IRS Expatriation Tax

This article is about the exit tax due from US persons, also known as the IRS Expatriation Tax, when they expatriate and relinquish their US citizenship. For relevant articles about the IRS Expatriation Tax for current US citizens living overseas, see this article here.

If you are going to renounce your citizenship, there is a form and payment you’ll need to make to the IRS:  The exit tax. Here’s the thing about the exit tax: it treats many taxpayers far worse than the estate tax, or “death” tax.

The only way to escape the IRS: Renounce your citizenship properly.

Just leaving the country does not do anything to change your US tax status. This is because the US is one of only two countries that asserts a universal tax jurisdiction on its subjects on income earned around the world (or on the moon, or anywhere else in the universe for the matter).

Some taxpayers who may be considering the expatriation process have considerable assets or global earning potential. In this age of globalization, many who have high earning potential in the United States also have high earning potential elsewhere in the world—in countries with lower tax rates and no capital gains or estate tax. If an American citizen or permanent resident were to move overseas and make a ton of money in Hong Kong or Singapore the question becomes: is the benefit of American citizenship really worth being subject to our oppressive tax regime and the penal IRS Expatriation Tax?

Americans and those deemed to have resident status are required to pay taxes on money earned overseas, taxes on domestic or international capital gains, and if very wealthy—again when they die. Most people who are considering expatriation already have substantial ties to a foreign country. They have lived and worked overseas, they are dual citizens, and sometimes they have only resident status in the United States. Few people decide one day to leave the country just on a whim having never lived abroad.

Just what is the IRS exit tax? Here’s the fine print.

Under section 877A of the Internal Revenue Code, wealthy individuals who expatriate may subject themselves to something called an exit tax. An exit tax is the government’s way of making sure that it does not lose out on uncollected lifetime and death tax revenue. Often the tax bill of expatriating is more than the actual taxes payable over one’s life and death.

There are a number of serious tax consequences when expatriating. IRC 877A applies to all persons who expatriate after 2008. First, for 2013, this includes individuals who had an average income over the past five years of $155,000 or more. Second, IRC 877A applies to individuals who had a net worth of more than two million dollars. Third, it applies to anyone who failed to file Form 8854. Expatriates to which IRC 877A applies are labeled “covered” expats.

These individuals are subject to a substantial exit tax and will be restricted in their ability to gift or will money to their heirs. There is an exit tax of 30% of any amount above two million dollars in global assets. This draconian tax applies to money that you may have inherited from a distant uncle from Hong Kong or India who never stepped foot in the United States. This includes any property that you have including your residence or assets you may have purchased or inherited.

Additionally, since 2008, the IRC has applied a market to market accounting for calculating capital gains. This means that the government will assess taxes on your appreciated assets as if you sold them on the date of expatriation. The exclusion for this is only the first $600,000 of gains. Thus, this section of the tax code affects a lot of people who have held stocks or mutual funds.

It especially harms individuals who plan on willing assets to their heirs in the United States because they lose their exemptions from estate tax under IRC 2010 which for 2013 is $10.5 million for a married couple. Such individuals would lose the ability to grant their heirs a stepped up basis in their investments which equates to an additional potential tax of up to 23.8% on long term holding and an automatic additional tax of the highest possible tax rate for any money repatriated.

Potential exit tax due happens when a wealthy couple expatriates

For illustration, we used the example of Jack and Jill Uphill. Jack and Jill are a wealthy couple with children in the United States. Jack and Jill’s assets are as follows:

  • They own one residence worth $2 million which they purchased in 1970 for $100,000.
  • They have $6 million in stock with a cost basis of $500,000.
  • If Jack and Jill will their assets to their children based on current tax laws, they are exempt from federal estate tax under IRC 2010. Of the original $8 million, the entire estate passes tax free to their heirs.

Let’s imagine that they expatriate. Jack and Jill would be forced to pay capital gains tax on their residence and stock. They would be taxed at the 23.8% capital gains tax rate for the sum of the gain on their house, $1.9 million and their stock, $5.5 million. They would be subject to the 30% exit tax. Lastly, since they are covered expatriates, the money that they leave their children would be taxed at the highest potential estate transfer tax rate, 40%.

There is a significantly different outcome in the amount of money that would successfully be transferred had Jack and Jill Uphill chosen not to expatriate (of course, with planning, this exit tax could have been lowered).

The tax treatment when a wealthy couple dies without expatriating.

The estate tax exemption is $10.5 million dollars for a married couple. That means no tax would be due to the IRS when Jack and Jill die. The favorable tax treatment does not end there. Their heirs receive a step-up in basis so that their basis for calculating their own capital gains is the value of the property at the date of their parents death. Expatriation can make sense for some people.

Generally speaking, those who may consider expatriation for tax planning purposes are those who may not yet fall under IRC 877A but who have great future earning power irrespective of their location or those who will inherit substantial fortunes. And there are legitimate ways of reducing an exit tax liability. One other example of a group of people who might benefit is; those with substantial ties to foreign countries and who have assets with no readily ascertainable market value.

Remember Eduardo Saverin? Such individuals may benefit from the fact that there was no market to market value and can afford to litigate the value of a security that was illiquid on the date of expatriation. Yet as we have just demonstrated, in certain circumstances, if not planned properly, the tax code treats you better if you are dead than alive.