Are You Considering Expatriation: A Beginner’s Exit Tax Guide

Are You Considering Expatriation?

Each year, our international tax attorneys are contacted by U.S. Taxpayers across the globe who find themselves in the same tax predicament when it comes to expatriation. Oftentimes, the situation is the same: the Taxpayer retained a firm that claimed to be an expert in expatriation — when all the firm did was write an article or two about expatriation and Form 8854 using AI. The firm (usually offering a free consultation) fear-mongers the Taxpayer into signing with them immediately before the Taxpayer has had a chance to interview experienced offshore tax lawyers — in fact, sometimes the firm is not even a law firm but just an online charlatan claiming to be an ‘expert’ in all things offshore tax for no reason other than that the person moved offshore themself. The firm does not have the experience to assist the Taxpayer and once the firm realizes they are in way over their head, they leave the Taxpayer out to dry, end communications, and ghost the client.  This can culminate into a very serious situation that can have financially crippling tax consequences for the unsuspecting Taxpayer. Let’s look at a few key facts about terminating U.S. tax status and the implications of what comes next.

You Must Be Compliant Before You Terminate Status

The most important thing that Taxpayers who are considering expatriating from the United States must know is that even if they are below the Net Worth and the Net Income Average Tax Liability tests to be considered a covered expatriate, if they terminate their status before they are in tax compliance they may still be considered a covered expatriate. That is because if they terminate their status before they are in tax compliance, then they were not five years tax compliant at the time of expatriation, which is on of the three (3) tests used to determine if a person is a covered expatriate.

The Form 8854 and instructions make it very clear that the IRS takes the position that when a Taxpayer signs Form 8854, they are affirming under penalty of perjury that the Taxpayer was tax compliant at the time they terminated their U.S. status (which is the expatriating act) and not just at the time they are submitting Form 8854.

Five-Year Tax Compliance Rule

The IRS Form 8854 and instructions:

• • • “Do you certify under penalties of perjury that you have complied with all of your tax obligations for the 5 preceding tax years? See 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.

What is Considered the Date of Expatriation?

The IRS instructions provide the following when it comes to citizenship:

“Expatriation.

• • • Expatriation includes the acts of relinquishing U.S. citizenship and terminating long-term residency.

    • Date of relinquishment of U.S. citizenship. You are considered to have relinquished your U.S. citizenship (and consequently, have an expatriation date) on the earliest of the following dates.

      • The date you renounced your U.S. citizenship before a diplomatic or consular officer of the United States (provided that the voluntary renouncement was later confirmed by the issuance of a certificate of loss of nationality).

      • The date you furnished to the State Department a signed statement of your voluntary relinquishment of a U.S. nationality confirming the performance of an expatriating act (provided that the voluntary relinquishment was later confirmed by the issuance of a certificate of loss of nationality).

      • The date the State Department issued a certificate of loss of nationality.

      • The date a U.S. court canceled your certificate of naturalization.”

A few years back the IRS Form 8854 instructions were revised to include the additional language about now having an expatriation date. This language was added presumably so that Taxpayers are aware that they must be compliant at the time they expatriate not just at the time they file the form.

• • • Example: David is a U.S. Taxpayer who wants to terminate his status. He is not five years tax compliant in the current year but files his current year return and then goes in and submits a form I-407 terminating his permanent resident status. David was goaded into quickly signing a retainer and led to believe that he could file the tax returns for his prior years to get into compliance after he expatriated and then realizes when he sits down to complete Form 8854 that he was not tax compliant at the time he expatriated (when he submitted his form I-407) and now he is considered a covered expatriate.

Relief Procedures Have Very Specific Eligibility Requirements

A few years back, the IRS developed Relief Procedures to assist Taxpayers with expatriating when they meet certain requirements. It is very important to note that to meet these requirements, not only must the Taxpayer must also not have filed U.S. tax returns in prior years but they have to be under certain threshold requirements both at the time that they are submitting five years of prior returns and with when they file their final return.

Accidental American Status is Often the Catalyst

Many times what sparks expatriation for many foreign residents is that the Taxpayer learns for the first time that they are an Accidental American and they may have a financial windfall coming — and prefer not to be a U.S. Person at that time.  The problem is that if the windfall happens before they can technically file the final return, they can lose the opportunity to qualify for the relief procedures. And, if the firm already filed back taxes in anticipation of submitting under the relief procedures but the Taxpayer is no longer eligible, it may lead to significant tax implications for the expatriate.

As provided by the IRS regarding the relief procedures:

• • • “Under the Relief Procedures for Certain Former Citizens (“these procedures”), the IRS is providing an alternative means for satisfying the tax compliance certification process for citizens who expatriate after March 18, 2010.

    • These procedures are only available to U.S. citizens with a net worth of less than $2 million (at the time of expatriation and at the time of making their submission under these procedures), and an aggregate tax liability of $25,000 or less for the taxable year of expatriation andthe five prior years. If these individuals submit the information set forth below and meet the requirements of these procedures, they will not be “covered expatriates” under IRC 877A, nor will they be liable for any unpaid taxes and penalties for these years or any previous years.”

  • Example: Michelle learns that she is an Accidental American in June of the current year and now she wants to renounce her U.S. Citizenship. Michelle’s grandma has fallen very ill and Michelle stands to inherit $7,000,000. In the current year, Michelle meets the requirements, but her current year return is not due until next year when she will file under the relief procedures. The firm filed her prior returns prematurely and she waits for tax season to open for her to file her current year return and Form 8854 under the relief procedures. Suddenly, Michelle’s grandma passes away and she receives the money. Now at the time she is filing her final return she no longer falls below the $2,000,000 mark and does not qualify. Unfortunately, the firm already filed her 5 years of returns (not under SFOP) and not she is at heightened risk for penalties.

401K for Net Worth vs Exit Tax

When a person has a 401K then the 401K is not going to be deemed distributed at the time of expatriation since it is eligible deferred compensation and not ineligible deferred compensation – the latter which is deemed distributed at expatriation (subject to step-up rules). Even though the 401K is not deemed distributed, it is very important to note that the value of the 401K is still used to determine the net worth of the Taxpayer at the time they expatriate. So even though the 401K may not be deemed distributed, the Taxpayer may be considered a covered expatriate and may have other forms of exit tax consequences such as ineligible deferred compensation or specified tax-deferred accounts.

• • Example: Brenda is a Lawful Permanent Resident who has resided in the U.S. for many years. She is an LTR with her only asset being a $4,000,000 401K. While she may not have any exit tax, she is covered and so this may impact the withholding in the future when she receives distributions – and impact the taxes when she wants to give gifts to U.S. persons later down the line.

Act 60 is Not an Alternative to Expatriation

Some Attorneys and CPAs advertise that you can submit to Puerto Rico Act 60 (previously Acts 20/22) instead of expatriation and derive the same benefits – but this is not the case. Not only is PR Act 60 completely different than expatriation, but PR Act 60 is under the microscope of the U.S. government. In addition, with PR Act 60, the Taxpayer is still considered a U.S. person for tax purposes for most types of income tax. We have a separate article explaining the dangers of being told that you can do Puerto Rico Act 60 as an alternative to expatriation.

Exit Tax is more than Mark-to-Market Tax

Another common scenario involves the complexity of exit tax. For example, the Taxpayer consults with a self-proclaimed expert about exit tax. The Taxpayer conveys to the lawyer that he does not have stock or other equities (mark-to-market items) and the firm then tells the Taxpayer not to worry there should not be any exit tax.

Fast forward 3 months later, and the firm realizes that while the Taxpayer does not own stock or other equities, he does have $5,000,000 in foreign pension with no step-up, three foreign properties that have a low basis and high fair market value, and a high-value Traditional IRA. Now, the Taxpayer who believed that they had no exit tax is subject to a six or seven-figure exit tax.

Bonds to Stave off Exit Tax are Possible but Not Probable

The IRS makes it seem like Taxpayers who have an exit tax but cannot pay it may be able to obtain a bond or other alternative sort of financing to avoid having to pay the exit tax. In the real world, Taxpayers should take note that it is very difficult to find these bonds and that they have a very high interest rate. Thus, at the end of the day it is typically not worth it from a financial standpoint to acquire such a bond to offset an inevitable exit tax.

Post-Expatriation Treaty Limitations

Another common issue for expatriating Taxpayers is the idea that after the expatriate they can rely on a treaty to avoid having to pay certain taxes and withholding on various sorts of income that are considered U.S.-sourced. Expatriates should keep in mind that Taxpayers who are deemed covered expatriates are limited in the type of post-expatriation treaty benefits they have available for certain types of U.S.-sourced income. When completing IRS Form 8854, the filer irrevocably waives certain rights to rely on a treaty to reduce or eliminate withholding distribution of future pensions for example that is U.S.-based.

• • • As provided on Form 8854:

      • “Do you have any eligible deferred compensation items? Checking the “Yes” box is an irrevocable waiver of any right to claim any reduction in withholding for such eligible deferred compensation item under any treaty with the United States.”

Visiting the U.S. Afterward is Fine

Many expatriates get scared that they cannot return to the U.S. after they expatriate, but this is nonsense. After expatriating, many expatriates find they want to spend time in the U.S. after expatriating – just not as a U.S. person for tax purposes. The expatriate may qualify for one or more different visas or even an ESTA/Visa Waiver.

Late Filing Penalties May Be Reduced or Avoided

For Taxpayers who did not timely file their FBAR and other international information-related reporting forms, the IRS has developed many different offshore amnesty programs to assist Taxpayers with safely getting into compliance. These programs may reduce or even eliminate international reporting penalties.

Current Year vs. Prior Year Non-Compliance

Once a Taxpayer missed the tax and reporting (such as FBAR and FATCA) requirements for prior years, they will want to be careful before submitting their information to the IRS in the current year. That is because they may risk making a quiet disclosure if they just begin filing forward in the current year and/or mass filing previous year forms without doing so under one of the approved IRS offshore submission procedures. Before filing prior untimely foreign reporting forms, Taxpayers should consider speaking with a Board-Certified Tax Law Specialist who specializes exclusively in these types of offshore disclosure matters.

Avoid False Offshore Disclosure Submissions (Willful vs Non-Willful)

In recent years, the IRS has increased the level of scrutiny for certain streamlined procedure submissions. When a person is non-willful, they have an excellent chance of making a successful submission to Streamlined Procedures. If they are willful, they would submit to the IRS Voluntary Disclosure Program instead. But, if a willful Taxpayer submits an intentionally false narrative under the Streamlined Procedures (and gets caught), they may become subject to significant fines and penalties. 

Need Help Finding an Experienced Offshore Tax Attorney?

When it comes to hiring an experienced international tax attorney to represent you for unreported foreign and offshore account reporting, it can become overwhelming for Taxpayers trying to trek through all the false information and nonsense they will find in their online research. There are only a handful of attorneys worldwide who are Board-Certified Tax Specialists and who specialize exclusively in offshore disclosure and international tax amnesty reporting. 

*This resource may help Taxpayers seeking to hire offshore tax counsel: How to Hire an Offshore Disclosure Lawyer.

Golding & Golding: About Our International Tax Law Firm

Golding & Golding specializes exclusively in international tax, specifically IRS offshore disclosure. 

Contact our firm today for assistance.