Deemed Capital Gains – as described in the Internal Revenue Code
(a) General rules
For purposes of this subtitle—
(1) Mark to market
All property of a covered expatriate shall be treated as sold on the day before the expatriation date for its fair market value.
We begin by identifying all of your property and then calculating the capital gain that would be payable if it were all sold.
Second: You get $600,000 (indexed to inflation) of capital gains tax free – as described in the Internal Revenue Code. This amount is higher because it is indexed for inflation
(3) Exclusion for certain gain
(A) In general
The amount which would (but for this paragraph) be includible in the gross income of any individual by reason of paragraph (1) shall be reduced (but not below zero) by $600,000.
We then exclude $600,000 (as indexed for inflation) from the total gain (more or less).
Third: (1) Pension plans (2) IRAs and (3) Interests in trusts are not subject to the capital gains rules above – as described in the Internal Revenue Code
(c) Exception for certain property
Subsection (a) shall not apply to—
(1) any deferred compensation item (as defined in subsection (d)(4)),
(2) any specified tax deferred account (as defined in subsection (e)(2)), and
(3) any interest in a nongrantor trust (as defined in subsection (f)(3)).
We now identify the assets that are NOT subject to the capital gains rules. They may be subject to worse treatment. I.e. the entire value may be included in income.
Fourth: Defines pensions – as described in the Internal Revenue Code
(4) Deferred compensation item
For purposes of this subsection, the term “deferred compensation item” means—
(A) any interest in a plan or arrangement described in section 219 (g)(5),
(B) any interest in a foreign pension plan or similar retirement arrangement or program,
(C) any item of deferred compensation, and
(D) any property, or right to property, which the individual is entitled to receive in connection with the performance of services to the extent not previously taken into account under section 83 or in accordance with section 83
Identify your pensions. The next question will be whether they are “eligible” (you can keep it) or “ineligible” (you lose it). The test as described in the Internal Revenue Code
(3) Eligible deferred compensation items
For purposes of this subsection, the term “eligible deferred compensation item” means any deferred compensation item with respect to which—
(A) the payor of such item is—
(i) a United States person
A U.S. pension is an eligible pension and is not subject to immediate tax – as described in the Internal Revenue Code (In other words you get to keep it.)
(2) Other deferred compensation items
In the case of any deferred compensation item which is not an eligible deferred compensation item—
(i) with respect to any deferred compensation item to which clause (ii) does not apply, an amount equal to the present value of the covered expatriate’s accrued benefit shall be treated as having been received by such individual on the day before the expatriation date as a distribution under the plan,
Full value of Canadian pension is included as taxable income. A Canadian pension is NOT an eligible pension. In other words:
“THE IRS” makes YOUR Pension “THEIRS”.
Fifth: A U.S. pension is an “Eligible pension” which means that only the income will be taxed when it is paid out. A Canadian (or other non-U.S. pension) is subject to immediate tax on the complete present value
Sixth: IRAs are “specified tax deferred accounts”. They are treated as paid out in full and that payment in full is taxable in full. This is because the contributions were tax deductible and the growth was tax free. As described in the Internal Revenue Code
(e) Treatment of specified tax deferred accounts
(1) Account treated as distributed
In the case of any interest in a specified tax deferred account held by a covered expatriate on the day before the expatriation date—
(A) the covered expatriate shall be treated as receiving a distribution of his entire interest in such account on the day before the expatriation date,
You will lose the IRA through taxation
These are fascinating and will demonstrate how much the Exit Tax discriminates against Americans abroad who have developed a life, career, business and investments outside the United States. You will also see the benefits of having been born a dual citizen. Finally you will see the benefits of relinquishing U.S. citizenship before the age of 18 1/2.