On Oct 05 2009

Tax Consequences of Losing US Resident Status

On June 17, 2008, President Bush signed the Heroes Earnings Assistance and Relief Tax Act of 2008 (HEART).  HEART extends or modifies several tax benefits for active-duty and former military service members, ranging from housing assistance to favorable treatment of some types of service compensation.

As a revenue offset for these provisions, an “exit tax” is included which applies to certain US citizens and long-term permanent residents (i.e., green card holders) who expatriate.  The exit tax is part of new Section 877A of the Internal Revenue Code (the “Code”).

Individuals subject to the exit tax

The exit tax provisions of Section 877A of the Code apply to certain US citizens who relinquish their citizenship and long-term residents who terminate their permanent residence status (known as “expatriation”).  An individual is a long-term resident if he/she was a lawful permanent resident in at least eight out of the fifteen taxable years ending with the year in which the residency termination occurs.

The mark-to-market tax would apply to any US citizen who relinquishes citizenship and any long-term resident who terminates US residency if the individual:

  • Has an average annual net income tax liability for the five preceding years ending before the date of expatriation that exceeds $139,000 (2008 amount, adjusted annually for inflation);
  • Has a net worth of $2 million or more on the date of expatriation; or
  • Fails to certify under penalties of perjury that he or she has complied with all US federal tax obligations for the preceding five years or fails to submit such evidence of compliance as the Secretary may require.

Certain exceptions apply to individuals born with dual citizenship and those who relinquish US citizenship prior to age 18-1/2 (provided certain requirements are met).

According to the TECHNICAL EXPLANATION OF H.R. 6081, prepared by the House Joint Committee on Taxation, May 20, 2008, the definition of “long-term resident” for the purposes of the HEART Act is generally the same as used in other sections of the Tax Code.  As under present tax law, an individual is considered to terminate long-term U.S. residency when the individual ceases to be a lawful permanent resident of the United States (i.e., loses his or her green card status through “revocation” or “has been administratively or judicially determined to have abandoned such status”).  See 26 USC § 7701(b)(6).

Treasury Regulation 301.7701(b)-1(b)(3) further explains what these terms mean, although it uses “rescission” rather than “revocation.”

Resident status is considered to be rescinded if a final administrative or judicial order of exclusion or deportation is issued regarding the alien individual.  For purposes of this paragraph, the term “final judicial order” means an order that is no longer subject to appeal to a higher court of competent jurisdiction.

An administrative or judicial determination of abandonment of resident status may be initiated by the alien individual, the Immigration and Naturalization Service (INS), or a consular officer.  If the alien initiates this determination, resident status is considered to be abandoned when the individual’s application for abandonment (INS Form I-407) or a letter stating the alien’s intent to abandon his or her resident status, with the Alien Registration Receipt Card (INS Form I-151 or Form I-551) enclosed, is filed with the INS or a consular officer.  If the INS or a consular officer initiates this determination, resident status will be considered to be abandoned upon the issuance of a final administrative order of abandonment.  If an individual is granted an appeal to a federal court of competent jurisdiction, a final judicial order is required.

Date of expatriation

Section 877A of the Code sets forth rules for establishing the date of expatriation.  In the most common cases, this will be the date the individual swears or affirms their oath of renunciation in front of a consular officer and witnesses or files Form I-407 terminating permanent residence status.  Long-term residents would also be treated as expatriating when utilizing residency ‘tie-breaker’ provisions of income tax treaties to be treated as US non-resident aliens despite their permanent residency status.

Mark-to-market tax imposed

Section 877A of the Code subjects expatriating individuals to tax on the net unrealized gain on their world wide property as if such property were sold for fair market value on the day before the expatriation date.

Gain from the deemed sale is taken into account at that time without regard to other tax code provisions; any loss from the deemed sale would generally be taken into account to the extent otherwise provided in the code.  The value of property held when an individual first became a US resident will be taken into account for purposes of determining the gain, unless the individual makes an irrevocable election for basis to be calculated under general US tax principles.

Deemed sale of property upon expatriation

The deemed sale rule generally applies to all property interests held by the individual on the date of expatriation.  Special rules apply in the case of certain deferred compensation items, specified tax deferred accounts, and interests in non-grantor trusts.

Any net gain on the deemed sale is recognized to the extent it exceeds $600,000 ($1.2 million in the case of married individuals filing a joint return, both of whom relinquish citizenship or terminate residency).  The $600,000 amount is increased by a cost of living adjustment factor for calendar years after 2008.

Deferral of tax

Expatriates subject to Section 877A of the Code are permitted to make an irrevocable election to defer payment of the mark-to-market tax on a property-by-property basis, which includes an interest charge during the deferral period.  Tax may be deferred only until the due date for the return of the taxable year in which the property is disposed of.  The individual would generally be required to provide a bond to the IRS in order to make this election, and is required to waive any treaty rights that would preclude the assessment or collection of the tax.

Information reporting

Information reporting requirements under Section 6039G of the Code apply to those who expatriate under Section 877A.  These requirements have historically been satisfied by filing IRS Form 8854.

Gifts and bequests from expatriates

HEART also creates Section 2801 of the Code, which imposes a tax on the recipient of certain gifts or bequests from expatriates.  The tax is imposed at the highest rate of tax specified in Section 2001(c) or Section 2502(a) of the Code, as applicable and as in effect on the date of receipt.

“The Bottom Line”

The change may be beneficial or harmful to different expatriates, depending on their circumstances.  Expatriates with substantial assets may be subject to significant taxes under the new provisions, even if little or no tax would have occurred as a result of former Section 877 of the Code.  Other expatriates with relatively low assets may owe no tax under Section 877A and be spared the ten-year tax and filing requirements that would have applied under Section 877.