U.S. citizens and permanent residents are subject to US income tax on their worldwide income regardless of where they reside in the world. In order to free oneself from the U.S. income tax, U.S. citizens or permanent residents must expatriate from the U.S. to become nonresident aliens. U.S. expatriates may be subject to the expatriation tax provisions under Internal Revenue Code (IRC) sections 877 and 877A. If you expatriated after June 16, 2008, you may find yourself to subject an immediate mark-to-market tax on your worldwide assets as well as possible tax liabilities if you are a “covered expatriate”.
Who are covered expatriate?
A “covered expatriate is either a U.S. citizen or Long-Term Resident who relinquishes, abandons or loses either his or her U.S. citizenship or permanent resident status and as of the day before expatriation, meet one of the following conditions:
- An average annual net income tax liability over the prior 5 years ending before the date of expatriation or termination of residency is more than a specified amount that is adjusted for inflation ($145,000 for 2009 and 2010, $147,000 for 2011, and $151,000 for 2012)—tax liability test..
- a net worth is $2 million or more on the date of your expatriation or termination of residency—net worth test.
- failed to certify on Form 8854 that he or she has complied with all U.S. federal tax obligations (including employment, gift tax, and information returns) for the 5 years preceding the date of your expatriation or termination of residency—certification test.
There are two exceptions that may exclude a U.S. citizen from otherwise being as a “covered expatriate”, if:
- the expatriate became a U.S. citizen and a citizen of another country at birth and, as of the expatriation date, continues to be a citizen of, and is taxed as a resident of, such other country, and has been a U.S. resident for not more than 10 taxable years during the 15 taxable year period ending with the taxable year during which the expatriation date occurs; or
- the expatriate relinquishes U.S. citizenship before the age of 181/2 and has been a U.S. resident for not more than 10 taxable years before the date of relinquishment.
The mark-to-market regime
The IRC 887A mark-to-market regime generally means that all property of a covered expatriate is deemed sold for its fair market value on the day before the expatriation date. IRC 887A further provides that any gain arising from the deemed sale is taken into account for the taxable year of the deemed sale notwithstanding any other provisions of the Code. Any loss from the deemed sale is taken into account for the taxable year of the deemed sale to the extent otherwise provided in the Code, except that the wash sale rules do not apply.
There is some relief to the mark-to-market tax. The covered expatriate may exclude the first $600,000 of gain, which amount is to be adjusted for inflation for calendar years after 2008 (the “exclusion amount”). For calendar year 2010, the exclusion amount as adjusted for inflation is $627,000. For calendar year 2011, the exclusion amount is $636,000. For calendar year 2012, the exclusion amount is $651,000. The amount of any gain or loss subsequently realized (i.e., pursuant to the disposition of the property) will be adjusted for gain and loss taken into account under the IRC 877A mark-to-market regime, without regard to the exclusion amount.
A covered expatriate may make an irrevocable election (“deferral election”) with respect to any property deemed sold by reason of section 877A(a) to defer the payment of the additional tax attributable to any such property (“deferral assets”). The deferral election is made on an asset-by-asset basis. In order to make the election with respect to any asset, the covered expatriate must provide adequate security and must irrevocably waive any right under any U.S. treaty that would preclude assessment or collection of any tax imposed by reason of section 877A. In addition, the covered expatriate must enter a tax-deferral agreement with the IRS which includes, among other things, appointment of a U.S. agent. If such an election is made to defer the mark-to-market tax, the deferred tax must be paid once the property is actually disposed of.
There are three groups of assets that will not be subject to the mark-to-market tax but are subject to other taxes upon expatriation or upon receipt: (1) deferred compensation items, (2) specified tax deferred accounts, and (3) interests in a nongrantor trust of which the covered expatriate was a beneficiary on the day before the expatriation date. If a covered expatriate has one or more of these types of accounts or interests the day before expatriation, Form W-8CE must be filed with each payor of any of these items within 30 days of expatriation. This form effectively notifies the payor of such account or interest that the covered expatriate is subject to these special tax rules.
Deferred compensation items are divided into “eligible deferred compensation items and “ineligible deferred compensation items”. In the case of “eligible deferred compensation items,” section 877A(d)(1)(A) provides generally that the payor must deduct and withhold from any taxable payments to a covered expatriate with respect to such items a tax equal to 30 percent of the amount of those taxable payments. In the case of “ineligible deferred compensation items,” section 877A(d)(2)(A) provides that a covered expatriate generally is treated as having received an amount equal to the present value of the covered expatriate’s accrued benefit on the day before the expatriation date.
In the case of specific tax-deferred account items, the expatriate is treated as receiving his or her entire interest in the account on the day before expatriation. However, actual subsequent distributions will be adjusted for tax purposes taking into account this deemed distribution.
With respect to nongrantor trusts of which the covered expatriate was a beneficiary as of the day before expatriation, the trustee must withhold thirty percent of the taxable portion of any direct or indirect distribution of property to the covered expatriate. The expatriate, however, may elect to be taxed immediately on his or her interest in the trust, effectively reducing or canceling the withholding requirement on subsequent distributions. The taxable portion is the portion that would be included as income if the expatriate were subject to tax as a U.S. citizen. If property is distributed to the covered expatriate, the trustee must declare any gain as if the property was sold for its fair market value on the date of distribution to the covered expatriate. This withholding rule applies to both domestic and
foreign nongrantor trusts.
Filing and report requirements
Unless the taxpayer’s expatriation date is January 1, the covered expatriate will file a “dual status return” for the year in which expatriation occurs. The dual status return requires preparation of both Form 1040NR and Form 1040 attached as a schedule.
All U.S. citizens who relinquish their U.S. citizenship and all long-term residents who cease to be lawful permanent residents of the United States must file Form 8854 in order to certify, under penalties of perjury, that they have been in compliance with all federal tax laws during the five years preceding the year of expatriation. A covered expatriate must file Form 8854 with the covered expatriate’s Form 1040NR or Form 1040, whichever is applicable, for the covered expatriate’s taxable year that includes the day before the expatriation date.
A covered expatriate who makes a deferral election must list all deferral assets on Form 8854 for the taxable year that includes the day before the expatriation date, as well as the amount of deferred tax attributable to each deferral asset. The covered expatriate also must file Form 8854 annually for taxable years up to and including the taxable year in which the full amount of deferred tax and interest is paid.
