Exit Tax for U.S. Expatriates Becomes Law

New rules impose tax on expatriates and withholding requirements on trustees

As more and more people vote with their feet, the U.S. Congress repeatedly threatened to enact legislation aimed at U.S. citizens who expatriate.  Congress finally made good on those threats by unanimously passing the Heroes Earning Assistance and Relief Tax (HEART) Act (the ‘Act'), which provides tax relief for active duty military personnel and reservists.

The new tax regime applies to certain individuals who relinquish their US citizenship and certain long-term U.S. residents (i.e., green card holders) who terminate their U.S. residence (hereafter referred to as ‘expatriates'). The so-called ‘mark-to-market' tax will apply to the net unrealized gain on the expatriate's worldwide assets as if such property were sold (the ‘deemed sale') for its fair market value on the day before the expatriation date.  Any net gain on this deemed sale in excess of US$600,000 will be taxable.

In addition, trustees of non-grantor trusts must withhold and pay over to the IRS 30 percent of the portion of any distribution (whether direct or indirect) that would have been taxable to the expatriate had he not expatriated.  Failure to withhold the tax could subject the trustee to direct liability for the unpaid U.S. tax.

The Act became law on 18 June, 2008.

Individuals Covered

The Act applies to any expatriate if that individual (i) has a net worth of US$2 million or more; (ii) has an average net U.S. income tax liability of greater than US$139,000 for the five year period prior to expatriation; or (iii) fails to certify that he has complied with all U.S. federal tax obligations for the preceding five years (the ‘covered expatriate').

The Act contains two exceptions, which are broader than those contained in current law.  An individual is not a ‘covered expatriate' if he certifies compliance with US federal tax obligations as specified in item (iii) above, and: (i) he was at birth a citizen of the U.S. and another country, provided that (a) as of the expatriation he continues to be a citizen of, and a tax resident of, such other country, and (b) he has been a resident of the U.S. for no more than 10 of the 15 taxable years ending with the taxable year of expatriation; or (ii) he relinquished U.S. citizenship before reaching the age of 18 ½, provided that he was a resident of the U.S. for not more than 10 taxable years before relinquishment.

In General

The Act consists of three key elements:

1. The mark-to-market tax on the covered expatriate's worldwide assets;

2. A tax on certain gifts and bequests made by the covered expatriate to any US person; and

3. A repeal of the current so-called 10-year shadow period for covered expatriates.

The Mark-to-Market Tax

As noted above, the mark-to-market tax will apply to the net unrealized gain on the covered expatriate's worldwide assets as if such property were sold for its fair market value on the day before the expatriation date to the extent that the net gain exceeds US$600,000.

However, the mark-to-market tax will not apply to (i) certain deferred compensation items; (ii) certain specified tax deferred accounts; or (iii) any interest in a nongrantor trust.

A.      Deferred Compensation Items

Under the Act, certain deferred compensation items will be subject to the mark-to-market tax.  For purposes of this calculation, the covered expatriate is deemed to receive the present value of his accrued benefit on the day before the expatriation date.  No early distribution excise tax applies by virtue of this treatment, and appropriate adjustments must be made to subsequent distributions from the plan to reflect such treatment. 

Other qualifying deferred compensation items will not be subject to the mark-to-market tax; however, the payor must deduct and withhold a tax of 30 percent from any taxable payment to a covered expatriate.  A taxable payment is subject to withholding to the extent it would be included in the gross income of the covered expatriate if such person were a U.S. citizen or resident. 

B.      Specified Tax Deferred Accounts

Under the Act, the mark-to-market tax will apply to certain specified tax deferred accounts.  In the case of any interest in a specified account held by a covered expatriate on the day before the expatriation date, the expatriate is deemed to receive a distribution of his entire interest in the account on that date.  Appropriate adjustments are made for subsequent distributions to take into account this treatment.  Such deemed distributions are not subject to additional tax. 

C.       Interests in Non-Grantor Trusts

The Act makes a distinction between grantor trusts and non-grantor trusts.  A grantor trust is ignored as a taxable entity for U.S. federal income tax purposes.  The ‘owner' of a grantor trust must include in computing his personal tax liability the items of income, deduction and credit that are attributable to the trust.  Therefore, in the case of the portion of any trust for which the covered expatriate is treated as the owner under the grantor trust provisions, the assets held by that portion of the trust are subject to the mark-to-market tax.

The mark-to-market tax does not generally apply to non-grantor trusts. Rather, in the case of any direct or indirect distribution from the trust to a covered expatriate, the trustee must deduct and withhold an amount equal to 30 percent of the distribution portion that would be includable in the gross income of the covered expatriate if he were subject to U.S. income tax.  The covered expatriate waives any right to claim a reduction in withholding under any treaty with the U.S.  The Act does not explain how the withholding will be enforced against a non-U.S. trustee of a trust.

In addition, if the non-grantor trust distributes appreciated property to a covered expatriate, the trust recognizes gain as if the property were sold to the expatriate at its fair market value.

If a non-grantor trust becomes a grantor trust of which the covered expatriate is treated as the owner, such conversion is treated as a distribution to the covered expatriate and will trigger the 30 percent withholding tax. 

Conversely, if a grantor trust becomes a non-grantor trust after the individual expatriates, it appears that the mark-to-market tax will apply to assets in the grantor trust, and the 30 percent withholding requirement will not apply to the trust once it becomes a non-grantor trust.  This is an important point because the grantor's expatriation commonly converts grantor trusts into non-grantor trusts.

Tax on Gifts and Bequests to U.S. Citizens or Residents

The Act taxes certain ‘covered gifts or bequests' received by a U.S. citizen or resident.  The tax, which is assessed at the highest marginal estate or gift tax rate at the time of the gift or bequest, applies only to the extent that the covered gift or bequest exceeds $12,000 during any calendar year.  The tax is reduced by the amount of any gift or estate tax paid to a foreign country with respect to such covered gift or bequest.  No allowance appears to exist for the $1 million exemption from U.S. gift tax or the $2 million exemption from U.S. estate tax normally granted to U.S. persons.  Gifts or bequests made to a U.S. spouse or a qualified charity are not subject to the tax.

In the case of a covered gift or bequest made to a U.S. trust, the tax applies as if the trust were a U.S. citizen, and the trust is required to pay the tax.  In the case of a covered gift or bequest made to a foreign trust, the tax applies to any distribution, whether from income or corpus, made from such trust to a recipient that is a U.S. citizen or resident in the same manner as if such distribution were a covered gift or bequest.

Repeal of 10-Year Shadow Period

Current law subjects expatriates to a so-called 10-year shadow period, which results in a covered expatriate being taxed as a U.S. citizen in any of the 10 years following expatriation in which the expatriate spends 30 days in more in the U.S. In addition, current law taxes expatriates on all U.S. source income and gain during the shadow period.

Under the Act, individuals who expatriate on or after the date of enactment will not be subject to the shadow period but will instead be subject to the mark-to-market tax and the tax on gifts and bequests to U.S. citizens and residents.

Effective date

The Act will be effective as of the date of enactment and will therefore not apply to those individuals who expatriate prior to its enactment.  Enactment occurs upon the signature of the President or 10 days after the Act is presented to the President if he does not veto it.

The White House has not issued an official position on the Act, but given the veto-proof margin by which the Act passed in both houses of Congress and the Act's emphasis on active duty members of the military, most commentators believe that enactment is imminent.

Conclusion

In light of the Act, individuals who are considering expatriation should consider the substantial new tax burdens that this action will generate. Those persons who expatriate after the enactment date and who are considering making gifts or bequests to U.S. persons in the future should also review their planning.  In addition, trustees should very carefully consider whether trust beneficiaries are covered expatriates before making any distribution without withholding U.S. tax.  Trustees who fail to become familiar with the new rules do so at their peril.

For purposes of the Act, an individual is treated as having relinquished his citizenship on the earliest of four possible dates:  (i) the date on which he renounces his U.S. nationality before a diplomatic or consular officer of the U.S.; (ii) the date on which he furnishes to the U.S. Department of State a signed statement of voluntary relinquishment of U.S. nationality confirming the performance of an expatriating act; (iii) the date on which the U.S. Department of State issues a certificate of loss of nationality; or (iv) the date on which a U.S. court cancels a naturalized citizen's certificate of naturalization. 

The term ‘long-term resident' means any individual (other than a U.S. citizen) who is a lawful permanent resident of the U.S. in at least eight taxable years during the period of 15 taxable years ending with the taxable years during which he ceases to be a lawful permanent resident or commences to be treated as a resident of a foreign country.

The definition of ‘non-grantor trust' includes both U.S. and non-U.S. non-grantor trusts.

An individual may elect to defer payment of the tax imposed on the deemed sale of property until the return is due for the taxable year in which he disposes of such property, but interest will apply for the period during which the tax is deferred.  This irrevocable election is made on a property-by-property basis and requires the individual to provide adequate security with respect to such property and a waiver of treaty rights that would preclude the assessment or collection of the tax.

Under certain circumstances, the mark-to-market tax may arguably apply to non-grantor trusts (i.e., where the non-grantor trust holds shares in a passive foreign investment company).

Defined as any property acquired (i) by gift directly or indirectly from an individual who was a covered expatriate at the time of such acquisition; or (ii) directly or indirectly by reason of the death of an individual who was a covered expatriate.  The definition excludes (i) any property shown as a taxable gift on a timely filed gift tax return by the covered expatriate, and (ii) any property included in the gross estate of the covered expatriate for U.S. estate tax purposes and shown on a timely filed estate tax return of the estate of the covered expatriate. 

See also, Renouncing US citizenship

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