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Are Expatriates Now Being Taxed As Heroes?

In June 2008, President Bush passed the Heroes Act, subjecting expatriates and long-term residents of the U.S. who have terminated their residency to a whole new tax regime.

July 17, 2008
by Tom Wechter, JD and Colleen Feeney, JD

The "Heroes Earnings Assistance and Relief Tax Act of 2008" (the "ACT"), which was signed into law on June 18, 2008, while intended to provide tax relief to members of the military, dramatically changed the taxation regime of expatriates and long-term residents who ceased to be permanent residents of the U.S.

Previously, expatriates who met certain net income tax and net worth tests and who, within the previous 10-year period had terminated their U.S. citizenship — or in the case of a long-term resident of the U.S., had ceased being a resident of the U.S. — were subject to an alternative tax regime. Generally that alternative tax regime applied rates applicable to U.S. citizens and residents to U.S. source income. This alternative tax regime applied to former citizens or former long-term residents for the 10-year period following loss of citizenship or residency who:

  1. Had average annual net income tax liability for five years preceding the date of loss of United States citizenship or residency that exceeded $139,000 for 2008 subject to adjustment for inflation;
  2. Had net worth over $2 million on the date of loss of U.S. citizenship or residency; or
  3. Failed to certify under penalties of perjury that they had met all U.S. tax obligations for the previous five years or failed to submit any required evidence of compliance.

This alternative income tax regime did not apply to a U.S. citizen or a resident who was physically present in the United States for longer than 30 days in any calendar year, ending in a tax year during the 10-year period following expatriation. In that case, the worldwide income of the individual would have been subject to U.S. income taxation.

Changes in Law

The Act eliminates the 10-year alternative tax regime. Instead, for certain U.S. citizens who relinquish their U.S. citizenship, and for certain long-term U.S. residents who terminate their U.S. residency, there is a mark-to-market deemed sale rule. For these individuals, their property is treated as if sold at fair market value on the day before their expatriation.

According to these mark-to-market provisions, the individual must pay tax in the year of the deemed sale on any gain over $600,000, without regard to other provisions of the tax code. Losses are subject to the normal limitations in the year of the sale, ignoring the wash sale rules (prevents individuals from claiming a loss on a sale of stock if they buy replacement stocks within the 30 days before or after the sale).

In calculating the gain on property owned by an individual on the date when he first became a resident, the basis of such property is the fair market value on that day, unless the taxpayer waives that treatment. In general, the Act seeks to capture taxes on nearly all unrecognized gain earned during the period of U.S. residency or citizenship. On a property by property basis, however, the individual can irrevocably elect to defer taxes until the property is disposed of or the individual dies. When deferring taxes, the individual must waive any potential tax treaty rights, pay interest on the tax owed, and provide a bond or other adequate security. Interest is charged for the period the tax is deferred at the applicable individual underpayment rate. The mark-to-market deemed sale rules apply to most property interest owned by an individual on the date of loss of citizenship or residency termination, while special rules apply to interests in deferred compensation, non-grantor trusts and specified tax deferred accounts.

Covered Expatriates

The alternative tax regime applies to U.S. citizens who relinquish citizenship or long-term residents who terminate U.S. residency if they meet the average annual net income tax test, net worth test or failure to certify test as under the prior law. However, an individual will not be considered a "covered expatriate" under the average annual net income tax test or net worth tests above, if:

  1. The individual at birth became a dual citizen of the United States and another country, continued to be citizen of the other country, is taxed as a resident of the other country, was a U.S. resident for not more than 10 years during the 15-year period ending with the year in which the expatriation date occurs, and never held a U.S. passport, or
  2. The individual  was a U.S. resident for not more than 10 years and who lost or gave up U.S. citizenship prior to turning 18½ years old.

A U.S. citizen remains to be treated as a U.S. citizen until he relinquishes his citizenship on the earliest of four possible expatriation dates: (1) the date a person renounces U.S. nationality in front of a consular or diplomatic officer, (2) the date the individual furnishes the State Department with a signed statement voluntarily relinquishing U.S. nationality, (3) the date the State Department issues a certificate of loss of nationality, or (4) the date a court cancels a naturalized citizen's certificate of naturalization.

Exceptions to the Deemed Sale

There are three important exceptions to the mark-to-market provisions, where assets may receive different tax treatment: (1) deferred compensation items, (2) tax deferred accounts, and (3) interests in trusts. Deferred compensation items are eligible for different treatment if the payor is a U.S. person (or non-U.S. person treated as a U.S. person for withholding purposes) and the covered expatriate notifies the payor of his expatriate status and irrevocably waives any withholding reduction under a tax treaty. The payor must withhold 30 percent from any taxable payment on eligible deferred compensation items. The covered expatriate acts as if ineligible deferred compensation items were sold for fair market value on the day before expatriation.

Additionally, the ACT treats specified tax deferred accounts (including individual retirement plans, qualified tuition plans, Coverdale education savings accounts, health savings accounts and Archer medical savings accounts) as distributed to the covered expatriate on the day before the expatriation date. Finally, for a grantor trust, the mark-to-market rules apply for the covered expatriate's trust assets. Alternatively, for non-grantor trusts, where the covered expatriate is a beneficiary, the trustee must withhold 30 percent of the taxable portion of any distribution to the covered expatriate. If the trust distributes appreciate property to the covered expatriate, the trust must recognize any gain as if the property was sold to the covered expatriate at fair market value. The 30 percent withholding does not apply for periods where the covered expatriate is taxed as a U.S. citizen or resident after expatriation.

Gift and Estate Taxes

The Act also applies a special transfer tax to gifts and bequests from a covered expatriate to a U.S. citizen or resident. The transfer tax rate is the highest marginal gift or estate tax rate for that year. The recipient is taxed unless the gift or estate tax has already been paid on the amount. Certain exclusions including the annual exclusion on gifts and those on spousal transfers continue to apply. Any foreign gift or estate tax paid decreases the transfer tax. In addition to the high rate, since the gift and estate tax provisions for covered expatriates no longer expire after a 10-year period, the special transfer tax will apply far into the future for covered expatriates and their U.S. beneficiaries or heirs.

Conclusion

Changes resulting from the Act are effective as of the date of enactment for people who relinquish citizenship or residency afterwards. Assets that previously might have gone untaxed are now taxed. The deemed sale provisions can create a potentially enormous tax liability with no change in cash flow. Additionally, the timing of the expatriation date has become more important than ever. Expatriation today will impact gift and estate taxes far into the future. For U.S. citizens and legal permanent residents considering expatriation, a fresh consultation with a tax planner is critical to minimize the impact of the Act.

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Thomas R. Wechter, JD, Partner, concentrates his practice in the area of tax planning for individuals, corporations, and partnerships and also handles matters involving tax controversies. Colleen M. Feeney, JD, Associate, concentrates her practice in taxation, including tax planning and litigation matters involving individuals, corporations and partnerships. Both work at the law firm Schiff Hardin LLP. The authors would like to thank Alan Boudreau, a summer associate in Schiff Hardinís summer program, for his help.