The tax treatment of individuals who renounce citizenship changed significantly in 2008. The information below applies to renunciations after June 17, 2008.
Exit tax on the wealthy
The “Heart” act of 2008 (a bill whose main intent was to increase benefits for veterans and families of deceased military members) included for the first time an “exit tax” on American citizens who renounce their citizenship. The law passed Congress by a unanimous vote.
Lawmakers attached the exit tax to the HEART act as a revenue enhancer to offset the increased military benefits. We’re not sure how they calculated the effect, but Congress predicted that the exit tax would raise $249 million from 2008 to 2013, and $162 million from 2013 to 2018.
A major intent of the act was to reduce the financial incentive of expatriation for the super-rich. As Senator Edward Kennedy explained when the exit tax was first proposed, “This is defined as the billionaires’ amendment.”
But the reality of “the billionaires’ amendment” is that it applies to significantly more than billionaires. The provisions of the tax apply to those deemed “covered expatriates”, defined as someone who meets any one of the following three tests:
If any one of these tests applies to you on the date of your expatriation, then you are considered a “covered expatriate” and the provisions of the exit tax, or “billionaires’ amendment” as Senator Kennedy named it, apply to you.
There is only one exception for adults which I like to refer as the “lucky-star exception”. If you received citizenship of both the US and some other country at birth, if you continue to hold the citizenship of that country, if you are taxed as a resident of that country, AND if you have been a resident of the US for no more than 10 of the 15 years prior to renouncing US citizenship, you’re exempted from the exit tax provision. (A minor who relinquishes US citizenship before age 18.5 and did not reside in the US for more than 10 years is also exempted).
So assuming you’re a covered expatriate and the exemption doesn’t apply to you, how does the exit tax affect you? Even the IRS is still figuring it out; they only issued their first guidelines a year-and-a-half after the law was passed, and they’re still trying to clarify all the details. But in general, there are three main areas you should be aware of, each of which we discuss separately below:
Mark-to-market tax: an exit tax on the “deemed sale” of all your assets
The first main provision is a tax on the “deemed sale” of all your assets the day before expatriation. In other words, you are taxed on the mark-to-market net gain of all your assets.
For the mark-to-market tax, you calculate as if you had sold all your assets on the day before expatriation. You have to pay tax on the theoretical profit which that sale would have given you.
The first $725,000 (as of 2019) is excluded, so only a net gain of above $725,000 is taxed.
As an example, let’s say that the value of all your assets the day before your expatriation is $3,000,000. You calculate that your basis, or the price you paid for those assets, is $1,000,000. So your net gain, or paper profit, from the “deemed sale” is $2,000,000. You’re allowed to exclude $725,000 (as of 2019) of that, so the amount subject to tax will be $1,275,000.
The actual tax you have to pay is whatever tax would apply if you actually had sold the assets the day before expatriation. So depending on your assets, it might be some combination of short-term gains, long-term gains, etc, and would be taxed accordingly.
Again, although you don’t actually sell anything, it’s all taxed for IRS purposes exactly as if you actually had sold it all.
Assets included in the “deemed sale”: everything in your estate
The IRS defines the assets which should be included in this “deemed sale” as everything which would have been included in your estate if you had died the day before expatriation. Deferred compensation plans and non-grantor trusts are not included (see below for their treatment), but any tax-deferred accounts, such as a tax-deferred retirement plan, are included at their value the day before your expatriation.
(Note that there are some problems with the IRS using the estate-tax definition of your assets. The issues here are technical- they relate to trusts and direct, beneficial ownership. In summary, it’s likely the IRS overstepped its boundaries, and it might be changed if challenged, but for now, that’s the definition.)
You can defer the tax payment… but you have to post collateral and pay interest
And what happens if you can’t actually pay the tax?
It’s a very likely scenario: you own a business, a house, or some other assets which you can’t sell – or don’t want to – so any supposed gain from the “deemed sale” is only a paper profit. If you don’t have the cash to pay the IRS, you can defer the payment, but you’ll have to post “acceptable” security as collateral against the tax bill for that asset (IRS guidelines are vague about what is acceptable; bonds and letters of credit are mentioned, but in essence the “acceptability” is solely at the discretion of the IRS). You’ll also be charged interest until you pay. The tax must be paid by the earlier of a) the sale of the asset, or b) your death.
Tax on deferred compensation and non-grantor trusts
Deferred compensation, such as IRAs, pension plans, and stock option plans, is not counted as part of your assets under the “deemed sale” described above. Instead, 30% of the total will be withheld and given directly by the payer to the government any time taxable payments are made to you from the deferred compensation item. This withholding replaces all other taxes on the deferred compensation.
To qualify for this treatment, the deferred compensation must be “eligible”, which means a) that the payer must be a US entity or, if non-US, must agree to US withholding and other requirements, b) that you tell the payer of your ex-citizen status (there actually is an IRS form for this, Form W-8CE), and c) that you permanently and irrevocably waive all claims to a reduction of the withholding tax under any tax treaty.
If those requirements aren’t met, then the deferred compensation would be considered part of your total assets and be subject to the “deemed sale” and mark-to-market tax described above.
Non-grantor trusts which pay distributions after your expatriation will also be subject to the 30% withholding tax. You’ll also have to waive all claim to tax treaty benefits to receive this treatment for them.
Note that the exemption of $725,000 (as of 2019) doesn’t apply to any gain you have from these deferred compensation or non-grantor trusts.
Tax on Gifts to US Citizens
Any gifts or bequests that you make as a covered expatriate to a US citizen will be subject to provisions of the exit tax. The total amount of the gift is reduced by the annual gift exclusion ($15,000 in 2020), and then subject to the highest marginal estate tax rate in existence in that year (40% in 2020).
As an example, let’s say a covered expatriate want to give $100,000 in 2020 to a US citizen after your expatriation. That person would have to pay [($100,000 – $15,000) * .40] = $34,000 of your gift in taxes to the IRS.
In contrast, the recipient doesn’t have to pay any taxes on the gift if you are a US citizen. In that case, the same annual gift exclusion ($15,000 annually as of 2020) applies. However, it’s you, the donor, who has to pay the tax, and even then only if the total you give in your lifetime in excess of the exclusion amount is more than $11,000,000.
The expatriate gift tax regime also applies to any bequests made at your death, and is Congress’s attempt to prevent ex-US citizens from gifting assets to their US citizen relatives.
It has a particularly noteworthy impact in preventing an ex-citizen from benefiting from the estate tax exemption (around $11.6 million in 2020) when making bequests to a US heir. Consider the following example.
Take two individuals, a US citizen and an ex-US citizen, who both have $16.5 million in assets which they bequest to their US-citizen heirs upon their death. The estate of the US citizen would pay tax of [(16,500,000 – 11,600,000 exemption) * .40] = $1,960,000, and his heir would receive a net amount of $14,540,000.
In the case of the ex-US citizen, his US-citizen heir will be liable for [(16,500,000 – 60,000) * .40] = $6,576,000 in taxes to the US, leaving him a net $9,924,000 from the bequest.
Because the ex-US-citizen’s estate does not benefit from the estate tax exemption, it’s clearly at a disadvantage when making bequests to US citizens.
On the other hand, an individual who renounces US citizenship is completely free from US tax and pays no US estate tax upon his death, nor do any non-US-citizen recipients of gifts or bequests from him pay any US tax.
It’s important to note that the details of this tax on gifts and bequests from renunciants are still unclear. There’s been little guidance from the IRS, and what information and forms have been released leave several important questions about the mechanics unanswered. We cover some typical scenarios in the next section, including bequests of US assets vs. non-US assets, bequests to US citizen heirs, and bequests to non-US citizen heirs.