If you have taken the far-reaching and irrevocable decision of giving up your US citizenship to permanently disconnect from your US tax obligation, you still have to settle your exit with the IRS. On June 17, 2008 a new law came into force that made the process relatively easier. However, if you are wealthy enough, giving up your US citizenship proves to be a rather expensive step.
Covered Expatriates and Exit Tax Threshold
The Heroes Earnings Assistance and Relief Tax Act of 2008 (the HEART Act) and the U.S. Treasury Notice 2009-85 establish the following rules for US expatriates.
The law applies to US citizens who expatriate, as well as long-term US permanent residents who give up their green cards that have been held for 8 of the last 15 years. Both categories are subject to an immediate “exit tax” on unrealized gains on all their assets both in the US and worldwide, including grantor trusts, as well as on any future gifts or bequests to US citizens and residents, if any.
You qualify for the covered expatriate and the related exit tax, if you meet any of the following criteria:
- you have a net worth of US$ 2 million or more;
- you have an average net U.S. income tax liability of greater than US$ 139,000 (thereafter indexed for inflation; $145,000 for people expatriating in 2009) for the five year period prior to expatriation; or
- you fail to certify that you have complied with all U.S. federal tax obligations for the preceding five years.
Herewith, all property subject to gift tax and all property, where you hold a use right, are included for purposes of the net worth test.
The exceptions are dual nationals from birth, who have not lived in the US for more than 10 years of the last 15, and persons younger than 18 and a half who have not lived in the US for more than 10 years.
Mark-to-market Tax on Unrealized Gains
The exit tax is being applied to the net unrealized gains on the covered expatriate assets estimated on the “mark-to-market” basis, as if the assets were sold at their fair market value on the day preceding the expatriation. Herewith, the tax base includes any interest in property that would have been taxable as part of your gross estate for federal estate tax purposes in case you die as a US citizen or resident, and assets are valued according to the rules governing estate tax computation.
The first US $600,000 (indexed for years after 2008; $626,000 for 2009) gains are exempt from the expatriation taxes. The excluded amount is to be allocated pro rata among all assets included in the exit tax base. Any gain over this figure is subject to US income tax.
The tax payment is due within 90 days after giving up your US citizenship. Expatriation is considered effective for tax purposes even if you fail to file the Expatriation Information Statement (form 8854).
The exceptions from the main rule are certain deferred compensation items, specified tax deferred accounts, and non-grantor trusts.
Specified tax deferred accounts are subject to immediate inclusion in the expatriate’s income subject to exit tax. This provision covers certain individual retirement plans, tuition programs, Coverdell education savings accounts, and an Archer MSA health savings account. No further tax, such as early distribution tax, is to be applied to these items thereafter.
30% Withholding Tax
Deferred compensation items, depending on their nature, are either subject to 30% withholding tax at the moment of payment, or to be included in the personal income of the expatriate subject to exit tax. Those items that are subject to 30% withholding tax by being a distribution to covered expatriates are also most likely to be taxed again at the 30% rate as payments to non-resident aliens. Such treatment may cut certain pension plans and retirement accounts by up to 51% net tax.
Withholding tax rate is not subject to reduction under any of the existing tax treaties between the US and other countries.
Distributions of non-grantor trusts are treated the same way with certain exceptions.
Future Gifts and Bequests
If being a covered expatriate you make a gift or bequest to a US citizen or resident in the amount exceeding US $12,000 in any calendar year, the recipient, including US trusts, is to withhold the tax at the highest marginal estate or gift tax rate existing on the moment of the gift or bequest, with no regular allowances for the same taxes granted to US persons. Though, any tax already paid to a foreign country in regards with the covered gift or bequest is allowed for credit in the US.
The covered gift or bequest is exempted from the tax, if the recipient is a US spouse or a qualified charity.
This provision is effective for your lifetime.
Furthermore, if you were not a covered expatriate at the moment of exit, but you qualify as such following the same criteria at the moment of making gift or bequest, the latter falls into the category of covered.
Procedure to Relinquish the US Citizenship or Residence
Basically, you need to undertake the following:
- Get a second citizenship in another country.
- Leave the US.
- Appear before the US Consul in that country to renounce your US citizenship.
- File the form 8854, Expatriation Information Statement.
- Pay the due exit tax.
As a covered expatriate, you will be able to visit and even stay for certain time in the United States; the mere fact of being an expatriate does not make you a US tax resident. You still can become taxable in the US under the normal US tax rules.
Best Time to Exit
These new rules entered into force in the middle of the global financial crisis while the real property and other assets values are really depressed. The lower the fair market price is, the smaller the unrealized gains it’s bringing, which makes it easier to fit into the US $626,000 threshold.
If you have thought it out well, you better do it now. A number of countries will be happy to have you as their new citizen. Some even established very attractive economic citizenship programs where foreign investors are eligible for instant naturalization in the country without long-term residence requirements.
The Dominica Citizenship and the St. Kitts and Nevis Citizenship programs are good examples. Providing you meet the established requirements to bona-fide investors, you can obtain your second citizenship and passport within mere two to three months.
Disclaimer: This article is being published for informative and recreational purposes. No information from this article should be taken as counsel or recommendation. Professional advice should be sought in each particular case.