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Part 6 – Understanding “Exit Taxes”



John Richardson 13

Part 6 – “Surely, expatriation is NOT worse than death! The two million asset test should be raised to the Estate Tax limitation – approximately five million dollars – It’s Time”

Introduction

Many Americans abroad have had their lives turned upside down by the combination of FATCA and the enforcement of U.S. “place of birth” taxation. Those who are “long term” residents abroad find themselves caught between a “rock and a hard place”.

On the one hand they can’t afford the costs and complexity of filing U.S. tax returns.

On the other hand, many “middle class” Americans abroad cannot relinquish their U.S. citizenship (freeing themselves from the complexity of U.S. tax laws and the IRS) without paying the U.S. an “Exit Tax”.

Many Americans abroad can neither afford to comply with U.S. tax laws nor afford to relinquish U.S. citizenship.

The “Exit Tax”

Yes, many “long term” U.S. citizens abroad are in a position where they are forced to “buy their freedom from the U.S. Government”. I am reminded of one of Ronald Reagan’s great speeches where he noted, that when it comes to Americans:

“The price of our freedom has sometimes been high. But, we have never been willing to pay that price”.

I often wonder what President Reagan would have thought of the America today. Yes, the United States of America has joined some of the nastiest regimes in history with it’s “Exit Tax”. (Well, we all know, there must be a good policy reason for it. Just ask your Congressman.)

Not all Americans abroad are subject to the “Exit Tax”. Only “covered expatriates” are subject to the “Exit Tax”.

The obvious question is:

“How does somebody become a “covered expatriate?”

The rules governing “Tax responsibilities on expatriation” are found in S. 877A of the Internal Revenue Code.

The S. 877A rules combined with S 877 (2) reveal that somebody is a “covered expatriate” and therefore subject to the “Exit Tax” if one fails at least one of the following three tests:

Test 1 – Tax Compliance Test – The “relinquisher” cannot certify that he has been compliant with the provisions of the Internal Revenue Code for the five years preceding the year of expatriation.

Test 2 – Income Test – The “relinquisher” has had an average U.S. tax liability (the amount that is payable to the IRS) of approximately $155,000 U.S. dollars for the five years prior to the year of expatriation.

Test 3 – Asset Test – The “relinquisher” has a “net worth” of only two million dollars. No, the two million is NOT a typo. And yes, one would think that a person with an income that would generate a tax liability of $155,000 would suggest that a person would have to have a net worth far in excess of two million U.S. dollars. In a previous post, I have demonstrated the disastrous and unjust effects of the low “asset threshold” on middle class Americans abroad. Two million dollars may sound like a lot of money. It is not.*

Speaking of that two million threshold – It’s the “principal residence stupid”

The two million threshold is so low that a home owner in Toronto, Vancouver, London, Paris or most other major centers is likely to meet the two million net worth test. Yet, they remain “middle class people”.

A brief diversion – U.S. citizenship in Canada and the principal residence

If a U.S. citizen in Canada sells his house, all he can do is buy a house worth 23.8% less (after paying the U.S. capital gains tax.) Canadian citizens who are also U.S. citizens will find it more difficult to move to another house. (In fairness, please remember that a U.S. citizen is entitled to a $250,000 deduction from the capital gains.)

Is the two million dollar asset threshold reasonable a reasonable amount to trigger the “Exit Tax”?

The purpose of this post is to explore this question.

The starting point is (I suppose) to consider the questions of:

What is an expatriation? What is the significance of ceasing to be a U.S. citizen? Why should the U.S. care at all?

These are three questions and I will approach them in order.

1. What is an expatriation?

By relinquishing U.S. citizenship a person ceases to be subject to the U.S. tax system. Remember that the U.S. taxes based on citizenship and NOT based on residence.

2. What is the significance of ceasing to be a U.S. citizen?

The U.S. loses the ability to tax the relinquisher on world income. The U.S. also loses the ability to impose an “Estate” tax on the individual. In effect, a person who relinquishes U.S. citizenship might as well be dead. From the perspective of the U.S. government (whose citizens have meaning only as taxpayers) the U.S. loses the ability to tax the person during (1) the rest of his life and (2) on his death.

3. Why should the U.S. care about an expatriation at all?

The answer is clear – the U.S. cannot tax the person anymore. Both death and expatriation mean the person leaves the U.S. tax system. Since, death and expatriation are (from the perspective of the U.S. government functionally equivalent), I suggest that:

The tax consequences of “expatriation” should NOT be worse than the tax consequences of death. In other words, one should NOT be subjected to the Exit Tax with a net worth that is less than what would trigger the the “Estate and Gift” tax.

A trip down memory lane – Internal Revenue Code S. 877 – “Expatriation to avoid tax”

How did the “Net Worth” test compare to the lifetime “Estate and Gift Tax” exemption?

1996 – 2004 – Prior to the creation of the “Tax Citizen”

Historical US Gift Tax Exemption: http://wills.about.com/od/understandingestatetaxes/a/gift-tax-chart.htm  – 1996: S. 877(a)(2) Net worth test $500 thous twice Gift tax exemption $600 thous

The S. 877 rules as they were during the period (prior to June 3, 2004) are here:

USCODE-1996-title26-chap1-subchapN-partII-subpartA-sec877

Notice two things:

– in 1996 the “net worth” was $500,000, but it WAS indexed to inflation. By 2004 the effects of indexing worked to make it higher

– the “net worth” test of $500,000 and the the 1997 “Estate and Gift” tax limitation of $600,000 were closely aligned

2004 – 2008 – The creation of the “Tax Citizen” and the American Jobs Creation Act

Historical U.S. Gift Tax Exemptions http://wills.about.com/od/understandingestatetaxes/a/gift-tax-chart.htm  – 2004: S. 877(a)(2) Net worth test of 2 mil twice Gift tax exemption of 1 mil

The provisions of the 2004 American Jobs Creation Act took effect on June 3, 2004. This was of great significance, because it created the concept of the “Tax Citizen”* (explained by Virginia La Torre Jeker here).

The American Jobs Creation Act made two major changes:

– it created the concept of the “Tax Citizen” by requiring those who relinquished U.S. citizenship to BOTH notify the State Department AND file an information return (Form 8854) with the IRS in order to cease being a U.S. citizen for tax purposes; and

– it set the “net worth” test to two million dollars BUT the “net worth” amount of two million dollars was NO longer indexed to inflation

This was accomplished in S. 604 of the American Jobs Creation Act which is here:

BILLS-108hr4520ih

which resulted in a a brand new S. 877 which is here:

USCODE-2005-title26-chap1-subchapN-partII-subpartA-sec877

Notice that:

– the “net worth” test was now two million and the “Estate and Gift” tax exemption was one million. In other words, the “net worth” test was twice the “Estate and Gift” tax exemption

2008 – Present – The continuation of the “Tax Citizen” and the modern day “Exit Tax”

The provisions of the 2008 HEART Act took effect on June 16, 2008. This was of great significance, because it created the modern “Exit Tax” and continued the concept of the “Tax Citizen”* (explained by Virginia La Torre Jeker here). All of this may be found in S. 877A of the Internal Revenue Code.

Notice that:

– in 2008 the “net worth” test continued to be two million dollars and the “Estate and Gift” tax exemption was only one million dollars.

– the “net worth” test was never an amount that was less than the “Estate and Gift” exemption and since 2004 has been greater than the “Estate and Gift” tax exemption!

2015 – The relationship between the two million net worth test and the current “Estate and Gift” tax exemption of $5,430,000

Notice that the “net worth” test for the purposes of expatriation is now significantly less than the “Estate and Gift” tax exemption of $5,430,000.

Conclusion:

Surely “expatriation” is NOT worse than death. In each case the person ceases to be a “U.S. taxpayer”. At present, the S. 877A “Exit Tax” operates in the following way:

Many “middle class” U.S. citizens abroad, who worked and saved a lifetime for retirement, by investing in assets outside the United States, who then renounce U.S. citizenship will have to pay the United States a tax based on:

1. The increase in the value of their principal residence located outside the United States

2. The increase in value in other assets they have anywhere in the world including outside the United States

3. A tax based on treating the present value of their pension located as outside the United States as ordinary income

4. A tax based on treating their RRSP located outside the United States as ordinary income.

The result will be the confiscation of between 20 and 50% of their retirement assets LOCATED OUTSIDE THE UNITED STATES.

That’s what the S. 877A rules really mean in application.

Surely, if this is to continue the threshold for the “net worth” test in S. 877 should be raised to the amount of the “Estate and Gift” exemption of $5,430,000 and should be indexed to inflation.

Original Post By:  John Richardson

Next:  Part 7 – Understanding “Exit Taxes” – “Why 2015 is a good year for many Americans abroad to relinquish U.S. citizenship – It’s the exchange rate”

 

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. Shovel says:

    Irrespective of how wrong Reagan is/was in what he said, the quote beneath the Reagan video above needs a couple of edits in order to match what the man’s actual words were.

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