1. Introduction

Individuals considering renouncing their U.S. citizenship, or terminating their long-term residency status, should familiarize themselves with the associated tax responsibilities mandated by the Internal Revenue Code (“IRC”). The current rules make it financially onerous for wealthy individuals to avoid tax by cutting their ties with the U.S. These provisions are also relevant to individuals seeking to obtain U.S. citizenship or residency status.

The expatriation regime under the IRC was amended by enactment of the Heroes Earnings Assistance and Relief Tax Act of 2008 (“HEART”).1 The new regime under IRC § 877A is applicable to individuals who expatriate after June 16, 2008. This replaced § 877, which now only applies to expatriations on or before June 18, 2008.2

2. Who does IRC § 877A apply to?

Not all expatriates are subject to the tax regime under § 877A. An expatriate is someone who renounces, relinquishes or loses her US citizenship (or terminates her long-term resident status3). § 877A only applies to “covered expatriates”.

A covered expatriate4, is an expatriate: (1) whose average annual net income tax for the five tax years preceding expatriation exceeds $147,000 ($139,000 in 2008);5 (2) whose net worth is $2 million or more on the date of expatriation;6 or (3) who fails to certify or submit evidence of compliance with all U.S. federal tax obligations for the five tax years preceding the tax year that includes the expatriation date7.

There are exceptions to the covered expatriate definition for certain minors and dual citizens.8 However, these exceptions do not apply if the expatriate fails to certify proper tax compliance as outlined above.9

Individuals who are captured by any part of the covered expatriate definition, and are not saved by one of the listed exceptions, may be subject to a so called exit tax.

3. Consequences for Covered Expatriates: The Mark-to-Market Tax

A covered expatriate is deemed to have sold her worldwide property for fair market value on the day before expatriation. The worldwide property captured by this mark-to-market regime includes all property that would be taxable as part of the covered expatriate’s estate under U.S. federal estate tax rules. Covered expatriates are then subject to income tax on the net unrealized gain on that property. This exit tax is due immediately. 

Notwithstanding other IRC provisions, any gain recognized on the deemed sale will be taken into account for the tax year of that sale and taxed at the appropriate capital gains rate. A covered expatriate cannot benefit from other ameliorative IRC provisions that might have provided relief.10 Any loss recognized on the deemed sale will be taken into account for the tax year of that sale, to the extent otherwise provided by tax law.11

One provision under § 877A provides some relief from the broad application of the mark-to-market rule. § 877A (3) directs that the amount that would otherwise be subject to the exit tax is reduced by $636,00012, though not below zero. Thus a covered expatriate could avoid the tax consequences of expatriation if her net gain realized from the mark-to-market rule is less than $636,000. Any gain above this value is allocated pro rata among all appreciated property and taxed accordingly.

(i) Exceptions for Certain Property

The mark-to-market rule does not apply to (i) eligible deferred compensation items, (ii) ineligible deferred compensation items, (iii) specified tax deferred accounts and (iv) any interest in a nongrantor trust.13  § 877A (d)-(f) discuss the special tax rules regarding these kinds of property.14

(ii) Election to Defer

If a covered expatriate has liquidity concerns, she may irrevocably elect to defer the exit tax on a particular piece of property until it is actually disposed of, or the expatriate dies. This election is made on an asset by asset basis. Interest will be charged on the deferred tax and compounded daily, starting from the due date of the return for the tax year that includes the day before expatriation.15

Certain conditions must be met before a covered expatriate may make a deferral election. First, a bond, or other security must be provided for the tax liability.16 This security will be updated and monitored over time to ensure it remains adequate to cover the debt. If the security is deemed inadequate, the exit tax will become due immediately.17 Second, a U.S. agent must be appointed to receive communications from the Internal Revenue Service (“IRS”).18 Finally, all benefits under any tax treaty that may impact the IRS’ ability to collect its debt must be waived.19

While the immediate financial consequences of the exit tax may be onerous, deferral applications come with their own set of burdens. A covered expatriate’s ability to enter into a tax-deferral agreement with the IRS is completely discretionary. The IRS’ acceptance or rejection of a deferral application would not be known until after expatriation. Further, when tax-deferred property is finally disposed of, the capital gains tax rate may be higher than it is currently.  All this, in combination with the ongoing accrual of interest on tax owed and the requirement to maintain adequate security, could result in a significant financial burden.

4. Considerations 

Many expatriates may not be able to avoid characterization as a covered expatriate. For these individuals § 877A has broad application with immediate tax consequences. If the covered expatriate’s tax liability exceeds the $636,000 exclusion, she will have to determine whether it is in her best interest to elect to defer the exit tax on some or all of her worldwide assets. This may be necessary if there are liquidity issues. However, the long term costs of deferral may be prohibitive and the uncertainty of future tax rates should be considered.

If an individual is looking to expatriate, guidance should be sought from the IRS website, which provides the current forms and filing instructions.20 It is important to note that there are substantial penalties for covered expatriates who fail to file the required information returns.21 Advice from a tax expert is necessary to ensure compliance with the IRC’s complex mark-to-market regime.