Most U.S. cross-border tax advisors concentrate on the income tax side of expatriation. In the year when U.S. citizenship or permanent residence is given up, a special “mark-to-market” income tax is imposed on certain “covered expatriates.” They must file Internal Revenue Service Form 8854 listing their worldwide assets and potentially pay a special exit tax on the appreciation in such assets in excess of a baseline exemption amount. This so-called “exit” tax is imposed at the highest U.S. capital gains rate, currently 23.8%. The tax has been well publicized when compared to its cousin, the U.S. inheritance tax under Internal Revenue Code Section 2801, which is far more pernicious and dreaded by well-versed tax advisors because it’s more elusive and can endure for many years following the actual date of expatriation.
U.S. Estate Tax Reach
As domestic estate tax practitioners know, the U.S. estate tax is a wealth tax imposed on all the assets owned or controlled by a decedent at the time of death. An expatriate is either a former U.S. citizen or a permanent legal resident of the United States (Green Card holder). Expatriates typically no longer live full-time in the United States.
The U.S. estate tax is imposed on worldwide assets of a U.S. citizen or on a non-citizen who lives in the United States and is considered domiciled in the United States. “Domicile” under the U.S. transfer tax system is defined in a manner that equates to domicile under the Anglo-American common law concept.1 “Residency” is defined for U.S. transfer tax purposes in Treasury Regulations Sections 20.0-1(b) and 25.2501-1(b). An individual becomes a U.S. domiciliary by living in a place, even for a brief period, with no present intention to leave there, and a later intent to change domicile won’t be effective unless the individual actually leaves. This highly subjective test for transfer tax purposes is in stark contrast to the mechanical and objective income tax residency rules. Individuals who are citizens or Green Card holders will, with few exceptions, be considered income tax residents. Others will be subject to the substantial presence test, a bright-line test based on the number of days spent in the United States over a period of three years.2 Domicile, on the other hand, has nothing to do with an individual’s visa status. A U.S. Green Card holder living permanently outside the United States might be considered domiciled outside the United States for U.S. transfer tax purposes, even though such individual has ongoing U.S. income tax obligations on his worldwide income and must satisfy other U.S. tax reporting requirements. An individual living in the United States with no immigration status but no current intent to leave would likely be domiciled in the United States.
Someone who’s neither a U.S. citizen nor domiciled in the United States for transfer tax purposes (commonly referred to as a “non-citizen, non-domiciliary” (NCND)) isn’t subject to U.S. estate tax or generation-skipping transfer (GST) tax on worldwide assets. Only assets that are owned (or controlled) by the NCND individual at death and are located in the United States are subject to U.S. estate tax and GST tax (known as “U.S. situs assets”). The most obvious U.S. situs asset is real estate situated in the United States. Stock issued by U.S. corporations is less obvious, but it too is considered a U.S. situs asset for estate tax purposes (but not for gift tax purposes). Debts owed by U.S. individuals that are held by expatriates are also treated as U.S. situs assets and may include certain U.S. bonds. As such, an individual who expatriates from the United States may nonetheless continue to have exposure to the U.S. estate tax and GST tax on assets that he leaves behind in the United States. These assets must be reported on a U.S. estate tax return (Form 706-NA) with only a very limited $60,000 exemption amount.
Who’s an Expatriate?
An “expatriate” is a former U.S. citizen or long-term resident. A “long-term resident” is an individual who’s been a permanent legal resident of the United States (that is, a Green Card holder) during eight of the previous 15 years. This is often referred to as the “8-of-15-year test.”
The act of expatriation itself is relatively straightforward and ordinarily the result of an affirmative action by the individual. An affirmative act of expatriation would typically occur when the individual formally renounces citizenship or the long-term resident voluntarily gives up his Green Card. Abandoning Green Card status is typically accomplished by filing with the U.S. Citizenship and Immigration Service (USCIS) or a consular officer a USCIS Form I-407.
Any individual who’s planning on expatriation and his U.S. tax advisor are likely aware of the significant U.S. income tax consequences (exit tax liability) that can occur when the act of expatriation results in the dreaded “covered expatriate” status. This status can come into play when an expatriate satisfies any one of three criteria. He: (1) has a prior U.S. tax compliance failure, (2) exceeds an average income tax liability, or (3) exceeds a net worth threshold. Different planning before and after expatriation may be appropriate depending on whether an individual is a covered expatriate. Sometimes, there may be uncertainty whether an expatriating executive of a start-up, private company is above the net worth threshold because this often comes down to a question of the value of illiquid stock in a non-public company that’s subject to a stock restriction agreement. An outside appraisal is highly recommended.
Certifying Full Compliance
An individual is a covered expatriate if he has a prior U.S. tax non-compliance issue. An expatriating Green Card holder must certify to the IRS on Form 8854 that he’s in full compliance with all U.S. tax obligations for the last five years. Most foreign executives are provided with U.S. tax return preparation services of a qualified accounting firm with international tax expertise, so non-compliance is unlikely. However, for those long-term Green Card holders who didn’t engage knowledgeable U.S. tax preparation services on entering the United States, this prong of the statute can be difficult to overcome without now engaging a U.S. tax accountant to undertake a costly and time-consuming forensic-like analysis of the preceding five taxable years of U.S. tax filings.
Compliance failures can include failing to file U.S. income tax returns, report income or pay tax due. Even more problematic is that a prior tax compliance failure also includes failing to electronically file a FinCen Form 114 Report of Foreign Bank and Financial Accounts (FBAR) with the U.S. Treasury. Long-term Green Card holders who are U.S. taxpayers may have failed to file any one of a number of U.S. information returns including for a controlled foreign corporation (CFC) (Form 5471) or perhaps the somewhat duplicative Form 8938. Tax compliance is required for all information returns that aren’t even tax returns. This imposes a very high bar for many Green Card holders to satisfy, especially those living outside of the United States, as English isn’t their first language, and they may be unfamiliar with the intricacies of the U.S. tax system.
Covered Expatriate Status
IRC Section 877A exit tax. Once considered a covered expatriate, the individual will be deemed to have sold all of his worldwide assets at a fair market value (FMV) on the date of expatriation. Any resulting gain in excess of the allowable exemption of $725,000 (inflation-adjusted amount in 2019) is taxed at the top capital gains tax rate of 23.8%. Various nuances can apply for assets that aren’t realizable, such as deferred compensation arrangements and options to defer payment of the tax on illiquid assets (subject to an interest change). Cash isn’t a realizable asset.
IRC Section 2801 inheritance tax. The lesser known cousin of the exit tax, the inheritance tax, can be far more draconian in applying to wealth accumulated outside the United States long after terminating Green Card status and can apply to U.S. beneficiaries who weren’t even born when an individual abandoned Green Card status. This inheritance tax provision has been part of the U.S. Tax Code since 2008.
A U.S. individual who inherits assets (or receives a gift or foreign trust distribution) from a covered expatriate must pay a U.S. inheritance tax under Section 2801. This is the opposite of the U.S. estate tax that taxes the transferor; here, the U.S. recipient pays a U.S. tax because of the covered expatriate status of the former long-term Green Card holder on the date of formally abandoning Green Card status (or former U.S. citizen on the date of turning in his U.S. passport).
The inheritance tax rate is the highest gift tax rate in existence at the time of the inheritance (currently 40%). Unlike the U.S. gift tax, which is tax exclusive, the U.S. inheritance tax is tax inclusive. The gift tax under Chapter 12 is imposed on the amount the donee receives, whereas the inheritance tax under Chapter 15 is imposed on the gross value received by U.S. heirs. The inheritance tax is reduced by gift or estate tax paid to a foreign country on such transfer.
A most difficult feature of the inheritance tax to grasp is that it takes effect on the date of expatriation by a Green Card holder and continues in perpetuity until all assets of such individual have been distributed. Inheritance tax consequences for the family of a former Green Card holder who’s a covered expatriate are just beginning on the date of expatriation. The tail period of inheritance tax exposure is open-ended. Most pernicious is the notion that a former Green Card holding covered expatriate who’s only moderately wealthy when he expatriates from the United States (that is, worldwide net worth slightly above $2 million), but then becomes extremely wealthy following departure from the United States, faces the prospect that all of his wealth may potentially be subject to the U.S. inheritance tax to the extent it’s distributed to family or friends who are U.S. citizens or residents when received by them.
Clearly, the inheritance tax can be imposed on property not even owned by the former Green Card holder on the date of expatriation (that is, the inheritance tax is imposed on after-acquired property) so long as he was a covered expatriate on such date. Moreover, the inheritance tax can be imposed on non-U.S. situs property that wouldn’t be subject to U.S. estate tax were it held at death by a NCND of the United States. The result is the same regardless of whether the covered expatriate created the wealth himself after departing the United States or inherited the wealth from another foreign relative. The U.S. inheritance tax is imposed on all property passing to U.S. individuals.
Special rules apply to gifts or bequests from covered expatriates to trusts. A domestic trust is treated as a U.S. citizen and is subject to inheritance tax in the year a transfer from a covered expatriate is received by the trustee. The tax consequences of transfers to a foreign trust are deferred until the foreign trust makes an actual distribution to a U.S. individual. A special election is available that enables a foreign trust to be treated as a domestic trust for inheritance tax purposes and accelerate the taxable event.
There are some exceptions to the inheritance tax. If a bequest will simultaneously be subject to U.S. estate tax (that is, because the covered expatriate owned U.S. situs assets) and the inheritance tax under Section 2801, then only the estate tax is applied. If the recipient of a bequest is a U.S. citizen and the surviving spouse of the covered expatriate, the inheritance tax doesn’t apply because the bequest qualifies for the unlimited marital deduction, and the transfer tax is postponed until such U.S. spouse subsequently transfers the property. If the spouse isn’t a U.S. citizen, a transfer by a former Green Card holder who was a covered expatriate to a qualified domestic trust for the benefit of such non-U.S. citizen spouse won’t be subject to the inheritance tax (but will be subject to U.S. estate tax as distributions of principal are made to the surviving spouse no later than the death of such U.S. citizen spouse). Gifts under the small gifts limit (currently $15,000) will also escape the inheritance tax.
The Green Card Dilemma
Often, the best and easiest immigration strategy isn’t ideal from a U.S. tax perspective. Permanent legal resident status (a Green Card holder) is generally the most flexible and secure immigration status short of U.S. citizenship; however, it can have both short-term and long-term adverse tax consequences. A Green Card is generally valid for five years, while many other immigration visas must be renewed annually. In the case of an individual who’ll hold a Green Card for more than seven years and is a covered expatriate, the potential risk of the U.S. mark-to-market exit tax and the onerous never-ending U.S. inheritance tax should make immigrating executives and individuals of wealth coming to the United States pause and reconsider obtaining a Green Card. By simply avoiding becoming a Green Card holder when moving to the United States, such immigrant will never become a long-term resident who ceases to be a lawful
permanent resident, and therefore, such individual can never become a covered expatriate.
In the short-run, an individual who obtains a Green Card who’s only in the United States for a few weeks a year will expose himself to the bewildering tax compliance problems of a U.S. taxpayer with overseas bank accounts. In addition, such individual might encounter more burdensome compliance problems if he owns a controlling interest in a CFC or holds foreign mutual funds in his investment portfolio. The U.S. Global Intangible Low Taxable Income and Subpart F rules now impose shareholder level tax on the business income and portfolio income of any CFCs regardless whether a cash dividend is paid to shareholders. The U.S. Passive Foreign Investment Company rules impose onerous reporting and adverse income tax results on U.S. taxpayers who own foreign passive investment corporations (for example, foreign mutual funds). Such individual would be better off exploring whether he can claim tie-breaker relief under an applicable treaty.
Most of the other interim options for entry into the United States are tax neutral because unlike having a Green Card, they don’t automatically make an immigrant to the United States a resident for income tax purposes, and they don’t carry with them the twin burdens of the exit tax and inheritance tax on departure and beyond. Foreigners working in the United States should engage experienced immigration counsel and inquire about alternatives to obtaining a Green Card so that they may meet their work and personal needs while in the United States. An individual who isn’t a U.S. citizen and who doesn’t obtain a Green Card can’t be considered a covered expatriate, even if he becomes a former U.S. resident for income tax purposes because he no longer satisfies the substantial presence test.3 An individual could satisfy the substantial presence test for decades, and while considered a U.S. income tax resident for all those years, such individual isn’t at risk of having to pay exit tax and inheritance tax, which are only imposed on long-term Green Card holders who are covered expatriates on the date of expatriation.
An incoming executive or other somewhat wealthy immigrant would be better off renewing periodic work visas and delaying obtaining a Green Card as long as possible to delay the beginning of the running of the 8-of-15-year test. This allows more time to attempt to plan around the exit and expatriation taxes. Avoiding permanent resident status might also be helpful in preserving foreign domicile for transfer tax planning purposes because only U.S. situs assets are subject to gift tax. Holding a Green Card is evidence, but not determinative, of residency (domicile) in the United States for transfer tax purposes.
Many incoming foreign individuals, especially those from Asia, maintain stronger family, social and economic ties in their home or originating country than in the United States. Too often, uninformed immigrants moving to the United States don’t know about the possible tie-breaker relief available under a bilateral income tax treaty between their home countries and the United States. Before obtaining a Green Card, these individuals should inquire about their possible eligibility for the tie-breaker rules under a treaty to continue to claim income tax residency in their home country based on their center of vital interests being located in the home country.
There are basically only two ways for a Green Card holder to avoid long-term resident status. The Green Card holder can either make an income tax treaty election (Form 8833) to be taxed as a resident of another country or give up Green Card status, which must occur in or before the seventh year before satisfying the 8-of-15-year test.
New immigrants must carefully keep track of their years in the United States. If the exit tax or inheritance tax is a serious risk for such immigrant on departure from the United States, he’ll want to abandon his Green Card in or before the seventh year after receiving it. As an alternative, before the end of the seventh year, an immigrant to the United States might consider definitively moving to another country that has a tax treaty with the United States and making an election on his U.S. tax return to be taxed as a resident of that country and a nonresident of the United States. This should toll the running of the 8-of-15-year test required to become a covered expatriate on eventual abandonment of Green Card status. However, for the incoming senior executive who’s accompanied by his family to the United States, such treaty relief may not be available as he’s effectively moving his family’s center of their economic and social lives to the United States. Moreover, executives from South America don’t have this treaty relief available to them because the United States has no income tax treaties with any of these countries.
It Follows
As noted, the inheritance tax regime can follow a former Green Card holder for years after he officially abandons permanent resident status in the United States or his estate long after his death. The most common profile is a foreign executive who, along with his spouse and dependent children, is on extended assignment to the United States and are, or will become, Green Card holders as permanent U.S. residents. The foreign executive and spouse may plan to leave the United States and abandon lawful permanent resident status when the executive’s assignment in the United States ends, at which point they would want to turn off their U.S. income tax reporting obligations.
For purposes of this test, any part of a tax year in which the individual is a Green Card holder counts as a year. Planning to sidestep the inheritance tax, however, should begin well before the seventh and final year during which a Green Card holder can avoid covered expatriate status by not being tagged as a long-term resident of the United States.
Unintentional Act of Expatriation
An unintended expatriation could occur if a long-term resident executive who satisfies the 8-of-15-year test moves to one of the many countries that has an income tax treaty with the United States and takes a treaty-based position providing relief.4 If this occurs, the individual is deemed to have expatriated for purposes of the exit and inheritance tax regimes even if not intended.5 To avoid such unintended expatriation, the foreign executive would have to continue to file his U.S. income tax return and not take advantage of a treaty (which often reduces U.S. tax liability). As long as the executive who’s met the 8-of-15-year test and is a long-term resident continues to file his U.S. tax return without treaty relief, he may be able to undertake other common planning strategies for avoiding classification as a covered expatriate before filing the USCIS Form I-407 to abandon U.S. residency. However, all Green Card holders must ensure they don’t first adopt a treaty-based return position after they’ve satisfied the 8-of-15-year test.
There’s a planning opportunity available for the Green Card holder who’s moved to a treaty country from the United States but who hasn’t yet met the 8-of-15-year test. In an unusual twist, such individual who’s now a resident of a country that has an income tax treaty with the United States may toll the accruing of years under the 8-of-15-year test by filing a U.S. income tax return and taking advantage of treaty relief.6 By continuing to file his U.S. income tax return claiming a treaty benefit, the not-yet covered expatriate living abroad tolls the accrual of years under the 8-of-15-year test. By taking a treaty-based position on a U.S. tax return before the end of the seventh year, this individual can give up his Green Card when desired during the tolling period and thereby avoid the exit tax and inheritance tax. However, during the years the individual has tolled the 8-of-15-year test, he must file Form 1040NR reporting all U.S. source income and comply with FBAR filings on all foreign bank accounts as well as Form 5471.
Avoid Covered Expatriate Status
Becoming tax compliant. An individual who would otherwise not be a covered expatriate but for past tax compliance failures should consider correcting them before he expatriates. Correcting prior tax compliance failures could be expensive as additional taxes, interest and penalties may be due. Often, a foreigner enters into the IRS Foreign Offshore Streamlined Procedures program, which requires filing amended tax returns going back three years and FBARs going back six years. Recognizing that certain individuals need to come into compliance to expatriate, the IRS announced a new program in September 2019 to provide relief procedures for non-willful cases of certain U.S. citizens.7 Note: The new program is only available to eligible accidental Americans and isn’t available to Green Card holders or other U.S. tax residents, such as those who satisfy the “substantial presence” test.
Keep U.S. average income tax liability below the threshold. An individual isn’t a covered expatriate if his average U.S. income tax liability for the five years preceding expatriation is below $167,000 (subject to inflation). The tax statute computes income tax liability after taking into account foreign tax credits. This means that a high income executive Green Card holder now residing in a high tax foreign country (for example, the United Kingdom, Germany or France) may fall below this threshold because his actual U. S. income tax liability may be mostly or fully offset by foreign tax credits. If so, the actual tax liability due to the United States may be well below the $167,000 threshold. It might also be possible to fall below this threshold through greater use of deferred compensation, stock options in lieu of cash compensation and investment in municipal bonds and non-dividend-paying stocks.
Reducing net worth through pre-expatriation gifts. The expatriating long-term Green Card holder isn’t a covered expatriate if he has a net worth below $2 million as of the date of expatriation (that is, the filing Form I-407). The net worth test offers significant planning opportunities; however, it may be impossible for many expatriating foreign executives and entrepreneurs with significant accumulated worldwide wealth to reduce their net worth below this amount.
Pre-expatriation gifts can serve at least two purposes. First, the expatriate may make gifts that cause him to stay below the $2 million threshold and thereby avoid covered expatriate status. A gift in trust may also be viable as discussed below. Second, a covered expatriate may make selected pre-expatriation gifts of his most highly appreciated worldwide assets to minimize the anticipated exit tax.
Here’s where it gets confusing. For purposes of determining whether an individual is a covered expatriate, the IRS determines net worth based on gift tax principles. On the other hand, in applying the exit tax, the IRS values a covered expatriate’s assets on estate tax principles.8 This methodology produces a harsh result for an asset in which the covered expatriate retains only a life estate, having given away the residuary interest. Only the value of the life estate counts toward an expatriate’s net worth, but the value of the entire asset, including the residuary interest given away, is subject to the exit tax.
All expatriates, covered or non-covered, must file Form 8854. That form requires a statement “explaining changes in your assets and liabilities for the five years preceding expatriation.”
Once the individual’s net worth is comfortably below $2 million, the Green Card holder could safely file Form I-407 with the USCIS and turn in his Green Card. Of course, that individual must file his final U.S. income tax return as a resident alien, not claim any treaty relief on such return and remain in full compliance with all U.S. tax and reporting obligations.
If the executive is still residing in the United States and is considered a U.S. domiciliary, traditional gift planning strategies may be appropriate. Valuation discounted gifts of non-voting interests in business or investment entities using the current generous $11.4 million gift and estate tax exemption amounts may enable the executive to reduce his net worth below $2 million. If the expatriating executive is transferring illiquid hard-to-value assets, he has the burden to establish the FMV of such assets, which is best achieved by obtaining a formal written appraisal accompanied by Form 709 demonstrating proper gift tax reporting of such asset. The departing executive must then report this value on Form 8854.
If the executive’s spouse is a U.S. citizen, there’s an unlimited gift tax marital deduction. If the spouse is a non-citizen, the executive is limited to a current annual marital deduction amount of $155,000. If the spouse is also expatriating, these marital gifts can only be used to the extent they don’t cause the spouse to become a covered expatriate. More importantly, gifts to a spouse may be unnecessary if the marital assets are subject to community property laws common in most civil law countries and some U.S. states. Of course, the U.S. advisor must consult with foreign country counsel to determine whether the couple’s country of nationality may impose a forced heirship regime that might be violated by transfers to a spouse.
No longer living in United States. Although as a Green Card holder living abroad, an individual remains a U.S. resident for income tax purposes, he may no longer be a U.S. resident (domiciliary) for U.S. transfer tax purposes. A Green Card holder who clearly settles in a new country, or perhaps resettles in his country of origin, even for a brief period of time and with no current intention of moving on, will become a domicile of the new country and will cease to be a resident (domiciliary) of the United States for gift tax purposes. The good news is that the Green Card holder residing in a new country (or country of origin) won’t incur U.S. gift tax on worldwide assets but will only incur U.S. gift tax if the asset in question is real estate or tangible personal property (for example, artwork or jewelry) having a situs in the United States. However, these gifts must be made before expatriation from the United States, which means before formally turning in the Green Card (that is, submitting Form I-407) or filing a U.S. income tax return on which a treaty-based position (tax relief) is claimed.
Local Counsel
Seasoned U.S. foreign tax experts recognize the importance of involving local counsel or tax advisors on the possible application of the law of the new jurisdiction. Most of Europe, Latin America and parts of the Far East are community property regimes for succession law purposes. Moreover, a transfer could result in inheritance or gift tax consequences in the new country of residence. For example, in the United Kingdom, an outright gift isn’t taxable so long as the donor survives for seven years.
—In Part 2 of this article, we’ll elaborate on the scope of the inheritance tax and consider possible workarounds as well as highlight the lack of certainty and incomplete guidance from Treasury.
Endnotes
1. See Internal Revenue Code 2501(a)(1).
2. See IRC Section 7701(b).
3. An individual will be considered a U.S. resident for income tax purposes if he meets the substantial presence test for the calendar year. To meet this test, the individual must be physically present in the United States on at least 31 days during the current year and 183 days during the 3-year period that includes the current year and the two years immediately before that, counting all the days the individual was present in the current year and one-third of the days the individual was present in the first year before the current year and one-sixth of the days the individual was present in the second year before the current year.
4. Dual residents use Form 8833 to disclose a treaty-based return position.
5. See“Internal Revenue Service FAQ About International Individual Tax Matters, Green Card Holders,” Question 3, last sentence, which states, “If you are a long-term resident and you claim treaty benefits of another country pursuant to a tax treaty you may be subject to the expatriation tax.”
6. IRC Section 877(e)(2).
7. The IRS recently announced a new voluntary compliance program specifically aimed at so-called “accidental Americans” who’ve relinquished, or intend to relinquish, their U.S. citizenship and who wish to come into compliance with their U.S. income tax and reporting obligations in preparation for filing Form 8854. For example, this program would be available to individuals who were born to a U.S. citizen parent but who may never have lived or worked in the United States, who have a net worth less than $3 million and whose aggregate income tax liability for the taxable year of expatriation and the five prior years is less than $25,000. Individuals who successfully comply with this new program will avoid being taxed as a covered expatriate.
8. See IRS Notice 2009-85.