Expatriation and the new mark-to-market rules.

• Author: Fava, Karl L.

EXECUTIVE SUMMARY

* Under Sec. 877A, expatriating citizens and long-term residents of the United States are taxed on the gains of a deemed sale (on the day before the expatriation takes place) of their worldwide assets in excess of $600,000. This mark-to-market tax replaces the 10-year alternative tax on U.S. source income under Sec. 877.

* Taxpayers may make an irrevocable election to defer the tax due on the deemed sale of specific assets under the mark-to-market rules until the due date of the tax return for the year in which the asset is sold and a realized gain occurs. Exceptions to the tax are provided for certain deferred tax items, specified tax-deferred accounts, and nongrantor trusts.

* New Sec. 2801 imposes a tax on a recipient (including a domestic trust) of a direct or indirect gift from a covered expatriate at the highest applicable gift or estate tax rates.

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The Heroes Earnings Assistance and Relief Tax Act of 2008 (1) (HEART) introduced Sec. 877A, which dramatically changed the rules for U.S. citizens and long-term residents who expatriate. (2) The new rules subject taxpayers that renounce their U.S. citizenship or abandon their U.S. residency to a mark-to-market exit tax on their assets. Under Sec. 877A, expatriating taxpayers are taxed on the gains of a deemed sale of their worldwide assets in excess of $600,000. This mark-to-market tax replaces the 10-year alternative tax on U.S. source income under Sec. 877.

Foreign InvestorsTax Act of 1966

Congress enacted Sec. 877 as part of the Foreign Investors Tax Act of 1966 (3) (FITA) to thwart expatriation as a method of tax avoidance.

Upon expatriation, former U.S. citizens or residents would be subject to taxation on their U.S. source income as nonresident aliens. Under FITA, a nonresident alien's income not effectively connected with a U.S. trade or business was not subject to progressive taxation. Sec. 877 required taxpayers who expatriated in order to avoid taxation to calculate their tax under two alternative methods for 10 years after expatriating. The taxpayers would calculate their tax on U.S. source income under the graduated rates or as nonresident aliens and default to the higher of the two alternatives. (4)

An expatriate was subject to the rules of Sec. 877 if the individual's principal purpose of expatriation was tax avoidance. If the IRS determined that the expatriation was for tax avoidance, the burden of proof fell to the taxpayer to substantiate that it was not. (5)

FITA also enacted gift and estate tax rules for expatriates. Sec. 2107 provides that an expatriate subject to Sec. 877 would also be subject to U.S. estate tax within the 10-year window after expatriation. (6) Under Sec. 2107, an expatriate's taxable estate would include U.S.-based property as defined in Sec. 2103. Also included is the value of the shares in a foreign corporation owned by the decedent if the decedent owned 10% or more of the total combined voting power of all classes of stock entitled to vote and is considered to have owned (by applying the ownership rules of Sec. 958(b)) 50% of the total combined voting power of all classes of stock entitled to vote of the corporation. The decedent's taxable estate would include the portion of the fair market value (FMV) of the foreign corporation's stock attributable to the United States. The U.S. portion would be based on the FMV of any assets owned by the corporation and situated in the United States at the time of death, relative to the total FMV of all assets owned by the foreign corporation. (7)

FITA included changes to Sec. 2501 whereby expatriates subject to Sec. 877 were also subject to gift tax on transfers of intangible property. Prior to FITA, only nonresidents engaged in a U.S. trade or business were subject to a tax on transfers of intangible property with U.S. situs. Transfers of intangible property outside the 10-year window that an expatriate was subject to Sec. 877 were now subject to a gift tax under Sec. 2501. (8)

Health Insurance Portability and Accountability Act, 1996

Prior to HEART, Congress modified Sec. 877 twice. The first modification was under the Health Insurance Portability and Accountability Act of 1996 (HIPAA). (9) In the early 1990s there was a concerted effort to strengthen the expatriation tax. During this period, the national press played up instances of millionaire businessmen expatriating and lamented the loss of tax revenues. Kenneth B. Dart, the president of Dart Container Corporation, was the poster child for this movement. The Clinton administration used Dart as an example of why there was a need for a stronger expatriation tax. (10) The Clinton proposal to implement an exit tax was not enacted, but HIPAA considerably strengthened the existing rules of Sec. 877.

HIPAA extended the reach of Sec. 877 to include long-term residents of the United States who abandoned their green card. A long-term resident was defined as a lawful permanent resident (green card holder) of the United States for 8 of the 15 years ending with the year the residency was terminated, (11) Under HIPAA, a taxpayer was deemed to have terminated his or her residency status for the principal purpose of tax avoidance if either of the following two tests were met:

* The taxpayer's average U.S. federal income tax liability for the five tax years ending before the termination date was greater than $100,000 (the tax liability test).

* The taxpayer's net worth as of the date of termination was $500,000 or more (the net worth test). (12)

The dollar amounts of the tax liability and the net worth tests were indexed for inflation for years after 1996. There was an allowance for a taxpayer to request a ruling substantiating that the expatriation was not for tax avoidance. (13)

The categories of income and gains to be treated as U.S. sourced were expanded under HIPAA. A taxpayer subject to Sec. 877 would be taxed at graduated rates on U.S. sourced income for 10 years after termination of U.S. residency. The act also provided a credit for relief of potential double taxation. U.S. income tax imposed solely under Sec. 877 and also subject to any foreign income, gift, estate, or similar taxes would have the benefit of any potential foreign tax credit. (14)

Expatriates, either citizens or long-term residents, had required information reporting under HIPAA. A U.S. citizen who lost his or her citizenship was required to provide a statement to the State Department that included the individual's Social Security number, foreign address, new country of residence, citizenship, and, in the case of individuals with a net worth of at least $500,000, a balance sheet. A long-term citizen whose residency Was terminated was required to attach a similar statement to his or her individual income tax return for the year of termination. The act provided for penalties for nondisclosure. (15)

American Jobs Creation Act, 2004

The second modification to FITA was the American Jobs Creation Act of 2004 (16) (AJCA). The AJCA attempted to strengthen the provisions of HIPAA because there was still a significant amount of public debate on the merits of expatriation and the loss of tax revenues. Harper's Magazine published an article in October 2004 titled "Electing to Leave: A Reader's Guide to Expatriating on November 3." (17) The 10-year alternative income...