As we have reported previously (see here, here, here, and here) in recent years the United States has intensified its efforts to force United States persons to disclose assets they hold and income they earn abroad. Two prominent examples of these efforts are the United States’ increased focus on imposing penalties and people for failing to file Foreign Bank Account Reports (FBARs), and the passage and impending implementation of the Foreign Account Tax Compliance Act (FATCA), Internal Revenue Code §§ 1471-1474. The primary objective of these efforts is to ensure U.S. citizens and residents are accurately reporting their income and paying the correct tax. U.S. persons who fail to do so face serious consequences, which can include not only additional taxes, but also penalties, interest, fines and even imprisonment.
The United States taxes its citizens on worldwide income, no matter where they live and regardless of how long they have been overseas. Further, the rules for filing income, estate and gift tax returns and for paying estimated tax are generally the same whether the U.S. citizen is living in the U.S. or abroad. In addition to reporting their worldwide income, U.S. citizens must also report on their U.S. tax return whether they have any foreign bank or investment accounts. As we previously reported, the Bank Secrecy Act requires U.S. persons to file a Form 114, Report of Foreign Bank and Financial Accounts (FBAR), if (1) they have financial interest in, signature authority, or other authority over one or more accounts in a foreign country, and (2) the aggregate value of all foreign financial accounts exceeds $10,000 at any time during the calendar year.
To avoid paying taxes to the U.S. government and the civil and criminal penalties associated with not disclosing foreign income or accounts, many U.S. citizens living abroad consider raising their right hand and reciting an oath renouncing their U.S. citizenship. As we have reported, over the past years there has been a significant surge in the number of Americans renouncing their U.S. citizenship. However, in terms of dollars and cents, this may well be a worse option than paying their taxes and reporting their foreign financial accounts to the IRS.
The expatriation tax provisions under Internal Revenue Code (I.R.C.) §§ 877 and 877A apply to U.S. citizens who have renounced their citizenship and long-term residents (as defined in I.R.C. §877(e)) who have ended their U.S. resident status for federal tax purposes. Different rules apply according to the date of expatriation. For U.S. citizens currently considering expatriation, and those who expatriated after June 16, 2008, the new I.R.C. §877A expatriation rules may apply. These rules apply if (1) their average annual net income tax for the 5 years ending before the date of expatriation or termination of residency is more than a specified amount that is adjusted for inflation ($147,000 for 2011, $151,000 for 2012, and $155,000 for 2013), (2) their net worth is $2 million or more on the date of your expatriation or termination of residency, or (3) they fail to certify on Form 8854 that they have complied with all U.S. federal tax obligations for the 5 years preceding the date of their expatriation or termination of residency. If any of these rules apply, you are a “covered expatriate.”
All of the property of a covered expatriate is deemed sold on the day before the expatriation date (i.e. the date the individual relinquishes U.S. citizenship) for its fair market value, and the covered expatriate is required to recognize any gain or loss resulting from the deemed sale. I.R.C. §877A(a). This is known as a “mark-to-market” regime. To determine the gain or loss from a deemed sale, all gains are taken into account notwithstanding any other provision in the Code. Any loss from the deemed sale is taken into account for the tax year of the deemed sale to the extent otherwise provided in the Code, except that the wash sale rules of I.R.C. §1091 do not apply.
The amount that would otherwise be includible in gross income by reason of the deemed sale rule is reduced (but not to below zero) by $600,000, which amount is to be adjusted for inflation for calendar years after 2008 (the “exclusion amount”). For calendar year 2013, the exclusion amount is $663,000. For other years, refer to the Instructions for Form 8854.
The amount of any gain or loss subsequently realized (i.e., pursuant to the disposition of the property) will be adjusted for gain and loss taken into account under the I.R.C. §877A mark-to-market regime, without regard to the exclusion amount. A taxpayer may elect to defer payment of tax attributable to property deemed sold. (For more detailed information regarding the I.R.C. §877A mark-to-market regime, refer to Notice 2009-85.)
Form 8854, Initial and Annual Expatriation Information Statement, and its Instructions have been revised to permit individuals to meet the new notification and information reporting requirements. The revised Form 8854 and its instructions also address how individuals should certify (in accordance with the new law) that they have met their federal tax obligations for the five preceding taxable years and what constitutes notification to the Department of State or the Department of Homeland Security.
A citizen is treated as relinquishing his or her U.S. citizenship on the earliest of four possible dates: (1) the date the individual renounces his or her U.S. nationality before a diplomatic or consular officer of the United States, provided the renunciation is subsequently approved by the issuance to the individual of a certificate of loss of nationality by the U.S. Department of State; (2) the date the individual furnishes to the U.S. Department of State a signed statement of voluntary relinquishment of U.S. nationality confirming the performance of an act of expatriation specified in paragraph (1), (2), (3), or (4) of §349(a) of the Immigration and Nationality Act (8 U.S.C. 1481(a)(1)-(4)), provided the voluntary relinquishment is subsequently approved by the issuance to the individual of a certificate of loss of nationality by the U.S. Department of State; (3) the date the U.S. Department of State issues to the individual a certificate of loss of nationality; or (4) the date a U.S. court cancels a naturalized citizen’s certificate of naturalization.
A long-term resident ceases to be a lawful permanent resident if the individual’s status of having been lawfully accorded the privilege of residing permanently in the United States as an immigrant in accordance with immigration laws has been revoked or has been administratively or judicially determined to have been abandoned, or if the individual: (1) commences to be treated as a resident of a foreign country under the provisions of a tax treaty between the United States and the foreign country, (2) does not waive the benefits of the treaty applicable to residents of the foreign country, and (3) notifies the IRS of such treatment on Forms 8833 and 8854.
Significantly, an individual does not have to be a high net worth individual to fall under the “covered expatriate” rules. As noted earlier, if any of the I.R.C. §877A rules apply, the individual will be considered a covered expatriate. One of those rules states that a taxpayer who fails to certify, under penalties of perjury, compliance with all U.S. Federal tax obligations for the five taxable years preceding the taxable year that includes the expatriation date. This means that if the individual failed to comply with his U.S. federal tax obligations or simply failed to certify that he complied, he will be automatically considered a “covered expatriate” subject to the tax imposed by I.R.C. §877A. Therefore, a close look at the expatriation tax makes evident that raising your right hand to renounce U.S. citizenship may be as costly (if not more) than keeping your U.S. citizenship and paying taxes on your worldwide income like all other U.S. citizens even if you are not considered a wealthy individual. The expatriation tax adds up, potentially to as much as paying income taxes to the IRS will. This raises the question: is paying a significant amount of expatriation tax and giving up one of the most desired citizenships in the world really worth it?