The Tax Consequences of Expatriating from the United States

• Publication year: 2020

Patrick J. McCormick^*

Abstract: Familiarity with the tax consequences of leaving the United States is important for immigration advisors, particularly for those working with individuals either renouncing citizenship or abandoning green card holder status. This article details the U.S. tax considerations in the expatriation context—first discussing the tax benefits of expatriation, then exploring the special tax rules applicable upon departure. Options to avoid tax consequences on expatriation are considered, discussing benefits and pitfalls of these options.

The inaugural issue of the AILA Law Journal included an excellent article by Kehrela Hodkinson exploring the non-tax reasons a U.S. citizen might renounce their citizenship. As Hodkinson noted explicitly, the article excluded an analysis of the tax rules associated with expatriation; as she stated, however, "[T]ax and renunciation go hand in glove, and compliance with the set of regulations governing one but not the other does not make for a complete exit from U.S. regulatory requirements."¹

This article provides an overview of the tax considerations for expatriates. For tax purposes, expatriates are either U.S. citizens or long-term U.S. green card holders. It provides background information on income and transfer tax differences between U.S.-based taxpayers and nonresidents, illustrating the tax benefits of expatriation. The article also details the tax considerations relevant when a U.S. taxpayer expatriates, focusing on "covered expatriates"—those for whom special tax rules apply. It then discusses the tax ramifications borne by covered expatriates (requiring tax recognition of built-in gain on worldwide assets at expatriation) and rules applicable to future beneficiaries of the covered expatriate. Finally, the article considers strategies for avoiding covered expatriate status and timing considerations associated with avoidance techniques.

U.S. Tax Background

Taxation of U.S. Individuals

U.S. citizens and tax residents are taxable on their worldwide income, no matter where they reside or how the income is generated (i.e., even if all activities associated with generating the income occurred outside the United States).² When compared to tax residency, citizenship determinations are usually more straightforward—individuals born citizens keep that status until they (formally) renounce it, even if they live overseas full time.

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Statutorily, U.S. income tax residency includes two general non-elective categories (for income tax purposes): (1) those lawfully admitted for permanent residence in the United States, and (2) those meeting substantial presence standards;³ only the former are subject to covered expatriate status.⁴ Individuals lawfully admitted for permanent residence are U.S. green card holders; importantly, green card holders, like citizens, are taxed on worldwide income irrespective of their actual physical presence, although, unlike for citizens, this result can be modified by income tax treaty "tiebreaker" provisions.⁵

Income tax treaties—agreements entered between two countries to facilitate economic activity between the countries' residents—allow green card holders to be reclassified as U.S. nonresidents. Reclassification is permitted if the relevant individual is classified as both a tax resident of the United States and a treaty party country, and if the individual's connections to the other country are closer than to the United States (normally focusing on the person's "center of vital interests").⁶ Critically, a long-term green card holder who reclassifies after years of U.S. presence risks classification as a covered expatriate by virtue of a reclassification election.⁷

Transfer taxes—estate and gift taxes—are also assessed by the United States. American citizens and domiciliaries (U.S. residents with no present intention of leaving the country) are subject to transfer taxes on gratuitous transfers of worldwide assets (gift taxes for transfers made during their lifetime, and estate taxes for transfers made at death).⁸ For transfer tax purposes, an individual is treated as a U.S. domiciliary when he or she is a U.S. resident and has no present intention of leaving the United States.⁹

Citizens and domiciliaries receive a lifetime exclusion for estate and gift tax purposes, protecting a set amount of transfers from U.S. tax. For 2020, this exclusion amount is $11,580,000.¹⁰ Exclusion amounts can be combined for married couples through portability, allowing a decedent's executor to transfer any unused exclusion amount to the surviving spouse. Importantly, the current exclusion amount is set to be halved in 2026, and further variance/revision of the exclusion amount (either upward or downward) is entirely plausible.¹¹

Taxation of Nonresident Aliens

Nonresidents are taxed by the United States on income connected to the United States, either by virtue of being: (1) effectively connected with the nonresident's conduct of a U.S. trade or business, or (2) U.S.-sourced income not connected with a nonresident's U.S. trade or business and not capital gains income (fixed or determinable annual or periodic income or "FDAP Income").

Case law dictates that a U.S. trade or business exists where profit-oriented activities that are regular, substantial, and continuous, are carried on in the United States.¹² Effectively connected income (ECI) is taxable in the United States at graduated rates. Income tax treaties (slightly) elevate the statutory standard, typically providing that residents of a treaty party country can instead elect to use a "business profits attributable to a United States permanent establishment" threshold.

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Nonresidents are generally not subject to capital gains tax by the United States for gains not effectively connected with a U.S. trade or business attributable to a permanent establishment. A nonresident disposing of a U.S. real property interest, however, is subject to tax on any gain from the disposition, as this income is statutorily classified as effectively connected income.¹³

FDAP income includes dividends, rent, salaries, wages, premiums, annuities, compensations, remunerations, emoluments, or other fixed or determinable annual or periodic gains, profits, and income sourced to the United States.¹⁴ Unlike most other types of income (including a nonresident alien's ECI), FDAP income is taxed at a flat 30 percent rate, with no deductions permitted and tax primarily collected through payor withholdings.

Nonresidents are subject to U.S. transfer tax on a limited scope of assets but are given only a fraction of the exemption amounts available to U.S. citizens and domiciliaries. Estate tax is assessable on all property (whether tangible or intangible) sitused to the United States, subject to exceptions.¹⁵ For estate tax, nonresidents receive a $60,000 estate tax exclusion with a maximum 40 percent rate of tax applicable.¹⁶...