The Internal Revenue Service (IRS) recently issued Proposed Treasury Regulations (“Regulations”) that will raise the fear of Armageddon in the hearts of Americans receiving gifts or inheritances from former US citizens or green card holders. The Regulations provide guidance under Internal Revenue Code Section 2801 regarding the imposition of tax on US recipients of certain gifts and bequests received from “covered expatriates”. The rules are extremely complicated, yet they must be understood and planning must be set in motion in order to prevent possible disastrous tax consequences occurring later.
Let’s take an example of a situation to which the rules might apply and see how they might work in a hypothetical case:
Our case study involves Philomena, a US citizen who held another nationality and who gave up her US citizenship. Alternatively, Philomena could have been a former green card holder, who held the card for 8 out of the past 15 years before formally relinquishing it and abandoning her US resident status. For simplicity, in either case, let’s refer to Philomena as someone who “expatriated”. At the time of her expatriation, Philomena had a net worth of USD1.2 million (fair market value of all of her assets owned around the world minus all of her legal liabilities). Philomena, a 40-year old divorced mother of one, had never owed much US income tax despite a professional degree because she had lived overseas, qualified for the foreign earned income exclusion, and worked only part-time while raising her son. Son was a dual national holding US and another citizenship. Generally, Philomena owed US tax of about USD 5,000 – 7,000 per year. Several years after her expatriation in 2009, with her son off to University, Philomena no longer had child-care duties and began working full-time. Her career flourished over the years and the consulting firm for which she worked eventually made her a partner. The years went by, Philomena invested her savings wisely, purchasing various rental properties overseas; she sold her partnership interest for a hefty sum at the age of 55, and married a wealthy foreign industrialist who gifted her a vineyard property in southern Spain as well as some exquisite jewelry. Sadly, 32 years later at the age of 72 Philomena passed away leaving her entire estate with a value of USD 6.2 million equally to her foreign husband and US dual-national son.
Her son, as a US citizen, duly filed Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts reporting that he received a bequest from a foreign person with a value over the reporting threshold of USD100,000. He provided the necessary details about his inheritance. When the IRS received the Form 3520, the agency decided to ask further questions and one of the questions asked was whether the foreign person who made the bequest to him had ever been a US citizen or long term green card holder. That’s when the trouble started……
The IRS asked Son to prove that he did not receive the bequest from a so-called “covered expatriate”. If Son could not do so, then he would be taxed at a 40% rate on what he received from his deceased mother under the punitive tax regime imposed by Code Section 2801. Son’s tax owed to the IRS would be $1.24 million (i.e., 40% x $3.1 million bequest). Son was at a loss and could not prove his mother was not a “covered expatriate”. Son explained that at the time his mother expatriated (32 years prior to death) she was not a woman of means and certainly did not have a net worth approaching the $2 million “covered expatriate” threshold (discussed below). He explained that her wealth was acquired many years after giving up her US status and he did not think the law could possibly be so inequitable that he pay a tax on the value of assets his mother came to own so many years after leaving her US status behind. The IRS kindly explained that the tax applies to gifts/bequests received from a “covered expatriate” regardless of whether the expatriate owned the property at the time of their expatriation or acquired it later. Gifts or bequests of property acquired after the “covered expatriate” had already terminated their US status are still wide open to being taxed in the hands of the US recipient. Son continued to argue that his mother was not a “covered expatriate” but because he could not come up with evidence to prove this, he lost almost half of his inheritance to the US Treasury.
What’s this all about and could Son have done anything to help avert this terrible result?
“Covered” Gifts or Bequests
Under the general tax rules, when a US person receives a gift or bequest, he need not pay tax on this item. Gifts and bequests are received tax-free to the recipient. However, the rules change pursuant to Internal Revenue Code Section 2801 if one receives a gift or bequest from certain foreign persons who previously gave up their US status (e.g., relinquished US citizenship or a green card held for a long time). Under tax laws that became effective June 17, 2008, gifts or bequests from so-called “covered expatriates” (referred to as “covered” gifts or bequests) may be taxable to the US recipient of that gift or bequest at the highest gift or estate tax rate in effect at the time of receipt. Currently, the highest Gift and Estate Tax rate is 40%.
Who is a “Covered Expatriate”?
A “covered expatriate” is an individual who was a former US citizen or long-term permanent resident if the individual met certain other requirements at the time of his expatriation.
Generally , an individual will qualify as a so-called “covered expatriate” if he meets any one of the following conditions:
- The individual’s average annual net income tax liability (this means, tax paid) 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 ($160,000 for 2015 and $161,000 for 2016). Remember, this means his average income tax paid, not his income.
- The individual’s net worth is $2 million or more on the date of expatriation or termination of residency. Remember this is based on the fair market value of WORLDWIDE assets.
- 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.
IRS Proposed Regulations
Before further discussion of the Proposed Regulations implementing Code Section 2801, it is important to bear in mind that currently, these are proposed regulations and they have not yet been adopted by the IRS and Treasury Department. They are open to public comment and generally will apply commencing with the date of their official publication as finalized Treasury Regulations. A public hearing is scheduled for January 6, 2016. It can take a considerable amount of time (many months or even years) before a proposed regulation is adopted as a final regulation. Even though proposed Regulations are not law, they cannot be ignored because they provide valuable insight as to the IRS’ position on the matters raised. While proposed regulations can be useful to gauge the IRS’s position, they are not binding on either the IRS or taxpayers.
What about prior transfers that occurred after the law became effective on June 17, 2008 when recipients did not know what would be required for reporting? The Regulations make clear that reports must be filed going back to the effective date of the tax law covering transfers made on or after June 17, 2008.
Under the IRS Regulations implementing Section 2801, the compliance burden is firmly placed on the US recipient of a gift or bequest from a foreign person to determine if the Code Section 2801 tax might apply to the recipient. What this means is that the US recipient must determine if the person from whom he received the gift or bequest was a “covered expatriate”. The Regulations propose that with the signed consent of an expatriate who is still living, the IRS will be able to disclose certain tax return information about the expatriate to the US recipient in order to help the recipient determine the donor’s “covered expatriate” status. If the living expatriate does not consent to disclosure of this tax information by the IRS, then there is a rebuttable presumption that the gift was “covered.” This means the recipient must overcome the rebuttable presumption that the gift is subject to the punitive tax regime. While the IRS has indicated that a recipient can “rebut” the presumption, the Regulations do not set out any guidelines as to how he can go about doing so.
The Regulations are not clear if this rebuttable presumption also applies in the case of a decedent who has left a bequest to a US recipient (a decedent, unlike a living breathing donor, cannot give permission to the IRS to release his prior tax returns and I am not sure if the representative of his estate can do this). Some of my colleagues think the rebuttable presumption also applies in the case of bequests/inheritances from decedents as well as gifts from living donors. Maybe it does – we must wait and see if the IRS provides clarification in due course.
Filing a “Protective” Return
The Regulations permit a US recipient of a foreign gift or bequest to file what is called a “protective” Form 708. Form 708 has yet to be prepared by the IRS, but it is the Form which must be filed when a US recipient is responsible for paying tax on “covered” gifts or bequests. Filing a “protective” Form 708 to indicate no tax is owing because the gift or bequest was not “covered” can start the running of the statute of limitations period after the individual has received the gift or bequest. A “protective” Form 708 can be filed, however, only when the US recipient “reasonably concludes” that the gift or bequest was not a “covered” gift or bequest. In other words, the filer must have information and grounds for his assertion, notably that the donor / decedent was not a “covered expatriate”.
The protective Form 708 must include lots of information – first, it must include all of the information required by the form itself. In addition, an affidavit signed under penalties of perjury must be included that provides the information on which the US recipient relied to determine that the gift or bequest was not “covered”, or that the donor or decedent was not a “covered expatriate”. The protective filing must also provide full details about the efforts undertaken by the US recipient-filer to obtain information that might be relevant in making these determinations, as well as include a copy of any information he obtained from the IRS and a copy of the relevant portions of Form 3520.
If the IRS does not call matters into question within the limitations period after the protective Form 708 is filed (I presume, 3 years), it will be barred from so doing later on.
What to do?
The preamble to the proposed Regulations notes that the “mere absence” of information regarding the expatriate’s status as a covered expatriate or regarding the qualification of the gift or bequest as one that is “covered” is not a sufficient basis for filing a protective Form 708. What this means is that the US recipient really needs proof in hand about the status of the foreign person. This proof may be difficult, if not impossible, to come by – especially if the gift or bequest is received many years after the expatriation has taken place. Individuals who expatriated when the law became effective on June 17, 2008 but who were not “covered expatriates” need a plan in place for making gifts or leaving bequests to US recipients. Advice of counsel is imperative so that a plan of action can be put into place now in readiness for the future. Individuals who expatriated before the effective date should still make sure that potential US recipients of gifts or bequests can have access to relevant documents indicating the date of loss of US status.
I work with tax attorney and accountant colleagues in the US, Canada, Asia and Europe. I have discussed this topic with various colleagues of mine, and we foresee the critical importance proper planning will take in this entire area. My colleague Jimmy of Sexton of the Esquire Group noted that “Just because you might not have been a ‘covered expatriate’ when you gave up US status, it is not enough to protect your loved ones who remain US persons and who will most likely receive a gift or inheritance from you in the future.” In my discussions with Nilar Chan, CPA, a tax partner at East Asia Sentinel in Hong Kong and her assistant, Ami Leng, CPA, both are curious as to how the law will develop, and both are very concerned. John Engelbrecht of Prager Metis foresees the rules affecting a vast number of individuals – many of whom have no idea what may be in store down the road. John Richardson, an attorney in Toronto at Citizenship Solutions has special concerns for Canadian citizens who believed they had given up their US citizenship many years ago when they took on Canadian citizenship. Many of these individuals have no Certificate of Loss of Nationality or other official documentation about the loss of US citizenship and worry whether the US tax law will recognize such earlier relinquishments. All of my colleagues think proactively and we are all running through action plans to reach out to clients who have expatriated to make them aware of this very important development.
If you’re a former American and you died tomorrow leaving assets to US heirs – are they ready for what appears will be an uphill battle with the IRS about the taxability of their inheritance? Do you know how to protect US recipients of your gifts 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 Armageddon. We’re keeping up to the minute on this topic. Watch this space and contact me if you would like to discuss possible planning.
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