Running Away Will Get You Nowhere: New Taxes Imposed on Expatriates

• Publication year: 2009

RUNNING AWAY WILL GET YOU NOWHERE: NEW TAXES IMPOSED ON EXPATRIATES

By Erin L. Prouty, Esq.^*

I. INTRODUCTION

Federal tax laws that apply to expatriating citizens and long-term permanent residents of the United States have been drastically changed. On June 17, 2008, President Bush signed into law the Heroes Earnings Assistance and Relief Tax Act of 2008¹ (the "Heroes Act"). The Heroes Act adds two new sections to the Internal Revenue Code affecting U.S. citizens who relinquish their U.S. citizenship and certain long-term lawful permanent residents ("green card" holders)² who relinquish their right to permanent residency in the United States on or after June 17, 2008. These new sections impose (1) an "exit tax" on the appreciation of an expatriate's worldwide assets,³ (2) continuing U.S. income tax on certain deferred compensation and distributions from nongrantor trusts,⁴ and (3) estate and gift taxes on gifts and bequests from an expatriate to any U.S. person.⁵ On October 15, 2009, the Internal Revenue Service ("IRS" or "Service") issued Notice 2009-85,⁶ which provides guidance on the exit tax and the continuing U.S. taxation of certain deferred compensation and of distributions from nongrantor trusts. Further guidance will be issued for the estate and gift taxes on gifts and bequests from an expatriate to a U.S. person.

The goal of this new regime is to capture the tax revenue that would have been generated in the United States if the expatriating individual had retained citizenship or green card status. It apparently is based on the presumptions that the individual would have sold all of his or her assets at some point before death, that lifetime gifts by that individual would all have been subject to U.S. gift tax, and that the individual's entire estate remaining at the time of death would have been subject to U.S. estate tax. These presumptions naturally produce the best tax result for the U.S. government. For example, not all U.S. citizens sell all of their appreciated assets before death, in which case the heirs receive the assets with a stepped-up basis, and capital gains tax on the appreciation prior to death is never paid.

As discussed in this article, the Heroes Act not only gives the U.S. the maximum tax revenue, but it goes further, taxing wealth and income sooner than if the expatriate had remained in the U.S., and forcing expatriates to waive treaty benefits and possibly incur double taxation. Furthermore, wealth accumulated after expatriation and, in some instances, income earned after expatriation are now taxed by the U.S. more comprehensively than under previous regimes applicable to expatriates. It appears that there remains little or no incentive from a tax standpoint to give up U.S. citizenship or green card status, and for many individuals there is now a significant reason not to do so.

The law in effect prior to the Heroes Act continues to apply to individuals who expatriated before June 17, 2008, and therefore a brief look at that old regime follows. The article then summarizes the new Heroes Act and suggests some unanswered questions and potential issues under the new law.

II. PRIOR LAW

A. History of U.S. Income Taxation of Expatriates

The United States imposes an income tax on its citizens and residents based on their worldwide income, while nonresident aliens are taxed at a flat rate on "fixed or determinable annual or periodic income" derived from U.S. sources (i.e., most passive investment income) and are taxed at graduated rates on income "effectively connected" with the conduct of a U.S. trade or business.⁷ The limited tax structure for nonresident aliens in the United States, coupled with more favorable tax laws elsewhere, can induce U.S. citizens and green card holders to give up their citizenship or green card status and change residency to another country to reduce or eliminate their U.S. tax liabilities.

In response to concern over the loss of tax revenue from expatriating citizens, the United States enacted the Foreign Investors Tax Act of 1966 (FITA).⁸ Under FITA, expatriates were subject to an expatriation tax on U.S.-source income (defined more broadly than for nonresident aliens who had not expatriated) at rates applicable to U.S. citizens for 10 taxable years following expatriation, unless the loss of U.S. citizenship did not have as one of its principal purposes the avoidance of U.S. federal income, estate or gift taxes. Thirty years later, the Health Insurance Portability and Accountability Act of 1996 (HIPAA)⁹ added a presumption of tax avoidance if an expatriate's five-year average net income tax exceeded $100,000, or if the expatriate's net worth was $500,000 or more (both adjusted for inflation). HIPAA also extended the rules to former long-term residents. The American Jobs Creation Act of 2004 (AJCA)¹⁰ eliminated the tax-avoidance test altogether and increased the income-tax-liability and net-worth thresholds to $124,000 (adjusted for inflation) and $2,000,000, respectively. However, an expatriate who failed to certify compliance with U.S. federal income tax laws for the five taxable years preceding the year of expatriation was subject to the expatriate income tax regime even if that individual did not meet the income-tax-liability or net-worth test. Also under AJCA, an expatriate who was in the United States more than 30 days in any year during the 10-year period following expatriation was considered a resident of the U.S. for that year, and thus subject to tax on worldwide income for that year. These rules continue to apply to individuals who expatriated prior to June 17, 2008.¹¹

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B. History of U.S. Taxation of Estates and Gifts of Expatriates

The United States taxes the estates of its citizens and domiciliaries on their worldwide assets. Estates of nonresident aliens are subject to U.S. estate tax only on U.S.-situs property, including real estate and tangible property located in the United States, stock in U.S. corporations and non-portfolio debt obligations of U.S. persons.¹² Gift taxes are similarly structured. U.S. citizens and residents are subject to U.S. gift tax on all gifts of worldwide assets. Generally, nonresident aliens are only subject to U.S. gift tax on gifts of U.S.-situs property, which does not include intangibles such as stock or debt obligations, regardless of where the intangibles are located.¹³ The definitions of resident alien and nonresident alien contained in Internal Revenue Code¹⁴ ("Code" or "IRC") section 7701(b) specifically do not apply for U.S. estate and gift tax purposes. Instead a "resident" for gift and estate tax purposes means a person who is domiciled in the United States.¹⁵

Prior to the Heroes Act, U.S. expatriates who were subject to the expatriate income tax regime were treated much the same as nonresident aliens for estate and gift tax purposes, but with some adjustments. The estate of an expatriate who was subject to the expatriation income tax regime as of the date of death included only U.S.-situs property, but the definition of U.S. situs property was expanded to include the stock of certain foreign corporations to the extent of their U.S. situs assets.¹⁶ If an expatriate was subject to the expatriation income tax regime at the time a gift was made, gift taxes applied only to gifts of U.S.-situs assets, but that definition again was expanded to include the stock of certain foreign corporations to the extent of their U.S.-situs assets, as well as stock of U.S. corporations and all debt obligations of U.S. persons.¹⁷ These rules continue to apply to individuals who expatriated prior to June 17, 2008.¹⁸

III. THE HEROES ACT

The Heroes Act repeals the 10-year alternative income tax regime (and the corresponding special gift and estate tax rules) for citizens who relinquish U.S. citizenship and long-term residents who give up their green cards, effective for those who expatriate on or after June 17, 2008. The new law instead imposes an income tax on the expatriate's unrealized gain, deferred compensation income and trust distributions—either immediately or when paid later—and subjects to U.S. gift and estate tax all future gifts and bequests from the expatriate to a U.S. citizen or resident. There are few exceptions, and no time limit.

A. Covered Expatriate

1. U.S. Citizens and Long-Term Residents Subject to Heroes Act

An "expatriate" under the Heroes Act may be either a U.S. citizen who relinquishes citizenship or a long-term resident of the United States who ceases to be a lawful permanent resident.¹⁹

A long-term resident is defined by cross reference to Section 877(e)(2)²⁰ as a non-U.S. citizen who is a lawful permanent resident of the United States in at least eight taxable years during the 15 taxable years ending with the taxable year during which lawful permanent resident status ceases. An individual is not treated as a lawful permanent resident for the purpose of this eight-year test in a year in which the individual is treated as a resident of a foreign country under a tax treaty and does not waive the benefits of that treaty.²¹ A "lawful permanent resident" of the United States is a green card holder,²² and holding a green card for even one day during a year causes that year to be counted toward the eight-year test. Conversely, if an individual is a resident of the U.S. for an entire year but does not hold a green card on any day during the year, that year will not count toward the eight-year test.

2. "Expatriation" Defined

Under prior law, an individual continued to be treated as a U.S. citizen or long-term resident for U.S. federal income tax purposes until the individual gave notice of an expatriating act or termination of residency and provided any required statement under Section 6039G to the Secretary of State or the Secretary of Homeland Security.²³ The Heroes Act now provides that an individual ceases to be a U.S. citizen for U.S. tax purposes upon relinquishment of his or her U.S. citizenship, which is...