The enactment of the Heroes Earnings Assistance and Relief Tax Act (the "HEART Act") on June 17, 2008, carries revised tax implications for certain individuals who relinquish United States citizenship or lawful permanent resident status after the effective date. Along with the purpose of providing tax relief for military personnel and their families, the HEART Act is intended to deter high-net worth U.S. citizens and long-term residents from avoiding the payment of U.S. taxes by imposing an immediate exit tax on both the U.S. and foreign assets of these individuals.
Who is Covered by the HEART Act?
An individual who meets the definition of a "covered expatriate" is subject to the provisions of the HEART Act.
Expatriates and Expatriation Date
An expatriate is any U.S. citizen who relinquishes his citizenship and any long-term resident of the U.S. who ceases to be a lawful permanent resident of the U.S. The date on which the individual relinquishes citizenship or ceases to be a lawful permanent resident is the "expatriation date" for federal tax law purposes.
An individual is considered to have relinquished his U.S. citizenship on the earliest of four dates: (1) the date on which the individual renounces his U.S. citizenship; (2) the date on which the individual provides the Department of State with a signed statement of voluntary relinquishment of U.S. nationality; (3) the date on which the Department of State issues a certificate of loss of nationality; or (4) the date a U.S. court cancels a naturalized citizen's certificate of naturalization.
A long-term resident is a foreign national who was a lawful permanent resident (often referred to as a "green card holder") of the United States for at least eight taxable years during the fifteen taxable years preceding the date of expatriation. An individual is a lawful permanent resident of the United States if "(A) such individual has the status of having been lawfully accorded the privilege of residing permanently in the United States as an immigrant in accordance with the immigration laws, and (B) such status has not been revoked (and has not been administratively or judicially determined to have been abandoned)."
An individual ceases to be a lawful permanent resident if he has such status revoked or administratively or judicially determined to have been abandoned. Alternatively, an individual can cease to be a lawful permanent resident if (1) the individual commences treatment as a resident of a foreign country pursuant to a tax treaty between the U.S. and the foreign country, (2) does not waive the treaty benefits accorded to residents of the foreign country, and (3) notifies the IRS of the beginning of such treatment under the treaty.
While the provisions state that an individual must reside in the U.S. for at least eight years in order to be considered a long-term resident, the calculation of these eight years is important to the determination of long-term residency. The year of receipt of the green card and the year of abandonment of the green card are both counted. For example, if an individual received his green card on December 30, 2002 and abandoned his green card on January 2, 2009, the individual is classified as a long term resident because the years 2002 and 2009 count towards the eight year requirement.
An expatriate is "covered" under the HEART Act if he (1) has an average annual U.S. income tax liability of at least $139,000 (in 2008 and as adjusted annually) for five years prior to expatriation; (2) has a net worth of at least $2 million; or (3) is unable or fails to certify that he met his U.S. tax obligations for the five years preceding expatriation or fails to submit such evidence of compliance as the IRS may require.
For U.S. citizens who relinquish citizenship, two exceptions apply with respect to the tax liability and net-worth qualifiers. The first exception is available to an individual who possesses dual citizenship (United States and a foreign country) if (1) as of the expatriation date the individual continues to be a citizen of another country and is taxed by that country as a resident; and (2) the individual has been a resident, determined pursuant to the "substantial presence" test, of the United States for not more than ten taxable years during the fifteen year taxable period ending with the taxable year of expatriation. The second exception is available to a United States citizen who relinquishes U.S. citizenship before reaching the age of eighteen and a half provided the individual has not been a resident of the United States for more than 10 years of his lifetime.
In order to avoid the classification of "covered expatriate" under these exceptions, a U.S. citizen must certify to the IRS compliance with U.S. tax laws for the five preceding years and supply any evidence in support of such compliance that might be required.
What Effect does the HEART Act have on Expatriates?
Prior to the enactment of the HEART Act, there was no immediate tax effect for expatriates. Instead, individuals who relinquished their citizenship or lawful permanent resident status were subject to a tax on their U.S. source income which was the greater of the tax imposed by the general rules applicable to non-resident non-citizens or an alternative tax. These individuals were subject to this tax regime for 10 years following expatriation. After this 10 year period, these individuals were no longer subject to U.S. tax on assets not located in the U.S. Accordingly, a U.S. citizen, who was taxed on worldwide income, could renounce his citizenship and at the end of the 10 year period the individual could sell investment property and avoid U.S. taxation on all of the capital gains attributed to this property.
Under the HEART Act, the taxable effect of expatriation is immediate and ongoing. An expatriate is deemed to sell all of his worldwide property on the day before his expatriation date, and he must recognize gain on this constructive sale (the "mark-to-market" rule). While certain items are excluded from the mark-to-market rule, distributions from these items are generally taxable even if they occur more than 10 years after expatriation. In addition, covered expatriates are subject to a reporting requirement and must provide an information statement to the IRS for any year in which the individual has any obligations under the HEART Act. Failure to provide the statement may result in a $10,000 penalty.
The mark-to-market rule provides that all property of a covered expatriate shall be treated as sold on the day before the expatriation date for its fair market value. Gains and losses from this constructive sale are recognized, but losses are only recognized to the extent of gains. The net gain is then reduced (but not below zero) by $600,000, as adjusted for inflation after 2008.
Accordingly, if a covered expatriate recognizes gain of $2 million and losses of $500,000 on the constructive sale, the individual is taxed on a net gain of $900,000 (gains of $2 million, less losses of $500,000, less exemption of $600,000).
In order to compute the gain for the constructive sale, the basis of the covered expatriate's property which was held on the date he first became a resident of the U.S. is not less than the property's fair market value on that date. A covered expatriate may elect out of this rule, but this election is irrevocable. The basis of any property acquired after the date the individual first became a resident of the U.S. would be computed under the standard basis rules.
The provisions state that adjustments are to be made for gain or loss recognized after the constructive sale, but it is unclear how these adjustments will be applied. The Treasury Department and the IRS have authority to issue regulations, so presumably this will be clarified in the future.
Election to Defer Payment of Tax
Gains and losses resulting from the constructive sale are recognized on the individual's final return as a U.S. citizen or resident. However, the covered expatriate may elect to extend the time for payment of the additional tax attributed to any gain which is recognized until the due date of the return for the taxable year during which the individual actually sells or exchanges the property. This election only applies to tax attributable to property described in the election. If the taxpayer elects to defer this tax, the deferred tax bears interest from the due date of the individual's final return as a U.S. citizen or resident.
In order to make the election to defer tax, an expatriate must provide adequate security for payment of the deferred tax and interest. Generally, this involves furnishing a bond to, and having the bond accepted by, the IRS that is conditioned on payment of the tax and interest. In addition, the expatriate must waive any treaty rights that would limit collection of the deferred tax.
Items Excluded from the Mark-to-Market Rule
Deferred compensation items, specified tax deferred accounts and interests in nongrantor trusts are excluded from the mark-to-market rule, but distributions from these items are still subject to tax. The treatment accorded to each item is summarized below.
1. Deferred Compensation Items
Deferred compensation items include: (i) an interest in a qualified pension, profit-sharing, stock bonus, or annuity plan, a tax-deferred annuity subject to § 403(b), a simplified employee pension, a simple retirement account or a plan established by the federal, state or local government for its employees; (ii) an interest in a foreign pension plan or similar retirement arrangement or program; (iii) any property, or right to property, which the individual is entitled to receive in connection with the performance of services to the extent not previously taken into account under section 83 or in accordance with section 83; and (iv) any other item of deferred compensation.
For "eligible" deferred compensation items, the payor must withhold a tax equal to 30% from any taxable payment to the covered expatriate. In order for a deferred compensation item to be considered "eligible" (i) the payor of the item must be a U.S. person or a foreign person who elects to be treated as a U.S. person which meets certain requirements to establish that the payor will withhold tax, and (ii) the covered expatriate must notify the payor of his status as a covered expatriate and make an irrevocable waiver of any right to claim a reduction in withholding on such item under a treaty provision.
For deferred compensation items that are not "eligible", if the item is property or a right to property that the individual is eligible to receive in connection with the performance of services, the covered expatriate will have gross income on the expatriation date equal to the amount by which the property's fair market value exceeds the amount paid for the property.
For other noneligible deferred compensation items, the covered expatriate is deemed to receive a plan distribution equal to the present value of his accrued benefit on the day before the expatriation date. This amount, less any amount to which the covered expatriate has already been taxed, must be included in the covered expatriate's gross income. No early distribution penalties apply to the constructive distribution.
2. Specified Tax Deferred Accounts
Specified tax deferred accounts include an IRA, a qualified tuition program, a Coverdell education savings account, a health savings account, and an Archer MSA. If a covered expatriate has any interest in one of the foregoing accounts on the day before his expatriation date, then he is treated as receiving a distribution of the entire amount held in the account on that day. This amount is subject to income tax at ordinary income rates, but no early distribution penalty will apply.
3. Nongrantor Trusts
A nongrantor trust is a trust for which the covered expatriate is not considered the owner and of which the covered expatriate was a beneficiary on the day before his expatriation date.
If a distribution is made to a covered expatriate from a nongrantor trust, the trustee of the trust must withhold an amount equal to 30% of the taxable portion of the distribution and, if the fair market value of the property exceeds its adjusted basis, the trust will recognize gain as if the property were sold at fair market value to the covered expatriate. For the purposes of withholding tax, the covered expatriate is treated as having waived any right to claim any reduction in withholding under a treaty provision.
If the covered expatriate is the owner of a grantor trust, this property will be subject to the mark-to-market rule discussed above.
As a result of the enactment of the HEART Act, the rules have changed dramatically for expatriating citizens and long-term residents. Foreign individuals who are considering moving to the U.S. should review the rules carefully before relocating. With proper planning, these individuals may be able to avoid classification as long term residents and thus avoid the imposition of this far reaching tax.