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Pay As You Go: Tax Rules Upon Expatriation

As the United States tax code grows each year, so too does the number of American citizens contemplating expatriation. Any who think relinquishing their citizenship will be as simple as buying a plane ticket, however, should reconsider.

The United States stands alone as the only major country that taxes its citizens regardless of where they live; other countries only tax income earned within their borders. This situation and new, aggressive rules for reporting foreign assets have many U.S. citizens who expect to spend the rest of their days abroad considering the benefits of giving up their American citizenship. Expatriation may be appropriate (or attractive) under certain circumstances, especially for an individual wanting to minimize taxes or reduce reporting requirements. Those who have taken the plunge and renounced their citizenship include Facebook co-founder Eduardo Saverin, martial artist and actor Jet Li and Monty Python alumnus Terry Gilliam.

While the actual process of expatriation is not incredibly difficult, the United States has actively tried to make it less attractive, at least in part to prevent citizens from surrendering their citizenship in hopes of avoiding taxation.

The Process Of Expatriation

Renouncing U.S. citizenship involves following the procedures dictated by the State Department and filing Form 8854 with the Internal Revenue Service. Failure to complete either of these steps results in continued taxation as a U.S. citizen.

Section 349(a) of the Immigration and Nationality Act (INA) governs how a U.S. citizen may give up his nationality. The citizen must first make a formal renunciation of nationality before a diplomatic or consular officer of the United States in a foreign state, in such form as prescribed by the secretary of state. If the United States is at war, the citizen may also submit a formal written renunciation to an officer designated by the attorney general. Any U.S. citizen who chooses to accept employment with a foreign government must relinquish his citizenship if he is already a citizen of the country in question, or if an oath or declaration of allegiance is required in accepting the position. Automatic revocation also follows conviction for an act of treason. In any of the above cases, the State Department must approve the change, and revocation is not final until the department issues a Certificate of Loss of Nationality.

Aside from exceptions as provided in Section 351 of the INA, renunciation of U.S. citizenship cannot be reversed without a successful judicial or administrative appeal.

In addition, the IRS requires anyone who renounces citizenship to file Form 8854, which includes a personal balance sheet and income statement. The form also requires filers to certify whether their average annual U.S. income tax liability over the past five years has been in excess of $147,000 (the tax liability test), whether their net worth is in excess of $2 million at the time of expatriation (the net worth test), and whether they have been tax compliant for the preceding five years (the compliancy test).

It is vital that citizenship be established with another country prior to renouncing U.S. citizenship to avoid being considered “stateless.”

Tax Consequences Upon Expatriation

The Heroes Earnings Assistance and Relief Tax Act of 2008 (HEART Act) established a new mark-to-market tax that applies to anyone who expatriated on or after June 17, 2008. Commonly referred to as the “exit tax,” it applies to any expatriate who meets the tax liability test, the net worth test or the compliancy test.

For purposes of the exit tax, a U.S. citizen is deemed to have sold his worldwide assets for the fair market value on the day before expatriation. The hypothetical sales proceeds are then subject to U.S. capital gains tax, with any short-term gains taxed at short-term capital gain rates and long-term gains taxed at lower long-term capital gain rates. This tax was put in place to severely limit the tax benefits of leaving the country and serves to deter citizens contemplating expatriation. The law does allow a portion of gains to be exempted from tax. (For 2012, the first $651,000 of hypothetical gains is excluded from taxation.)

Additional rules apply to eligible deferred compensation items and ineligible deferred compensation items. To be classified as an eligible deferred compensation item, the item’s payer must be either a U.S. person or a non-U.S. person who elects to be treated as a U.S. person, and the payee must notify the payer of his or her status as an expatriate and irrevocably waive any right to claim any withholding reduction on taxable distributions. Any deferred compensation item that does not qualify in this way is an ineligible deferred compensation item.

For an eligible deferred compensation item, the payer must deduct and withhold a tax equal to 30 percent of any taxable payment. Ineligible deferred compensation items are taxed as though the payee received the current value of all accrued benefits the day before the expatriation date; such items must be included on Form 1040. In addition, Form W-8CE (Notice of Expatriation and Waiver of Treaty Benefits) must be filed with the payer of the ineligible deferred compensation item; the payer would then provide a written statement that included the current value of all accrued benefits.

Certain tax-deferred accounts, including IRAs, Section 529 plans and health savings accounts, are treated as though the account’s owner received a complete distribution on the day before the expatriation date. There is some leniency with excise taxes that would otherwise be incurred on actual distributions. For example, an expatriate with an IRA who is under 59½ years of age will not be subject to the typical 10 percent excise tax on early retirement distributions.

Post-Expatriation Considerations

After the expatriation process is complete, ex-citizens may continue to face certain U.S. tax issues and filing requirements. A non-U.S. citizen with income effectively tied to the United States may be required to file Form 1040NR with the IRS each year. In addition, if the expatriate holds any interest in a non-grantor trust, he or she must annually file Form 8854 to certify that no distributions were made.

The HEART Act also includes provisions for transfer taxes on anyone who receives a gift or bequest from an ex-citizen who expatriated after June 17, 2008. U.S. citizens and residents who receive any bequests or gifts from an expatriate in excess of the annual gift tax exclusion amount (currently $13,000) are liable for a transfer tax at the highest applicable estate or gift tax rate. However, the transfer tax does not apply to transfers that are reported on a timely filed U.S. gift or estate tax return, or for which a marital or charitable deduction is otherwise allowed. If an expatriate makes a gift or bequest to a U.S. trust, the trust must pay the transfer tax. In contrast, if a gift is made to a foreign trust, the transfer tax will only be payable if assets are distributed to a U.S. citizen or resident.

Despite the new, harsher consequences of leaving the country permanently, the number of citizens choosing to expatriate has risen from 235 in 2008 to about 1,800 in 2011. To be clear, expatriation is not the first strategy to consider if your aim is simply to lower your tax burden. It should likely be the last. There are plenty of ways to lower taxes without uprooting your life and moving to a foreign locale. Options include maximizing itemized deductions; using tax-sheltered retirement accounts, tax-exempt bonds or life insurance; or even moving to a low-tax state. But there remains (and likely always will) a minority of U.S. citizens who expect to live abroad for the rest of their lives and who are disadvantaged in some way by the U.S. tax code. These people might want to at least consider expatriation.

Vice President and Chief Investment Officer Paul Jacobs, of our Atlanta office, is the author of Chapter 20, “Giving Back,” in our firm’s most recent book, The High Achiever’s Guide To Wealth. He also contributed several chapters to the firm’s previous book, Looking Ahead: Life, Family, Wealth and Business After 55.