Increasingly, U.S. citizens and lawful permanent residents are cutting their ties with the United States. This process, called expatriating, includes renouncing U.S. citizenship and terminating lawful permanent resident status. Regardless of whether there is any tax-related motive for doing so, there are always tax-related consequences. Many people believe that when they surrender their U.S. passport or green card, their relationship with the IRS comes to an uneventful end. They are wrong.
Internal Revenue Code (IRC) section 877A imposes an “exit tax” on certain former U.S. citizens and long-term residents. This tax is computed on the gain (above an exemption amount that increases each year) that would be realized if the taxpayer had sold all of his or her assets for fair market value the day before expatriating. When working with someone who has ceased to be a U.S. taxpayer or who plans to do so, managing the filings properly is of the utmost importance. Failure to do so can result in severe unintended consequences.
Covered Expatriate Status
The exit tax imposed under IRC section 877A applies to “covered expatriates.” Subject to certain limited exceptions, a covered expatriate is a taxpayer 1) whose average annual net income tax for the five taxable years ending before the expatriation date is greater than a threshold amount adjusted annually for inflation (for 2016, $161,000), 2) whose net worth as of the expatriation date is at least $2 million, or 3) who fails to certify, under penalties of perjury, compliance with U.S. tax obligations for the five preceding taxable years by filing IRS Form 8854 for each year. This last factor is tricky; even if a taxpayer does not meet the tax liability or net worth test, failure to make the certification by filing Form 8854 on a timely basis will render her a covered expatriate subject to the exit tax.
One modification to the definition of a covered expatriate applies to an individual who 1) was a dual citizen of the United States and another country at birth, 2) continues to be a citizen and taxed as a resident of the other country, and 3) has been substantially present in the United States [as defined in IRC section 7701(b)(1)(A)(ii)] for no more than 10 of the last 15 years. Such an individual is effectively exempt from the tax liability and net worth tests; however, the certification test still applies. This can be disastrous in the case of a wealthy dual citizen who lives abroad. Although the tax liability and net worth tests are inconsequential, failure to make a timely certification can trigger an exit tax on nearly all of her wealth. Filing of Form 8854 for a given year is considered timely if done by the due date of the original IRS Form 1040NR or 1040, including extensions, for that year.
Five Years of Compliance
Both the IRC and Form 8854 state that the taxpayer must certify compliance with his U.S. tax obligations for the past five years. These sources do not, however, clarify which five years are at issue—specifically, whether they end with the year of renunciation or the year before renunciation. Notice 2009-85 provides some guidance, suggesting that the five-year period relating to the certification of compliance is the same as the five-year period relating to the tax liability test, and that both end on December 31 of the year preceding the date of expatriation.
Certifying compliance for five years may be problematic. Many individuals who give up their U.S. citizenship have never filed U.S. tax returns because they are “accidental Americans.” This group includes people who happened to be born in the United States, often while their parents were attending school or temporarily working there, went to their parents’ home country during infancy or childhood, and never returned. It also includes people who have never lived in the United States and merely inherited U.S. citizenship from one of their parents under the laws of the jurisdiction in which they were born.
Given that most other countries do not tax their nonresident citizens on worldwide income, most such individuals who have not lived or worked in the United States had no idea that they should have been filing U.S. tax returns and paying U.S. tax for their entire adult lives. If they expatriate, and assuming they meet the income thresholds, these individuals must file U.S. tax returns and pay any tax, penalties, and interest due for the five years preceding the year of expatriation.
To assist such persons, the IRS currently offers the Streamlined Filing Compliance Procedures. Under the Streamlined Foreign Offshore Procedures, U.S. taxpayers with no U.S. abode who resided outside the United States for at least 330 days in any of the past three years can file returns for the past three years and Reports of Foreign Bank Accounts (FBAR) for the past six years, along with a Streamlined Certification explaining that their failure to file was non-willful, without incurring any penalty. The Streamlined Domestic Offshore Procedures apply to U.S. taxpayers who have had a U.S. abode or resided in the United States for at least 330 days during each of the past three years; this procedure requires payment of a 5% penalty on the value all unreported foreign accounts. These procedures provide a way for a delinquent taxpayer to certify compliance for five years, assuming he otherwise meets the streamlined eligibility requirements. The taxpayer can make a streamlined filing for three years, fulfill his U.S. tax obligations on a timely basis for the following two years, and then expatriate in the sixth year. Alternatively, he can make a streamlined filing for the past three years and also file for the two years preceding the streamlined period. While in theory this approach should satisfy the five-year compliance requirement, it may cause confusion within the IRS and create more problems than it solves.
Taxpayers who do not qualify for the Streamlined Filing Compliance Procedures may consider other ways of coming into tax compliance for five years. Options include making a domestic voluntary disclosure to report previously unreported U.S. source income or entering the Offshore Voluntary Disclosure Program (OVDP) to report unreported non-U.S. income and accounts.
Filing for Year of Expatriation
Treasury Regulations section 1.871-13(a) states that an individual who renounces U.S. citizenship or terminates U.S. long-term residency splits the year into 1) the portion during which she was a U.S. tax resident, which ends on the day before expatriation, and 2) the portion during which she was not a U.S. tax resident, which begins on the date of expatriation. The regulations further provide that she is taxed accordingly, subject to U.S. federal income taxation on her worldwide income for the first portion of the year and on U.S. source income or income effectively connected with the conduct of a U.S. trade or business for the second portion of the year.
Expatriating taxpayers should file Form 1040NR for the year of expatriation with “Dual-Status Return” written across the top. The Form 1040NR should be accompanied by Form 1040, marked “Statement” across the top, that shows the computation of the U.S. federal income tax for the portion of the year preceding expatriation. The Form 1040 functions as a schedule to the Form 1040NR.
Form 1040NR should also be accompanied by an original Form 8854. A copy of Form 8854 should be sent to the IRS Service Center in Philadelphia (Department of the Treasury, Internal Revenue Service, Philadelphia, PA 19255-0049). If the individual is not required to file Form 1040NR for the year of expatriation, then he should file the original Form 8854 with the Philadelphia Service Center.
If the tax analysis and filings are handled correctly, the former U.S. citizen or resident can indeed bring his or her relationship with the IRS to a proper and peaceable end.