IRS Provides Some Guidance on the New Expatriation Exit Tax  

Notice 2009-85 covers a great deal of material and clarifies many issues arising with respect to the mark-to-market tax that generally replaces the ten-year regime imposed on expatriates. Nevertheless, the Notice explicitly does not cover some questions, and silently ignores others. ]

The tax consequences associated with expatriating changed significantly with the enactment of the Heroes Earnings Assistance and Relief Tax Act of 2008 (P.L. 110-245, 6/17/08; the "HEART legislation"). U.S. citizens seeking to terminate their citizenship and long-term residents seeking to return their green card (collectively, "expats") are no longer subject to an alternate U.S. income tax regime for ten years following the date of expatriation. Instead, section 301 of the HEART legislation added two new sections to the Code: a new income tax provision, Section 877A, that subjects certain expats to an exit tax; and a new transfer tax provision, Section 2801, pursuant to which the U.S. recipients of gifts and bequests from certain expats could be subjected to gift or estate tax. In addition, other Code provisions were revised to be consistent with the new approach. 1

In an effort to clarify issues generated by the HEART legislation and to implement the new statutory provisions, the IRS issued Notice 2009-85, 2009-45 IRB 598. The Notice, 65 pages in all, contains 58 pages of guidance applicable to Section 877A, including several examples. It also includes two appendices that add seven more pages. The Notice does not make any changes with respect to Section 877, which remains applicable to those expats who expatriated prior to 6/17/08, or provide any guidance with regard to Section 2801. Taxpayers may rely on the terms of the Notice pending the issuance of Regulations.

COVERED EXPATRIATE

The exit tax applies to "covered expatriates," which can include U.S. citizens who expatriate and green card holders who relinquish their green cards after having been a permanent U.S. resident for at least eight of the 15 years prior to expatriating (including the year of expatriation). 2 To be classified as a covered expatriate under Section 877A(g)(1)(A), the expat must have either:

  1. A net worth of at least $2 million on the date of expatriation (the "net worth test"), or
  2. As of 2009, an average annual net income tax for the five tax years prior to expatriation greater than $145,000 (this amount is adjusted periodically for inflation) (the "income tax test").

Nevertheless, an expat can be classified as a covered expatriate even if the expat does not satisfy the net worth test or the income tax test. Any expat seeking to expatriate after 6/17/08 must certify under penalties of perjury that the expat has been compliant with the U.S. tax laws for the five-year period prior to expatriation (the "certification test"). The certification test is satisfied by filing Form 8854 (discussed below under "Compliance"). Failure to satisfy the certification test and file Form 8854 will result in the expat's being classified as a covered expatriate and subject to the exit tax, irrespective of the net worth test or the income tax test.

There are two exceptions by which U.S. citizens, if they expatriate, are

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exempt from the expatriation rules. The first applies to individuals who became dual citizens at birth. In order to qualify for this exemption, (1) the individual must have obtained both U.S. citizenship and citizenship of another country solely by reason of birth, (2) at the time of the expatriation the individual must remain both a citizen and income tax resident of the other country, and (3) the individual must not have qualified as a U.S. resident under the substantial presence test for more than ten years out of the 15-year period ending with the year of expatriation. 3

The second exemption applies to persons (1) who expatriate before attaining the age of 181/2 and (2) who did not qualify as a U.S. resident under the substantial presence test for more than ten tax years prior to the year of expatriation. 4

THE MARK-TO-MARKET TAX

In general, Section 877A subjects a covered expatriate to an exit tax on the net unrealized gain with respect to all worldwide property when that covered expatriate terminates U.S. citizenship or permanent U.S. residency. The property owned by the covered expatriate will be deemed sold on the day before the expatriation date, and if and to the extent that the gain on the deemed sale exceeds a $627,000 exclusion, the covered expatriate will be liable for tax. 5

If the covered expatriate is deemed to be the owner of a trust under the grantor trust rules, all of the assets held by the trust (which the covered expatriate is deemed to own) also are subject to the mark-to-market tax. 6 An interest held by a covered expatriate in a nongrantor trust 7 as well as certain interests held by a covered expatriate in deferred compensation plans 8 are exempt from the mark-to-market tax. Instead, distributions from such a trust or deferred compensation plan to the covered expatriate are subject to a 30% withholding tax.

Exit Tax Base

While the statute generally subjects a covered expatriate to the exit tax on the FMV of all property, wherever located, on the day before the expatriation date, it does not define what property is considered to be included in the covered expatriate's tax base. Notice 2009-85, however, explains in section 3.A. that for purposes of determining the tax base, a covered expatriate is deemed to "own any interest in property that would be taxable as part of his or her gross estate for Federal estate tax purposes under Chapter 11 of Subtitle B of the Code as if he or she had died on the day before the expatriation date as a citizen or resident of the United States." The credits provided by Sections 2010 through 2016 are excluded from the determination as to whether property constitutes part of the covered expatriate's gross estate.

Once the tax base is determined, the Notice instructs that for valuation purposes the principles applicable to estate tax valuations (i.e., Section 2031 and the accompanying Regulations) are to be used for determining the FMV of the tax base on the day before the expatriation date. For this purpose, various deductions—the Section 2055 charitable, Section 2056 marital, Section 2056A qualified domestic trust provisions, and Section 2057 rules for qualified family-owned business interests—are denied, as is a deduction for the tax liability incurred by virtue of the exit tax.

Similarly inapplicable are the alternate valuation rules of Section 2032 and the special-use valuation rules provided by Section 2032A. The Notice states that the special valuation provisions of Sections 2701 through 2704 are applicable, so that the covered expatriate's interests subject to those provisions will be deemed transferred to family members.

Notice 2009-85 also states that a covered expatriate must include within the tax base the FMV of any beneficial interest in a trust, other than a nongrantor trust, to the extent the beneficial interest would have been included in the covered expatriate's gross estate in accordance with the gift tax valuation principles of Section 2512. Finally, addressing an area that had been the subject of much discussion, the Notice makes clear that the IRS intends to value any interest held by a covered expatriate in a life insurance policy in accordance with Reg. 25.2512-6, as if the covered expatriate made a gift of the policy on the day before expatriating.

It is clear that the IRS intends to expand the tax base by using all available estate tax inclusion provisions and denying the use of any provisions that otherwise would reduce the tax base. As a result, assets that the covered expatriate no longer owns could be subject to the exit tax. This could occur because provisions such as Sections 2035, 2036, and 2038 are designed to include assets in the decedent's gross estate for estate tax

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purposes where the decedent made a transfer within three years of death or retained a proscribed interest or power.

There does not appear to be a sound policy justification for this expansion, especially considering the covered expatriate is prohibited from taking deductions. The ultimate implication is that there may be many circumstances in which the covered expatriate could be paying double tax—first, a gift tax on a transfer made within three years of expatriation, and then a second tax on the same transfer under Section 2035 in the covered expatriate's tax base subject to income tax. This is a perverse result considering that, in the estate tax context, the decedent's gross estate would include the same property but there would be an offset for previously taxed gifts.

Perhaps this expanded tax base is designed to catch individuals with green cards, but who would otherwise qualify as covered expatriates, who made gifts of their non-U.S.-situs assets prior to expatriating. If done carefully, such gifts might otherwise allow these individuals to circumvent the net worth test and income tax test because a green card holder is not de facto domiciled in the U.S. and non-U.S.-situs assets would not be subject to U.S. gift tax. A cynic might conclude that because the expat community has virtually no PACs lobbying Congress, the decision was made to use the exit tax and expanded tax base as a revenue raiser.

Allocation of Exclusion

While Section 877A(a)(3) provides each covered expatriate with an exclusion, it does not discuss how to allocate the exclusion among the covered expatriate's gain assets. Notice 2009-85, however, clarifies in section 3.B. that the exclusion is to be prorated among all gain assets based on the amount of relative built-in gain on each such asset. It also confirms that the exclusion applies to all assets that are subject to the deemed sale rule, including U.S. real property interests (USRPI). What is perhaps the strangest result of this provision, at least from a policy standpoint, is that it can permanently exempt from U.S. federal income tax some gain on USRPIs that otherwise would be subject to tax in the hands of anyone other than a covered expatriate.

Example: A covered expatriate's only asset is U.S. real property worth $1 million, with a $400,000 basis. The expatriation date occurred in December 2008, when the Section 877A(a)(3) exclusion was $600,000. The covered expatriate thus pays no gain when he leaves the U.S., since the entire $600,000 realized gain is excludable. Notice 2009-85 directs that on departing the U.S., the expatriate is to adjust his tax basis in each item of property subject to the deemed sale to its FMV on the expatriation date. The covered expatriate thus obtains a basis step-up on the USRPI to $1 million. If he immediately sells the property for $1 million, there is no U.S. gain realized on the sale, and thus no U.S. tax liability is triggered (i.e., no FIRPTA liability arises).

In contrast, other nonresident aliens and U.S. taxpayers alike are always subject to tax on any gain realized with respect to a sale or other taxable disposition of USRPI, and therefore such persons would be subject to tax on that same $600,000 gain. Accordingly, covered expatriates who own appreciated U.S. real property at the time of expatriating generally receive tax-favored treatment under this provision as compared to all other classes of persons.

Notice 2009-85 also states that each covered expatriate has one exclusion per lifetime. If a covered expatriate subsequently becomes a U.S. citizen or green card holder, expatriates a second time, and otherwise is within the ambit of Section 877A, he is eligible for only whatever proportion of the exclusion, if any, was not used at the time of the first expatriation. This limitation is not reflected anywhere in the statute or the relevant legislative history.

Section 877A provides that "proper adjustment" is to be made to any gain or loss subsequently realized, to account for any gain or loss realized on property marked-to-market under Section 877A ("determined without regard to" the exclusion provided under Section 877A(a)(3)). 9 Notice 2009-85 confirms that the adjustment is to be made by way of an increase or decrease, as the case may be, to the taxpayer's basis in each asset. The Notice sets forth examples of downward as well as upward adjustments. Of course, from an income tax standpoint, assuming the expatriate never again resumes U.S. income tax residency, these adjustments are relevant only with respect to assets that remain subject to U.S. taxing jurisdiction, such as U.S. trade or business assets and USRPI.

Deferral and Adequate Security

A covered expatriate may defer payment of the exit tax in exchange for providing security to the IRS that satisfies Section 877A(b)(4). As discussed further below, however, it remains to be seen how many taxpayers will actually find it possible to take advantage of this provision.

Section 877A(b) provides that if "adequate security" is posted, a covered expatriate (who irrevocably waives any relevant treaty benefits 10 that otherwise might preclude assessment or collection of the tax) may elect to defer payment of the tax due under Section 877A, on an asset-by-asset basis, until the earlier of an actual sale of the asset in question or the expatriate's death.

Where deferral is successfully elected, Notice 2009-85 provides that interest accrues on the deferred tax at the usual underpayment rate under Section 6621, compounded

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daily pursuant to Section 6622. The Notice says that although the election to defer tax must be "irrevocable," the covered expatriate may pay the tax and interest due at any time.

Appendix A of Notice 2009-85 includes an "Agreement on Deferral of Tax Imposed Under I.R.C. §877A." Appendix B is a sample "Authorization of Agent" (appointing a U.S. person to process information requests, which the deferral agreement requires). The agreement explicitly says, as does the statute, that the IRS may accept collateral other than a bond or letter of credit, but neither Notice 2009-85 nor the sample agreement give any further guidance on this point.

The question of security or collateral is the biggest practical issue covered expatriates and their advisors currently face with the deferral provision, because those covered expatriates who most need to defer the payment of tax liability triggered under Section 877A do not generally have enough liquid assets to post an adequate bond or letter of credit. It simply is not clear what else the Service might be willing to accept as "adequate" security for deferral purposes. Unfortunately, the Notice does little to settle this pressing issue.

The sample deferral agreement states that it has a specified term and must be renewed periodically as provided therein. In addition, several timing rules are provided relating to curing defaults in adequacy or other issues. The covered expatriate generally has 30 days to cure a default after receiving notice from the IRS.

Notice 2009-85 provides that monitoring of the deferral program is assigned to "Advisory" in the Service's Plantation, Florida, office, and that the agreement is governed by the laws of the U.S. (although no particular state law is mentioned in the Notice). The request to enter into a deferral agreement itself, however, is filed in Bensalem, Pennsylvania, and this request is made by submitting two copies of the deferral agreement on the due date of the tax return for the year that includes the day before the expatriation date.

The deferral request must show the calculation of the gain on assets for which deferral is proposed and documentation of the proposed collateral, a copy of the agreement to appoint an agent, and a copy of the covered expatriate's income tax return. The deferral request also must be attached to that income tax return and may be filed simultaneously therewith.

Coordination With Other Code Sections

Section 877A(h)(1)(A) causes the termination, on the day before the expatriation date, of any period for acquiring property that otherwise would result in a reduction in the amount of gain recognized by the covered expatriate with respect to the disposal of property. Notice 2009-85, section 4, clarifies that this provision is intended to apply to like-kind exchanges and involuntary conversions.

Similarly, Section 877A(h)(1)(B) provides that any extension of time to pay tax terminates on the day preceding the expatriation date. The Notice explains that as a result of this rule, tax is due and payable on the earlier of (1) the date the tax would have been due in the absence of the application of Section 877A or (2) the due date of the covered expatriate's return for the tax year that includes the date preceding the expatriation date.

Section 877A also implicates a number of other specific Code sections, and Notice 2009-85 provides some guidance on coordinating these provisions.

Section 367. Section 367(a) applies to outbound stock transfers to a foreign corporation. The Notice provides a timing rule with respect to gain recognition agreements under that section. Temp. Reg. 1.367(a)-8T(d)(6) states that if a U.S. transferor loses citizenship or permanent residency (i.e., a green card), the individual is treated as having disposed of the stock of the transferee corporation at that time. Notice 2009-85 clarifies that this deemed disposition is considered to occur before the application of Section 877A.

Section 684. The Notice also provides a timing rule for Section 684, which deals with tax on gains realized on outbound transfers to foreign nongrantor trusts. It specifies that covered expatriates also must take Section 684 into account before applying Section 877A.

If the expatriation causes a grantor trust to cease being classified as a grantor trust, and to instead be treated as a foreign nongrantor trust, all the resulting gain must be recognized under Section 684. Thus, the rule providing that a covered expatriate is treated as owning only assets in a grantor trust of which he is a beneficiary will not prevent gain recognition if the trust becomes a foreign trust, but the covered expatriate may avoid tax if the trust becomes a U.S. complex trust.

FIRPTA. Notice 2009-85 states the obvious in providing that Section 897, relating to foreign investment in U.S. real property, does not apply to the deemed sale under Section 877A. Clearly, Section 897 should not apply in such cases because the covered expatriate is, at the time of the deemed sale, a U.S. resident and thus not subject to FIRPTA. Section 897 will, of course, apply to any subsequent taxable disposition of U.S. real property interests that take place when the covered expatriate is a nonresident alien. 11

Prior expatriation rules. Notice 2009-85 reiterates that an individual whose expatriation date occurred prior to 6/17/08 continues to be

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subject to the ten-year alternative tax regime set forth in Section 877, as well as the accompanying reporting requirements under Section 6039G, as in effect on the individual's expatriation date. The Notice further explains that an individual whose expatriation date occurred after 6/3/04 but before 6/17/08 continues to be also subject to the provisions of Section 7701(n) as in effect prior to 6/17/08 (in these cases, the ten-year period described in Section 877(a) does not begin to run until the date on which the expatriate files Form 8854).

The Notice provides a couple of examples illustrating the foregoing. In Example 7, a covered expatriate who expatriated on 6/10/08 but did not file Form 8854 until 12/12/09 is subject to Section 877 (and is not subject to the mark-to-market rule under Section 877A) for ten years beginning on 12/12/09 and ending on 12/12/19. In Example 8, a person who is treated as having expatriated as a result of commencing to be treated as a resident of a foreign country under an income tax treaty with the U.S. generally is treated as having been a resident of the treaty country as of January 1 of the relevant tax year.

Deferred Compensation

Under Section 877A(d), deferred compensation items are generally subject to the exit tax under Section 877A(a), and thus an amount equal to the present value of the covered expatriate's account is treated as having been received on the day before expatriation and is taxed to the expatriate accordingly, unless the deferred compensation item at issue qualifies as an "eligible deferred compensation item."

For purposes of the mark-to-market rules, under Section 877A(d)(4) a "deferred compensation item" generally includes the following:

  • Any interest in a qualified plan or other arrangement described in Section 219(g)(5).
  • Any interest in a foreign pension, retirement, or similar plan or arrangement.
  • Any "item of deferred compensation."
  • Any interest in property to be received in connection with the performance of services to the extent not previously taken into account in accordance with Section 83.

Notice 2009-85 expands on several of the foregoing classes of items, in particular providing guidance on what items are includable by reference to Section 83, and what specific items are considered to be within the class that the statute unhelpfully refers to only as "item[s] of deferred compensation."

With respect to Section 83 items, section 5.B(1)d of the Notice states that until further guidance is provided (presumably until Regulations are issued), Section 83 items are those items of property that have been transferred (as defined in Reg. 1.83-3(a)) to the covered expatriate, or a right to property to which the covered expatriate has a legally binding right as of the date preceding the expatriation date, in connection with the performance of services. Notice 2009-85 clarifies that it is not relevant whether such items are substantially vested. Therefore, nonvested amounts are deemed to vest for purposes of this rule. Nevertheless, such items are includable only to the extent they have not been previously included by the covered expatriate. Examples of includable items are:

  • Statutory and nonstatutory stock options.
  • Stock and other property.
  • Stock-settled stock appreciation rights.
  • Stock-settled restricted stock units.

Notice 2009-85, section 5.B(4), similarly defines an "item of deferred compensation" to mean any amount of compensation if the terms of the compensation arrangement give the covered expatriate a legally binding right to the compensation as of the day before expatriation, the compensation has not been actually or constructively received by that date, and pursuant to the compensation arrangement the amount is payable to or on behalf of the expatriate. This catch-all provision, however, does not encompass items that are includable within one of the other classes of "deferred compensation items" under Section 877A(d)(4) (not to be confused with "items of deferred compensation" under Section 877A(d)(4)(C)), namely, as either an interest in a qualified plan or other arrangement described in Section 219(g)(5), an interest in a foreign pension, retirement, or similar plan or arrangement, or a Section 83 item.

Pursuant to Section 877A(d)(3), a deferred compensation item is "eligible" only if the payor is either (1) a U.S. person or (2) a foreign person who elects to be treated as a U.S. person for this purpose, and provided that the covered expatriate notifies the payor of his or her status and makes an irrevocable waiver of any right to claim a reduction in withholding under an applicable U.S. tax treaty.

In contrast to ineligible deferred compensation, eligible deferred compensation items are not subject to U.S. income tax until a covered expatriate receives a "taxable payment." For this purpose, a "taxable payment" generally means a payment that would be taxable if the individual continued to be subject to tax as a U.S. person. 12 The tax on such taxable payments is collected by means of a 30% withholding tax. Notice 2009-85, section 5.F, confirms that payors are liable for the withholding tax under Section 1461 where an expatriate notifies the payor of his or her covered expatriate status on Form W-8CE.

Notice 2009-85 also states that, if a payor does not withhold on an

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item of eligible deferred compensation, the covered expatriate must report such amounts on an income tax return for the relevant tax year. The Notice further acknowledges that there are issues in the withholding area that it simply does not address, and directs that, pending further guidance, payors are not required to withhold income taxes on amounts that are deemed to be received under Section 877A(d)(2)(A) (i.e., ineligible deferred compensation items). This makes sense given that the covered expatriate is still a U.S. tax resident on the date that the receipt is deemed to occur, and thus the covered expatriate has a clear U.S. filing obligation that includes the duty to report these items on Form 1040 for the relevant tax year. Additionally, the Notice clarifies that FICA and FUTA taxes continue to be computed without regard to Section 877A. 13

Notice 2009-85 reiterates that a foreign plan can qualify as eligible only if the payor elects to be "treated as a U.S. payor" and thus becomes subject to the accompanying withholding obligations and liability. Unfortunately, guidance as to how foreign payors are to make this uncertain election is not included in the Notice, which in section 5.B(2) repeats the Service's earlier announcement that such direction will be the subject of separate guidance. Until these instructions are provided, it is not clear how foreign payors are to make such an election and precisely what the consequences of doing so may be.

Consequently, many foreign payors may be currently unwilling to make such an election, leaving covered expatriates who have interests in foreign plans in a potentially costly position. In the absence of such an election, the present value of their interests in such plans (even if such an interest is not yet vested and may never vest) must be included in income and taxed at the time of expatriation. Such deemed receipts are not eligible for deferral under the statute; deferral is available only with respect to items that are treated as sold under Section 877A(a) and not with respect to items of ineligible deferred compensation, which are explicitly excepted from that subsection. 14

Under Section 877A(d)(5), deferred compensation attributable to services performed outside the U.S. while a covered expatriate was not a U.S. citizen or resident is not included, and thus is not taxed under the mark-to-market rules. Notice 2009-85, section 5.E, expands on this point, saying that until further guidance is issued (presumably in the form of Regulations), taxpayers may use "any reasonable method that is consistent with existing guidance ... and is based upon a reasonable, good faith interpretation" of Section 877A(d)(5) to calculate the excludable portion. As "existing guidance" the Notice specifically cites Reg. 1.861-4(b)(2), Rev. Rul. 79-388, 1979-2 CB 270, and Rev. Proc. 2004-37, 2004-1 CB 1099.

The cited Regulation vaguely states that such amount is to be determined on the basis that most correctly reflects the proper source of that income under the facts and circumstances of the particular case. It goes on to note that, in many cases, the facts and circumstances will be such that an apportionment on a time basis, as defined in the same Regulation, will be acceptable. The time basis generally looks to the amount that bears the same relation to the individual's total compensation as the number of days of performance of the labor or personal services by the individual within the U.S. bears to the total number of days of performance of labor or personal services. 15

The statute and the Notice are clear that, where ineligible deferred compensation is concerned, nonvested amounts are deemed to vest for purposes of the tax under Section 877A. Although Notice 2009-85 confirms and expands on the point that subsequent "appropriate adjustments" are made to prevent double taxation of such amounts, there is a more fundamental issue which the Notice fails to address. No provision in the Notice directly speaks to what relief, if any, will be provided where such nonvested amounts are deemed to vest and are taxed in full, but then in reality never vest or are never received by the covered expatriate.

In such instances, imposing even a single level of tax is unfair. From a practical perspective, the only way to properly restore the position of an expatriate who is faced with this situation would be for the IRS to provide a refund of the overpayment. A later U.S.-source deduction would be of limited or no use to most nonresident aliens, except where such a person had sufficient U.S. source income of the right character to offset against this deduction.

Specified Tax Deferred Accounts

Section 877A(e) provides that specified tax deferred accounts are deemed received on the day preceding expatriation. Notice 2009-85 provides that within 60 days of receiving a properly completed Form W-8CE, the custodian of such an account must advise the expatriate as to the interest's value as of the day before the expatriation date.

With respect to later "appropriate adjustments" to distributions taxed under this provision, section 6 of the Notice clarifies that where such distributions are taxable under Section 72, the amount includable in income under Section 877A(e)(1) is treated as investment in the contract. The Notice simply reiterates the definition of specified tax deferred account as set forth in Section 877A(e)(2).

Nongrantor Trusts

A covered expatriate's beneficial interest in a nongrantor trust is

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exempt from the exit tax. Under Section 877A(f), however, the trustee is required to withhold 30% of the taxable portion of any future distribution from the trust to the covered expatriate. The withholding applies to any direct or indirect distribution of property or money to a covered expatriate from a nongrantor trust so long as the covered expatriate was a beneficiary on the day before the expatriation date. The portion of the withheld distribution is subject to tax under Section 871 provided such payment would have been included in the covered expatriate's gross income had he or she remained a U.S. citizen or green card holder. 16

"Taxable portion" is defined in Section 877A(f)(2) to include the portion of a distribution that would have been includable in the covered expatriate's gross income if the covered expatriate had continued to be subject to U.S. income tax as a U.S. person.

Notice 2009-85, section 7.A, explains when a covered expatriate is deemed to have a beneficial interest in a nongrantor trust. It provides that a "beneficiary is a person (a) who is entitled or permitted, under the terms of the trust instrument or applicable local law, to receive a direct or indirect distribution of trust income or corpus (including, for example, a distribution in discharge of an obligation of that person), (b) with the power to apply trust income or corpus for his or her own benefit, or (c) to whom the trust income or corpus could be paid if the trust or the current interests in the trust were then terminated."

If the nongrantor trust distributes appreciated property to the covered expatriate, the trust must recognize gain as if the property were sold to the covered expatriate at its then FMV. 17 The Notice provides two examples demonstrating the tax treatment of appreciated property from both a nongrantor domestic trust and nongrantor foreign trust.

In addition, if a covered expatriate is deemed to become the owner of a nongrantor trust subsequent to expatriating, this will be viewed as a conversion and treated under Section 877A(f)(1) as a distribution to the covered expatriate in an amount equal to the value of the property he or she is deemed to own under the grantor trust rules. 18

While covered expatriates are deemed to have made irrevocable waivers of any rights to treaty benefits pursuant to Section 877A(f)(4)(B), the Notice permits the covered expatriate to preserve the right to claim a treaty benefit with respect to future distributions from certain nongrantor trusts. To do so, the covered expatriate must make an election on Form 8854 to be treated as having received the value of the covered expatriate's interest in the trust on the day before expatriation. Thus, the value is added to the tax base against which the exit tax is applied.

The covered expatriate making the election must receive a letter ruling from the IRS in accordance with Rev. Proc. 2010-4, 2010-1 IRB 122, which will be used for purposes of setting the value of the beneficial trust interest. Until the letter ruling is received, the trustee must continue to withhold 30% of each taxable distribution.

If the IRS determines that the beneficial interest is incapable of being valued, then the ruling request will be denied. If the election is successfully made, however, the tax is considered fully satisfied, and thus all future trust distributions to the covered expatriate will escape the 30% withholding. The covered expatriate may in such cases claim treaty benefits with respect to future distributions from the trust. The covered expatriate must file Form W-8CE with the trustee to advise the trustee of the covered expatriate's status.

COMPLIANCE

Notice 2009-85, section 8, requires covered expatriates to satisfy the compliance rules set forth in the Notice until Regulations are issued. Some of these rules also apply to individuals who expatriate from the U.S. but who otherwise are not covered expatriates. There are rules applicable to income tax, Form 8854 (Expatriation Information Statement), and Form W-8CE (Notice of Expatriation and Waiver of Treaty Benefits).

Income Tax Rules

During the year of expatriation, the covered expatriate must file a dual-status return unless the date of expatriation is January 1. A dual-status return requires the covered expatriate to file a Form 1040NR with a Form 1040 attached as a schedule. 19 The Form 1040NR would report the income associated with the period in which the taxpayer was taxable as a nonresident alien, and the Form 1040 would reflect the income associated with the period in which the taxpayer

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was a U.S. person for income tax purposes (including the items associated with the deemed sale, which is deemed to occur while such person is still a U.S. tax resident).

In subsequent years, the covered expatriate will be required to file a Form 1040NR in accordance with Reg. 1.6012-1(b). If, however, the covered expatriate has no effectively connected income from the conduct of a U.S. trade or business for the year in question, and all other U.S. income tax liability has been fully satisfied by withholding, there is no requirement to file the Form 1040NR. 20

Form 8854

Individuals who expatriated prior to the HEART legislation had to file Form 8854 to notify the IRS of the expatriation, and they continued to be taxed as U.S. tax residents until this form was filed. 21 Such individuals must continue to file Form 8854 annually for the duration of the ten-year term subsequent to expatriation. 22

The HEART legislation made it clear that persons who expatriated subsequent to the legislation were also required to file Form 8854 reflecting their expatriation, but there was generally no requirement to file it for the next ten years. 23 Notice 2009-85, section 8.C, expands on this filing requirement by mandating that all expatriates, regardless of whether they are covered expatriates, must file Form 8854 under penalties of perjury certifying that they have been in compliance with all federal tax laws during the five-year period prior to their expatriation. Failure to make this certification will cause an expatriate who fails to meet the income tax test or net worth test, and thus would otherwise not be classified as a covered expatriate, to be subject to the exit tax imposed by Section 887A.

In addition, covered expatriates with eligible deferred compensation items or interests in nongrantor trusts (except where a valid election is made to include the present value of the trust at the time of expatriation pursuant to the private letter ruling Revenue Procedure noted above) generally must file Form 8854 annually to provide certain information with respect to such items.

The Service posted a new Form 8854 and new instructions on its website on 5/14/09. The form is divided into five parts, and not all parts need to be completed:

  • Part 1 is applicable to all expatriates and requires them to provide general information.
  • Part 2 is applicable to taxpayers who expatriated after 6/3/04 and before 6/17/08 (the effective date of the HEART legislation), and must be completed as well as Part 4.
  • Part 3 is applicable to certain taxpayers who expatriated after 6/16/08 and prior to 2009.
  • Part 4 is applicable to taxpayers who expatriated in 2009 and must be completed in addition to Part 5, which contains a balance sheet and income statement.

Any expatriate who fails to file Form 8854 or who files an incomplete form is subject to a $10,000 penalty. 24 There is, however, a reasonable cause defense under which the government may waive the penalty. Notwithstanding, and far worse than the $10,000 penalty, is the fact that an expatriate who fails to file Form 8854 will be subject to the same exit tax that is applicable to a covered expatriate.

Form 8854 is due on the later of the due date for the expatriate's Form 1040 or Form 1040NR (including extensions), and is to be filed along with such Form 1040. 25

Form W-8CE

The HEART legislation made necessary Form W-8CE, the notification that a covered expatriate must file to indicate that he or she has expatriated and waives treaty benefits. The form was first posted on the IRS website on 4/28/09 and was subsequently revised in November 2009. It applies to covered expatriates with interests in nongrantor trusts or with deferred compensation items.

The instructions require a covered expatriate who is a beneficiary of a nongrantor trust on the day before the expatriation date to indicate such status. The covered expatriate then has the option to apply for a letter ruling and pay tax on the entire value of the interest in the trust, valued as of the day before the expatriation. Unless the covered expatriate elects to pay current tax on the interest in the trust, the form is designed to provide notice to the trustee that such beneficiary is a covered expatriate who is deemed to have waived any right to claim any reduction in withholding on any distribution from the trust under any treaty with the U.S.

Notice 2009-85 also requires a covered expatriate with a deferred compensation item or specified tax deferred account to file Form W-8CE. The covered expatriate should file the form with the relevant payor on the earlier of (1) the day prior to the first distribution on or after the expatriation date or (2) 30 days after the covered expatriate's expatriation date. 26 If the covered expatriate's expatriation date was prior to the release of the Form W-8CE, however, the form should be filed with the

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payor within 30 days of the release of the form.

This requirement presents a potential practical timing problem for green card holders who elect to be treated as nonresidents under a treaty, since the expatriation date in such cases is typically retroactive to January 1 of the tax year with respect to which the return is filed, making it impossible in such cases for taxpayers to meet the stated deadline for timeliness. The Notice does not address this issue.

Filing Form W-8CE will have the following consequences:

  • If the item is an eligible deferred compensation item, the form provides notice to the payor that the individual is a covered expatriate who has waived treaty benefits with respect to the item, with the result that there will be a 30% withholding on any payments.
  • An ineligible deferred compensation item is generally one in which the payor is not a U.S. person or does not otherwise assume the responsibility for withholding. For purposes of an ineligible deferred compensation item, the form is designed to inform the payor that the recipient is a covered expatriate who is treated as having received an amount equal to the present value of his or her accrued benefit on the day before the expatriation. Adjustments need to be made by the payor on future distributions to reflect the tax imposed by reason of the current taxation. The payor is required to provide the covered expatriate with the present value of the benefit within 60 days of having received the Form W-8CE. For a defined contribution plan, the value is the account balance, and for a defined benefit plan the present value of the accrued benefit is determined under Rev. Proc. 2004-37. For other benefits, the accrued benefit is calculated using Prop. Reg. 1.409A-4 or "any other reasonable method." Again, value is calculated as if all rights were fully vested.
  • For a specified tax deferred account, Form W8-CE is designed to provide the payor with notice that the recipient is a covered expatriate who is treated as having received a distribution equal to such beneficiary's entire interest in the account on the day before the expatriation. Adjustments need to be made by the payor on future distributions to reflect the tax imposed by reason of the current taxation. The payor is required to provide the covered expatriate with the present value of the benefit within 60 days of having received the Form W-8CE.

Transfer Tax

The HEART legislation also enacted Section 2801, which applies to covered gifts and covered bequests from covered expatriates:

  • A "covered gift," under Section 2801(e)(1)(A), is any property acquired by gift directly or indirectly from an individual who is a covered expatriate at the time the gift is received (i.e., who has not subsequently resumed U.S. tax residency as of the time of the transfer).
  • A "covered bequest," under Section 2801(e)(1)(B), is any property acquired directly or indirectly by reason of death from an individual who was a covered expatriate immediately before death.

The U.S. recipient of either a gift or bequest from a covered expatriate is subject to transfer tax on the product of (1) the highest estate tax rate in effect under Section 2001(c) on the date of receipt, or, if greater, the highest gift tax rate in effect under Section 2502(a) on that date, and (2) the value of the covered gift or covered bequest. 27 Even though the U.S. currently has no estate tax by virtue of the Economic Growth and Tax Relief Reconciliation Act of 2001, the gift tax was not repealed and thus liability remains on receipt of a covered gift or covered bequest. Instead of the value of the gift being subject to estate tax rates, which are currently not in existence, a covered bequest in 2010 would be subject to the 35% gift tax rate.

On 7/20/09, the IRS announced that it "intends to issue guidance under section 2801, as well as a new Form 708 on which to report the receipt of gifts and bequests subject to section 2801. The due date for reporting, and for paying any tax imposed on, the receipt of such gifts or bequests has not yet been determined." 28 Unfortunately, Notice 2009-85 does not provide any additional guidance with regard to the compliance associated with receiving a covered gift or covered bequest.

The Notice states in section 9 that "[s]atisfaction of the reporting and tax obligations for covered gifts or bequests received will be deferred, pending the issuance of guidance. That guidance will provide a reasonable period of time between the issuance of that guidance and the date prescribed for such reporting and tax payment." It would appear that any future compliance would include Form 3520, as it is already required to be filed by certain U.S. persons who receive gifts or bequests from foreign persons, and has been revised to make reference to covered gifts and bequests. 29

In light of the fact that section 3.A of Notice 2009-85 includes any interest held by a covered expatriate in a life insurance policy in the computation of the tax base subject to the exit tax, it would seem that the future guidance for Section 2801 also may treat such assets similarly. For example, death benefits paid from a life insurance policy insuring the life of a covered expatriate could be classified as a covered bequest when payable to a U.S. person.

CONCLUSION

The Service has clarified many of the issues arising from the enactment of the mark-to-market exit tax applicable to individuals expatriating from the U.S. after 6/16/08. Many questions remain, however.

Practice Notes

The question of security or collateral is the biggest practical issue covered expatriates and their advisors currently face with the deferral provision, because those covered expatriates who most need to defer the payment of tax liability triggered under Section 877A do not generally have enough liquid assets to post an adequate bond or letter of credit. It simply is not clear what else the Service might be willing to accept as "adequate" security for deferral purposes. Unfortunately, the Notice does little to settle this pressing issue.