Proposed Methods to Enhance the Implementation and Enforcement of the Expatriation Tax (irc § 877a)

• Publication year: 2018
• Author: By Helen S. Cheng & Dina Y. Nam

Proposed Methods to Enhance the Implementation and Enforcement of the Expatriation Tax (IRC § 877A)1

By Helen S. Cheng & Dina Y. Nam²

EXECUTIVE SUMMARY

Section 877A of the Internal Revenue Code of 1986, as amended ("IRC"), sets forth the current expatriation tax regime for U.S. citizens and long-term residents who relinquish their U.S. citizenship or terminate their long-term U.S. residency status. Although individuals choose to expatriate for different reasons, some of which could be construed as tax-motivated, the ultimate purpose of IRC Section 877A (hereinafter referred to as "Section 877A") is to provide an objective system for collecting what is colloquially referred to as an exit tax for those wanting to cut ties with the United States.

The current regime imposes a one-time tax liability on expatriating individuals who meet certain income, asset or reporting requirements. These individuals, who are considered "covered expatriates" under the law, are subject to a mark-to-market tax when they relinquish their citizenship or long-term residency status. In effect, a covered expatriate is treated as having sold all of his or her worldwide assets as of the date of expatriation, and is subject to tax on the deemed gain. Further, any gift or bequest from the covered expatriate to a U.S. person is considered a "covered" gift or bequest, and the U.S. transferee must pay transfer tax on this covered gift or bequest at the highest gift or estate tax marginal rate.

There are major challenges in implementing and enforcing the provisions of Section 877A, as the expatriating individual is required to affirmatively file a Form 8854 and fully disclose worldwide assets. If, however, an expatriating individual does not comply with this requirement, the IRS may not even be informed of the expatriation. Even if it were aware, enforcement is nearly impossible once the expatriate leaves the United States. This paper offers proposals to enhance the implementation and enforcement of Section 877A, including methods for putting individuals on notice of the requirements under Section 877A, coordinating communication between the Department of Treasury, the Department of State and the Department of Homeland Security, and providing for continued jurisdiction over expatriating individuals even after they renounce their U.S. citizenship or terminate their long-term U.S. residency status.

DISCUSSION

I. INTRODUCTION

Section 877A sets forth the current expatriation tax regime for U.S. citizens and long-term residents who plan to expatriate, and essentially applies an exit tax to certain persons deemed to be covered expatriates under the law.

For U.S. tax purposes, an expatriate generally includes U.S citizens who renounce their citizenship and U.S. long-term residents who have terminated their permanent resident status in the United States. An expatriate who is a "covered expatriate" is subject to an exit tax in which all of his or her assets are deemed to have been sold for fair market value as of the date of expatriation. Further, any gift or bequest from the covered expatriate to a U.S. person is considered a "covered" gift or bequest, and the U.S. transferee must pay transfer taxes on this covered gift or bequest at the highest gift or estate tax marginal rate.

A "covered expatriate" is defined as (1) an expatriate who has a 5-year average net income tax liability of more than $124,000, as indexed for inflation ($162,000 as of 2017), (2) an expatriate who has a net worth of $2,000,000 or more at the time of expatriation, or (3), an expatriate who fails to certify under penalty of perjury that he or she has not met the tax or net worth thresholds described above, or who fails to submit such evidence of compliance as the Secretary may require.³ Form 8854 is the required evidence of compliance, and if an individual fails to file this Form 8854, then that person will automatically be considered a covered expatriate, regardless of his or her asset base or net income tax liability.⁴

Despite multiple attempts over the past decades to apply an income tax on certain expatriating individuals, the implementation and enforcement of an expatriation tax, including the most recent iteration under Section 877A, remains problematic. First, there remain significant communication gaps which create challenges both in providing proper notice to expatriating individuals of the requirements under Section 877A, and in sharing information on expatriating individuals between governmental agencies. Second, under the current Section 877A mark-to-market regime, if an expatriating individual is considered a covered expatriate, either by virtue of the income tax or asset tests or because he or she did not file the Form 8854, it is virtually impossible for the IRS to enforce the exit tax.

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It is the authors' belief that effective implementation and enforcement of the Section 877A exit tax cannot occur unless and until it is prioritized among government agencies. However, there are small administrative and/or legislative changes that could be implemented to provide incremental change.

II. BRIEF HISTORY OF THE EXPATRIATION TAX

A. Pre-2004 Law 1. Legislative History

The basic infrastructure of the modern U.S. tax regime was created after 1913, after the ratification of the Sixteenth Amendment. The Sixteenth Amendment gave Congress the power to levy and collect taxes on income, from whatever source derived, and paved the way for the United States to subject U.S. citizens to U.S. income tax reporting and liability on their worldwide income regardless of their country of residency. Thus, the only way for a U.S. citizen to avoid being subject to the U.S. income tax regime is to give up his or her U.S. citizenship.

There has been a long history of individuals expatriating to avoid U.S. tax liability, and although the legislature has recognized the right of any individual to leave the United States, it has also long sought to ensure that it is able to collect its fair share of any taxes due by those expatriating individuals. "The Congress does not believe that the Internal Revenue Code should be used to stop U.S. citizens and residents from relinquishing citizenship or terminating residency; however, the Congress also does not believe that the Code should provide a tax incentive for doing so. In other words, to the extent possible, an individual's decision to relinquish citizenship or terminate residency should be tax neutral."⁵

The tension brought about by linking U.S. income taxes to citizenship was increased when, in 1966, Congress passed the Foreign Investors Tax Act, in which certain interest payments which were taxable to U.S. citizens became tax-free for nonresident non-U.S. citizens. In that same year, Congress enacted the first iteration of tax rules aimed at expatriating individuals. In this first round of expatriation taxes, U.S. citizens who relinquished their citizenship, and whose "primary motive" was tax avoidance, were subject to special tax rules for the ten-year period following expatriation (referred to as the "alternative tax regime"). In practical terms, however, it was difficult and cumbersome to demonstrate the intent of tax avoidance, and the IRS was often not even aware of the expatriating act. The then Commissioner of the IRS, Margaret Milner Richardson, stated that the alternative tax regime required monitoring an expatriate's activities for ten years to ensure compliance, but that such monitoring effort was difficult because it "required the cooperation of taxpayers who no longer lived in the United States and who generally are no longer otherwise subject to U.S. law."⁶

In 1995, the issue again came to the national forefront when a number of wealthy U.S. citizens elected to give up their citizenship in order to avoid the long-arm of the U.S. income tax regime.⁷ The legislature responded by providing that where any individual had a net worth of at least $500,000 or had an average income tax in the five years prior to expatriation over $100,000, the assumption was that tax avoidance was the principal motivation for expatriation. The new law expanded the definition of expatriating individuals included in the alternative tax regime to certain long-term residents aliens defined as "lawful permanent residents" (otherwise known as green card holders), and also required the IRS to publish a list of ex-citizens in the Federal Register, effectively serving as a form of public shaming for those expatriating individuals.

2. Enforcement Issues

In 2003, the Joint Committee on Taxation issued a comprehensive analysis of the existing expatriation rules ("the 2003 Joint Committee Report"). ⁸ The 2003 Joint Committee Report stated that several fundamental problems undermined the ability of the IRS to effectively implement the existing expatriation regime, as described below. It concluded by stating that "there is little or no enforcement of the special tax and immigration rules applicable to tax-motivated citizenship relinquishment and residency termination,"⁹ and that the IRS made "no attempt to monitor and enforce" the alternative tax regime.¹⁰

i. Difficulty in Identifying Expatriating Individuals Who Are Potentially Subject to Alternative Tax Regime

An obvious, but critical, first step in enforcing the alternative tax regime was to identify those individuals who relinquish citizenship or long-term residency and thus were possibly subject to the alternative tax regime. The IRS did not independently obtain this information, but rather would rely on the expatriating individuals themselves or other government agencies to supply this information.¹¹ "In many cases, the necessary information was not always being supplied by the former citizen or former long-term resident or requested by the appropriate agencies responsible for providing such information to the IRS." ¹²

The most common method to identify an expatriating individual is when he or she renounces U.S. citizenship...