The Treasury Department just released its “Name and Shame” List for the third quarter of this year. The list shows that for the third quarter, 1,376 Americans renounced their US status. With this figure, the current 2016 record-high of renunciations (5,411) may be toppled. It is clear that the number of individuals divorcing the US continues to rise unabated. The number of published expatriates for the first two quarters of 2017 already reached the skyrocketing number of 3,072 (first quarter 1,313 + second quarter 1,759). With the third quarter results, the tally now stands at 4,448, paving the way for easily breaking the 2016 record (a mere 964 expatriations in the fourth quarter will do it).
Boris Johnson, the former mayor of London officially divorced the United States last year. Apparently, many are following in Boris’ footsteps…. Including the aptly named Mr. John Quitter.
Before having your Boris Johnson / John Quitter moment, here is some basic US tax information about expatriation, “covered expatriate” status and the unfortunate tax consequences associated with that status:
Am I a “Covered Expatriate”?
Under the US expatriation rules, an individual will be treated as a “covered expatriate” if any of the following tests apply:
- The individual’s average annual net income tax for the 5 years ending before the date of expatriation or termination of residency is more than a specified amount that is adjusted for inflation ($162,000 for 2017 and $165,000 for 2018).
- The individual’s net worth is $2 million or more on the date of expatriation or termination of residency (note that this dollar amount is not indexed for inflation and has remained the same many years).
- The individual fails to certify on Form 8854 that he or she has complied with all US federal tax obligations for the 5 years preceding the date of expatriation or termination of residency.
The tax certification requirement is usually the most troublesome provision for so-called “Accidental Americans” who reside outside the US, and are often blissfully unaware of their US tax filing duties until they learn of their unpleasant surprise.
What Happens If I Am a “Covered Expatriate?”
If any one of the three tests is triggered, the individual is classified as a so-called a “covered expatriate”.
Under the “Exit Tax” or “Mark-to-Market” regime, generally, all property owned by the covered expatriate worldwide is treated as sold for its fair market value on the day before the expatriation date. This ‘phantom’ gain is then taken into account for the tax year of the deemed sale and subject to tax, usually at capital gains rates.
An exception for a certain amount of gain (which is adjusted annually for inflation) is provided in the tax law. On account of this exception, some individuals may not be impacted by the “Exit Tax”. The amount of gain that can escape tax is $699,000 for 2017 and $713,000 for 2018. See the Internal Revenue Service announcements for inflation adjustments for 2018 here.
In addition, a 3.8% “net investment income tax” will likely also apply to this deemed gain if certain modified adjusted gross income thresholds are met. The Exit Tax must be computed via one’s Form 1040 with the gain or loss being reported on the relevant part of the 1040 for the part of the year that the taxpayer is still considered a US person. You can read more here about the 3.8% surcharge and how it impacts US persons abroad. Let’s keep our eye on this one, as repeal of the NIIT has been bandied about recently.
The tax burdens don’t stop there. Onerous tax rules apply to the covered expatriate’s deferred compensation plans and specified tax deferred accounts.
Special Transfer Tax
In addition to the Exit Tax, US recipients of any gift or bequest at any time in the future from the “covered expatriate” will be hit with a special tax upon receiving that gift or inheritance under Code Section 2801. In essence, this is an alternative way for the US to recoup US Gift or Estate taxes that it would otherwise have received (upon the making of lifetime gifts, or upon death) had the individual not given up his US citizenship or long-term residency. Currently, the tax rate is 40% and must be paid by the US recipient on the value of the gift or bequest from the covered expatriate (e.g., if the covered expatriate leaves a $1,000,000 bequest to his US citizen son, the son must pay $400,000 to the IRS pursuant to Section 2801. Ouch!).
US recipients of a gift or bequest from a former American should be ready for what appears will be an uphill battle with the IRS about the taxability of their gift or inheritance, since the burden of proving that the person was not a “covered expatriate” is firmly placed on the recipient. Do you know how to protect US recipients of your gifts/ bequests from a 40% take by the IRS? My colleagues and I have been brain-storming about what should be done now in order to prepare for this likely scenario. I am available to discuss possible planning.
Let’s keep our eye on this one! If the US Estate tax is repealed as suggested in recent tax reform proposals, what will happen to this transfer tax?
Get the Right Advice
Individuals who plan to divorce the US should have a complete understanding of the laws regarding “expatriation”. The individual must carefully examine the rules for tax filings that are required (for example, Form 8854 and the final income tax returns reflecting dual status tax years). These issues, as well as possible tax planning, should be discussed with a tax professional before you kiss the USA good-bye.
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