The United States is one of the few countries to tax the worldwide-earned income of its citizens and permanent residents. Millions of American citizens residing outside the U.S. have no direct ties to their home country since they became citizens by being born in the U.S. or by association to one or both parents, but they are still subject to U.S. income tax on their worldwide income and must meet their annual filing and reporting obligations to the Internal Revenue Service. These expatriates could soon face even more of a burden when the Foreign Account Tax Compliance Act launches on July 1, 2014. It is intended to have a dragnet effect to catch non-compliant U.S. taxpayers with funds located abroad. To avoid these consequences, many American expatriates have opted to give up their U.S. citizenship.
Although the decision to renounce citizenship is drastic and often irrevocable, recent statistics show that an increasing number of U.S. expatriates are doing just that. According to CNN reports, more than 670 U.S. citizens gave up their citizenship in the first 90 days of 2013. Although doing so will reduce or eliminate a number of tax responsibilities, there may still be a price to pay in the form of an “exit tax.”
A. Legal Framework for Exit Tax
Although there has been a U.S. exit tax for some time, the Heroes Earnings Assistance Relief Tax (“HEART”) Act, which came into effect in 2008, fundamentally changed the way taxes are calculated for U.S. citizens who renounce their citizenship. In short, after the HEART Act, a U.S. citizen who gives up his or her citizenship is subject to U.S. income tax on any gain that would be realized upon the sale of all of his or her assets (including interests in grantors’ trusts, gifts and bequests) if they were sold at that time.
The HEART Act requires some U.S. citizens who renounce their U.S. citizenship to pay income tax on the net gain from the “deemed sale” of their worldwide assets. A U.S. expatriate renouncing citizenship is subject to this income tax regime if either of the following applies:
Net income or net worth: the person has either (i) a U.S. income tax liability greater than US$124,000 (adjusted for inflation) for the year prior to expatriation OR (ii) a net worth of U.S. $2 million or more; or
Taxation history: the person has failed to comply with U.S. federal tax obligations (including reporting requirements) during the preceding 5 tax years.
For a U.S. citizen who does not meet the net income or net worth threshold, the second part of the test becomes a significant issue if he or she has not filed U.S. income tax returns, regardless of whether taxes were due. Such a person would not have complied with his or her U.S. federal tax obligation and would fall into the second category of U.S. expatriates who are subject to the exit tax.
Although there are exceptions to the exit tax regime, they are not available to most U.S. expatriates. The first exception is limited to dual citizens who have not lived in the U.S. for more than 10 of the last 15 years. The second exception is even narrower and is limited to U.S. citizens who have not been present in the U.S. for more than 30 days in any of the 10 years before the age of 18 1/2 years. As minors are generally not allowed to renounce their U.S. citizenship, this exception effectively allows only a six month window for such individuals to avoid the imposition of the exit tax.
B. Tax Consequences
Once it is determined that the U.S. expatriate intending to renounce citizenship is subject to the exit tax rule, the exit tax applies to the net unrealized gains on such person’s worldwide assets estimated on a mark-to-market basis. For this purpose, the expatriate is subject to tax on any interest he or she has in property that would have been taxable as part of his or her gross estate for federal estate tax purposes if the person had died as a U.S. citizen or resident. The calculation must be made in accordance with U.S. law, which may differ from the law of the country where the person resides, and assets are valued according to the rules governing estate tax computation. Although US$600,000 of gain is excluded, the excluded amount is allocated pro rata among all of the assets included in the exit tax base. Any gain over this amount is subject to U.S. income tax. The U.S. expatriate will generally pay a tax of 20 percent on any gain.
The HEART Act also imposes a tax on any “covered gift or covered bequest”  (in excess of the US$14,000 annual exclusion, adjusted for inflation) made by a U.S. expatriate after he or she renounces U.S. citizenship, if such person was considered a covered expatriate either (1) when he or she renounced U.S. citizenship or (2) at the moment of making the gift or bequest. Covered gifts and bequests are taxed at the highest rate of estate tax, subject to the annual exclusion amount specified in the Internal Revenue Code. Unfortunately this tax cannot be avoided by deferring transfer until the death of the former citizen since the Internal Revenue Code defines a covered bequest as “any property acquired directly or indirectly by reason of the death of an individual who, immediately before such death, was a covered expatriate.”
The HEART Act also has a special regime for deferred compensation of a covered expatriate. Depending on the type of “deferred compensation item,” such item will either be immediately included in the U.S. expatriate’s income subject to the exit tax, or be subject to a 30 percent withholding tax when it is later paid out. Generally, deferred compensation items under the HEART Act include qualified pension, profit-sharing and stock bonus plans. If the U.S. expatriate (1) notifies the payor that he or she is a covered expatriate and (2) irrevocably waives certain treaty rights to claim a reduction in withholding on such an item, the deferred compensation item is deemed an “eligible deferred compensation item” under the HEART Act. Eligible deferred compensation items are subject to a 30 percent withholding tax, which is preferable to the HEART Act’s treatment of deferred compensation items that are not deemed “eligible.” However, it is also likely that eligible deferred items which are subject to the withholding tax will be taxed again at the 30 percent tax rate as payments to non-resident aliens, which are not subject to reduction under any of the existing tax treaties between the U.S. and other countries.
With respect to non-eligible deferred compensation items, an amount equal to the present value of the U.S. expatriate’s accrued benefit is deemed to have been received by him or her on the day before renouncing citizenship as a distribution under the plan for purposes of calculating the exit tax.
Assuming that the proper tax compliance steps have been or will be taken, the actual procedure to relinquish U.S. citizenship is relatively straightforward. To renounce one’s U.S. citizenship, the renouncing individual must “voluntarily and with intent to relinquish U.S. citizenship” take the following steps:
Appear before the U.S. Embassy or U.S. Consulate Office in a foreign country to renounce U.S. citizenship by signing an oath of renunciation; and
File Form 8854 and the Expatriation Information Statement.
Once the U.S. Department of State has reviewed and approved the renunciation, a Certificate of Loss of Nationality (“COLN”) will be issued. Where applicable, the individual must pay the exit tax due within 90 days from the issuance date of the COLN. Finally, the individual must also file a U.S. federal income tax return for the year of his or her expatriation.
The position of the U.S. Department of State is that citizenship is a status that is personal to the individual U.S. citizen. Therefore, a parent may not renounce the citizenship of his or her minor child. As for minors seeking to renounce their own U.S. citizenship, they must demonstrate to a consular officer that they are acting voluntarily and that they fully understand the implications and consequences that accompany the renunciation of their U.S. citizenship.
D. Factors to Consider Prior to Renouncing U.S. Citizenship
Each U.S. expatriate contemplating renouncing his or her U.S. citizenship needs to fully understand the law and how it applies to his or her particular situation. There are many factors that need to be considered in each case. The following is a non-exhaustive list:
How long has the person lived in the U.S.?
Which family members are U.S. citizens?
Will future heirs and beneficiaries of the estate of the person considering renunciation be “U.S. persons” for U.S. tax purposes?
What is the total value of the worldwide assets of the U.S. expatriate?
What is the adjusted tax basis, as determined in accordance with U.S. law, of each worldwide asset of the person considering renouncing U.S. citizenship?
Has the U.S. expatriate properly filed U.S. federal income tax returns?
In addition to payment of exit tax and other tax obligations, there may be other consequences associated with the renunciation of U.S. citizenship. For example, renunciation of citizenship does not change a person’s liability for debts incurred while that person was a U.S. citizen. In addition, the individual will be subject to U.S. taxation (and may have reporting requirements) with respect to U.S. source income earned after renunciation.
After successfully renouncing U.S. citizenship, traveling into or through the U.S. may become difficult for some former U.S. citizens. Individuals who suffer from certain communicable diseases or who have committed crimes of moral turpitude in the past may be denied entry into the U.S. if they do not obtain permission from the U.S. before traveling. Moreover, additional amendments were added under the U.S. Immigration and Nationality Act to deny re-entry to the U.S. if it has been determined by the U.S. Attorney General that the former citizen renounced his or her U.S. citizenship to avoid U.S. tax. If flagged by the U.S. for any of these reasons, the former citizen can be denied boarding of a plane heading to the U.S. or physically detained (and even arrested) if he or she attempts to cross a U.S. ground border.
One should remember that renouncing U.S. citizenship is permanent. There are no reversals once the COLN is issued and the only way to regain one’s U.S. citizenship is through the long and difficult process of naturalization under the current U.S. immigration law.
Furthermore, in recent years the U.S. Congress has considered increasing the exit tax to 30 percent for anyone leaving the U.S. for tax reasons. If Congress increases the rate, leaving the U.S. may become even more financially burdensome.
Renouncing U.S. citizenship can be, and often is, a costly process. With U.S. immigration and U.S. tax pitfalls scattered throughout the process, understanding the repercussions of renouncing and proceeding carefully is imperative to a smooth departure.
 The rules discussed here for renunciation of U.S. citizenship apply also to lawful permanent residents (“LPRs”) who give up their permanent residency status.
 In the case of an LPR, the same rule applies if the LPR has obtained LPR status for at least 8 of the last 15 tax years.
 See IRC §.2801(e)(1)(A). A “covered gift” is defined as “any property by gift directly or indirectly from an individual who, at the time of the acquisition, is a covered expatriate.”
 The covered gift or bequest is exempted if the recipient is a U.S. spouse or a qualified charity.
 See IRC. §. 2801(e)(1)(B).
 U.S. citizens, LPR or persons residing predominantly in the U.S.
 8 USC §. 1182(a)(10)(E)(2011). The burden to prove that there was a tax avoidance purpose lies with the U.S. government.