Expatriation, Offshore Disclosure & Exit Tax: Offshore Voluntary Disclosure and IRS Tax compliance are very complicated and specialized areas of international tax law that have several moving parts working simultaneously. This is amplified when a person is considering expatriation (e.g., leaving the US for good).
Because some U.S. Citizens and Long-Term Residents who want to expatriate may become subject to U.S. Exit Tax calculation rules (even if they are below the net-worth and net-income tax liability tests) if they cannot certify they are 5-Years tax compliant as required under IRC 877(a)(C)(2), before they expatriate.
When a client seeks to both get into offshore compliance and expatriate, many different avenues must be explored.
Just throwing a client into the Streamlined Program without explanation can cause serious tax consequences – and many of these tax consequences are irreversible.
Recent Example of Bad Lawyering
A general tax lawyer with a little international tax knowledge is very dangerous.
In this situation, the Taxpayer wanted to get into IRS compliance for non-filing of FBAR and FATCA and PFIC — and also give up their U.S. status. Taxpayer was single, with no spouse or children and was worth about $1.9M, which is what sparked the journey into seeking compliance help.
Taxpayer got baited into representation by inexperienced counsel before they had a chance to really explore the market and understand the limitations of just using the Streamlined Program for their complicated tax matter.
The Attorney misrepresented their background in these types of matters, and irresponsibly sold the client on the fact his tax non-compliance was minor, when clearly it wasn’t. The taxpayer also wanted to expatriate, and the client told this to the attorney, but the Attorney stated that expatriation is different, and something they can discuss later.
The attorney shipped the client off to a pre-selected general practice CPA whom the client did not have a good experience with overall, as the CPA was not experienced in PFIC matters.
The client preferred to use an attorney to prepare the whole submission, but this attorney misrepresented the dynamics of tax return preparation and “Kovel,” and stated they now had to use the CPA for confidentiality and privilege purposes (another false misrepresentation).
After submitting to Streamlined, the Taxpayer moved abroad files a Form I-407 the same year, and then starts the search for Expatriation Help.
Let’s go through the damage this has caused to the Taxpayer.
What is Expatriation?
Expatriation refers a person wanting to leave the U.S. for good. More specifically, it refers to wanting to “permanently” give up their U.S. status.
It does not require actually moving from the U.S., since you can be a U.S. Person and reside outside the U.S. (Voluntarily letting your green card expire with nothing else is not an expatriating act)
The taxpayer will either relinquish their legal permanent resident status (usually with a Form I-407) or give up their citizenship.
How to give U.S. citizenship will vary based on whether they reside in the U.S. or abroad. They can go to the Consulate or use the “Statement of Understanding Concerning the Consequences and Ramifications of Renunciation or Relinquishment of U.S. Nationality” process.
Once the Taxpayer relinquishes their U.S. status, the expatriating act is complete, and that is a very important date.
This was not explained to the Taxpayer by prior counsel.
What is Exit Tax?
Exit tax is a “Tax” that some individuals will have to pay when they exit the U.S. for good.
“For Good” is a misnomer, because a person can come back to the U.S., but they only get one bucket of gain exclusion ($725,000 for 2019).
If they do not use the whole bucket at the time of exit, they can use the rest of the bucket later if they go through this exercise again, but there is no refilling the bucket.
Who is Subject to Exit Tax?
Only a Covered Expatriate is subject to exit tax.
Not all expatriates are covered expatriates.
Not all covered expatriates will owe any exit tax at expatriation.
What is a Covered Expatriate?
Let’s go through the analysis below:
Which Individuals may be a Covered Expatriate?
- U.S. Citizens
- Legal Permanent Residents who are LTRs
What is a Long-Term Resident?
Generally, if you have had Legal Permanent Resident status for 8 of the last 15-years, you are a Legal Permanent Resident.
As provided by the IRS:
“You are an LTR if you were a lawful permanent resident of the United States in at least 8 of the last 15 tax years ending with the year your status as an LTR ends.
In determining if you meet the 8-year requirement, don’t count any year that you were treated as a resident of a foreign country under a tax treaty and didn’t waive treaty benefits applicable to residents of the country.”
Exception for dual-citizens and certain minors
Dual-citizens and certain minors (defined next) won’t be treated as covered expatriates (and therefore won’t be subject to the U.S. exit tax) solely because one or both of the statements in paragraph (1) or (2) above (under Covered expatriate) applies.
However, these individuals will still be treated as covered expatriates unless they file Form 8854 and certify that they have complied with all federal tax obligations for the 5 tax years preceding the date of expatriation as required in paragraph (3) (under Covered expatriate, earlier).
Three (3) Covered Expatriate Tests
There are 3 main ways a person meets the covered expatriate test:
Average Tax Liability Test
Your average annual net income tax liability for the 5 tax years ending before the date of expatriation is more than the amount listed below:
- $168,000 for 2019
Net Worth Test
Your net worth was $2 million or more on the date of your expatriation.
5-Year Tax Compliance
You fail to certify on Form 8854 that you have complied with all federal tax obligations for the 5 tax years preceding the date of your expatriation.
Covered Expatriate Under the 5-Year Compliance Rule
Why is this Taxpayer a Covered Expatriate?
Because even though they did not meet the Net-Worth Test (it was below $2M) or the Net-Income Tax Liability test, the Taxpayer expatriated before being 5-years tax compliant.
Taxpayer had two easy options available:
- Taxpayer could have gone back and filed 5-years of amended/original returns and then expatriated; or
- Waited another two-years (until 5-years of tax compliance) and then expatriated in the subsequent year.
The problem is the lawyer never advised the client about these options.
Form 8854 is used for U.S. Citizens and Long-Term Residents who Expatriate.
The form specifically asks: Do you certify under penalties of perjury that you have complied with all of your tax obligations for the 5 preceding tax years?
As provided in Form 8854 Instructions:
“You fail to certify on Form 8854 that you have complied with all federal tax obligations for the 5 tax years preceding the date of your expatriation.”
Exit Tax Imposed
Now the Taxpayer is a Covered Expatriate, and will have some major tax consequences.
Not only does the Taxpayer have significant tax deferred investments that will be deemed distributed the day before expatriation. In addition, Taxpayer has nearly $700,000 in foreign pension, which will also be deemed “ineligible deferred compensation” as well, and is subject to immediate tax under the deemed distribution rules.
The purpose of the individual getting into compliance was to avoid this exact issue.
Their foreign pension would not be taxable in the foreign country.
Moreover, the funds and assets would have received 0% and 5% tax in the country of source.
And, future 401K distributions will be taxed at 30% as all treaty benefits are deemed “irrevocably waived.”
An incredibly bad outcome, which could have easily been avoided.