On June 17, 2008, President Bush signed into law the Heroes Earnings Assistance and Relief Tax Act of 2008 (the “HEART Act”). The HEART Act contains a new expatriation tax regime that applies to individuals who expatriate from the United States on or after June 17, 2008. As explained by the Senate Finance Committee, Congress intends for the new expatriation rules to tighten the prior rules so that certain high net worth individuals cannot renounce their U.S. citizenship or terminate their long-term U.S. residency in order to avoid U.S. taxes. Congress expects that the new expatriation rules will raise $411 million over the next ten years.
Prior Expatriation Rules
Generally, under prior law, an individual continued to be taxed by the United States as a U.S. citizen or long-term resident until the individual gave notice of an expatriating act or termination of U.S. residency. In that case, a special tax regime applied to persons who expatriated from the United States if the application of the special tax regime would result in greater tax liability than would otherwise be imposed under the rules governing nonresident alien individuals. Specifically, U.S. citizens who relinquished their U.S. citizenship and foreign nationals who terminated their long-term U.S. residency remained subject to U.S. tax on U.S. source income for the ten taxable years following expatriation unless such individuals met certain exceptions. Under this regime, U.S. source income was defined more broadly than for other purposes of the Code. An individual present in the United States for more than thirty days in a calendar year after expatriation would be treated as a U.S. citizen or resident for such taxable year and taxed on his or her worldwide income.
The New Mark-to-Market Tax
The new provisions impose a mark-to-market tax on individuals who are “covered expatriates.” A covered expatriate is subject to U.S. federal income tax on the net unrealized gain in his or her property as if the property had been sold for its fair market value on the day before the expatriation or termination of U.S. residency. Any net gain in excess of $600,000 (as adjusted for inflation after 2008) on the deemed sale is recognized. The taxpayer must make adjustments for gain or loss realized after the deemed sale, without regard to the $600,000 exemption. A taxpayer may elect to defer payment of the mark-to-market tax until the taxpayer actually disposes of the property. Interest accrues on the unpaid tax and the taxpayer must post adequate security. In the case of a resident alien, property held by an individual on the date the individual first became a resident of the United States is treated as having a basis on such date of not less than its fair market value (unless the individual elects otherwise).
In general, a covered expatriate is defined with reference to prior law. A covered expatriate is an expatriate (1) whose average annual net income tax for the five taxable years preceding expatriation exceeds $139,000 (as adjusted in 2008 for inflation); (2) whose net worth is $2 million or more on the date of expatriation; or (3) who fails to certify under penalty of perjury that he or she has complied with all U.S. federal tax obligations for the five preceding taxable years or fails to submit such evidence of compliance as the IRS may require. Certain dual citizens and persons who relinquish U.S. citizenship before reaching 18 ½ years of age are not treated as covered expatriates.
In turn, an expatriate is a U.S. citizen who relinquishes his or her citizenship, or any long-term resident (i.e., an individual who is a lawful permanent resident of the United States in at least eight of the fifteen taxable years ending with the taxable year in which the individual terminates U.S. residency) of the United States who ceases to be a lawful permanent resident of the United States. Under the new rules, an individual ceases to be a lawful permanent resident of the United States for all tax purposes if he or she revokes or abandons his or her green card or if he or she (1) commences to be treated as an resident of a foreign country under a tax treaty between the United States and that foreign country; (2) does not waive the benefits of the treaty applicable to residents of the foreign country; and (3) notifies the IRS of the commencement of such treatment.
Deferred Compensation Items
The mark-to-market tax does not apply to interests in certain deferred compensation items. In the case of certain “eligible” deferred compensation items, the payor must deduct and withhold 30 percent of a taxable payment (i.e., a payment that would be includable in income if the recipient were a U.S. citizen or resident) made to a covered expatriate. This withholding requirement applies in lieu of any other withholding requirements under current law, but items that are subject to the withholding requirement are nevertheless subject to tax under section 871. In the case of deferred compensation items that are not “eligible,” an amount equal to the present value of the item is generally treated as having been received by the covered expatriate on the day before expatriation.
New Rules on Interests in Trusts
The mark-to-market tax applies to assets held by a portion of a trust for which the covered expatriate is treated as the owner under the grantor trust provisions of the Code. In contrast, a 30 percent withholding tax applies to direct or indirect distributions from the portion of any trust of which a covered expatriate is a beneficiary but not a grantor. In this case, the trustee must deduct and withhold from the distribution an amount equal to 30 percent of the distribution that would be includible in the gross income of the covered expatriate if such person continued to be subject to tax as a U.S. citizen or resident. This portion of the distribution is subject to tax under section 871, and the covered expatriate is treated as having waived any right to a reduction in withholding that is otherwise provided under a U.S. income tax treaty. Further, if the fair market value of the property exceeds its basis in the hands of the trust, gain must be recognized by the trust as if the property were sold to the covered expatriate at fair market value.
New Rules on Gifts and Bequests
The new rules subject U.S. citizens and residents who receive certain gifts or bequests from a covered expatriate to a transfer tax of 45 percent. This new transfer tax represents a significant departure from the general rules under which donees and heirs do not normally pay tax on the receipt of gifts or bequests. The transfer tax applies to property directly or indirectly acquired by gift from an individual who, at the time of the transfer, is a covered expatriate, or to any property directly or indirectly acquired by reason of the death of an individual who was a covered expatriate immediately before death. However, the first $12,000 (as adjusted for inflation) of gifts received by the U.S. citizen or resident from a covered expatriate in any taxable year is exempt from the transfer tax. Additionally, the tax is reduced by any foreign gift or estate taxes paid in connection with the property.
Covered expatriates must provide an information statement to the IRS for any year in which the covered expatriate has any obligations under the new rules. The IRS will impose a penalty of $10,000 for failure to comply with these reporting requirements in a timely manner, unless the covered expatriate can show that such failure is due to reasonable cause and not willful neglect.