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September 2, 2010 |
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| July 27, 2009 |
By: Seth R. Kaplan |
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xpatriation, is it the ultimate tax plan or the ultimate tax trap?
Unlike most other countries, the United States taxes its citizens and permanent residents on all worldwide income regardless of where people reside and the source of income. Nonetheless, people become expatriates for many reasons, including returning to their country of origin to be with family members, marriage to nonresidents and employment outside the U.S.
Over the years, expatriation of the famous and wealthy has been a source of controversy and intrigue. Famous expats include Ernest Hemingway, T.S. Eliot, Jack Kerouac, Jim Morrison and more recently Ted Arison of Carnival Cruise Lines and Campbell’s Soup heir John Dorrance III.
After Forbes magazine brought national attention to the lavish lifestyles of expatriates, Congress responded in 1996 and again in 2004 by passing legislation to minimize the tax benefits of expatriation and impose an alternative U.S. tax regime for a 10-year period after expatriation. Dissatisfied with the effectiveness of the laws, Congress passed a new set of statutes as part of the Heroes Earnings Assistance and Relief Tax Act of 2008, primarily to finance tax relief for members of the armed services. The HEART law replaced the existing expatriation rules and affects anyone who expatriated after June 16, 2008.
The law introduced new Internal Revenue Code sections that apply a “mark-to-market exit tax” to the expatriate’s appreciated property as well as a transfer tax on gifts and bequests from expatriates. The legislation affects U.S. citizens and “long-term residents” who meet certain net worth or income requirements. A long-term resident is a foreign individual who was a permanent resident for eight of the prior 15 years. To be covered under the act, the individual must either have a minimum net worth of $2 million or an average annual net income tax liability for the five preceding years in excess of $145,000 in 2009 dollars adjusted for inflation on the date of expatriation.
The exit tax essentially taxes expatriates as if they sold all worldwide assets the day before departing to the extent the gain exceeds $626,000 in 2009 dollars indexed for inflation. For example, if an expatriate has $5 million in assets with an initial cost of $100,000, assuming long-term capital gain property and a rate of 15 percent, the tax would be $641,100. There are provisions for deferring payment of the exit tax until the due date of the return for the year in which one or more specified assets are sold by posting a bond or other security, paying interest on the deferral and waiving any treaty benefits.
Assets include property held in so-called grantor trusts where the expatriate retains certain powers over the trust. Distributions to the expatriate from other nongrantor trusts and deferred compensation arrangements are subject to a flat 30 percent withholding tax on each payment to the extent it would have been taxed for a U.S. resident. In some cases, plan benefits are immediately taxable depending on the nature of the deferred compensation plan. The law does not apply to nongrantor trusts created after the expatriation date.
Any gifts, including foreign situs property, in excess of the gift tax annual exclusion of $13,000 per donee or $133,000 in the case of a non-U.S. citizen spouse donee, or bequests made to U.S. beneficiaries or trusts for their benefit following expatriation will be subject to gift or estate taxes at the highest rate, currently 45 percent. The tax may be reduced by any foreign gift or estate tax paid. Transfer tax deductions also are available for gifts to charities, a U.S. spouse or certain trusts for the benefit of a non-U.S. spouse. In addition to the tax considerations, U.S. recipients are required to report gifts from expatriates to the IRS. Failure to report can result in significant penalties.
It is worth noting that the Department of Homeland Security has reserved the right to deny re-entry granted under the 1996 expatriate legislation. Although this power has yet to be implemented or enforced and wasn’t addressed in the HEART Act, those looking to expatriate should take this factor into consideration.
Although HEART may have caused expatriation to be less attractive, the exit tax is only on appreciated assets, so if one is considering renouncing U.S. citizenship, it may make more sense to do so when asset values are depressed and capital gains rates are low. Additionally, one should consider doing estate and tax planning before expatriation.
Seth R. Kaplan is a Miami partner in Bilzin Sumberg Baena Price & Axelrod’s tax and wealth transfer groups. He concentrates his practice in the areas of domestic and international estate planning, charitable tax planning, business succession and personal income tax planning.
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