US Expatriation: Look before you leap
We have blogged in the past about the general expatriation rules and proposed regulations concerning covered expatriates. Today, we thought we would dig a little deeper and alert the reader to some specific issues that they should be aware of prior to giving up their US citizenship.
First and foremost, one should take steps to avoid being a covered expatriate (for starters, a covered expatriate faces a possible exit tax on deemed sale of their assets). This may require some time and planning (such as using your lifetime gift allowance of $5.49 million, in 2017, to reduce your net worth below the $2 million amount discussed below) and will possibly delay the year in which you can safely expatriate. However, the potential tax savings in most cases warrants the additional steps required to be considered a non-covered expatriate.
Simply put, if your net worth is under $2 million, your average tax liability for the prior five years is less than $162,000 (for 2017), you have been compliant with your US tax filings for those prior five years and file the required final year tax forms, you should be considered a non-covered expatriate. As well, if you are a dual-citizen by birth of the country you are residing in when you renounce and the US and you did not reside in the US for more than 10 years during the 15 year period ending with the tax year during which you expatriated, you can qualify for an exception to the covered expatriation status with regard to the $2 million net worth requirement and average tax liability requirement (assuming you exceed either of these thresholds), but you still must be compliant with your prior five years of US tax filings.
If you are unlucky enough to be considered a covered expatriate, there are still some steps to potentially take to avoid possibly expensive pitfalls. One such pitfall is concerning ‘eligible deferred compensation’. The typical eligible deferred compensation item for most people is their US pension plan (typically a 401K plan) or stock options (both vested and unvested). If treated incorrectly, it will be subject to a lump sum tax at expatriation. To avoid that, form W-8CE must be filed with the plan administrator the earlier of 30 days from expatriation or the day prior to the first distribution on or after the expatriation date. Failure to do so results in the item being converted into an ineligible deferred compensation item, which under the exit tax rules is taxed on a lump sum basis (even though the taxpayer would not receive any actual distribution from the plan currently, they would be required to pay the tax as if the entire plan were distributed on the day before expatriation). This is a very harsh penalty and something that is easy to overlook.
If form W-8CE is properly filed, the plan provider will withhold a flat 30% on future distributions. Depending on the individual covered expatriate, they may be able to apply a tax treaty to obtain more favourable tax rates than are typical under the US tax code. For example, Swiss residents are able to avoid US tax on US pension distributions by utilizing the US/Swiss tax treaty which states that the taxpayers’ country of residence has the right to tax pension distributions. The covered expatriate would need to file a non-resident tax return (1040NR) to claim the treaty position and request a refund of the 30% tax withheld.
Another item that may require action before expatriating concerns one’s principal residence. Assuming one meets specific IRS rules, there is an exemption of up to $250,000 per spouse available on gain associated with the sale of one’s principal residence. It is currently unclear if this exclusion is available under the exit tax rules when the home is not actually sold. Until such time that this issue is clarified by the IRS, thought should be given to selling the principal residence prior to expatriation to properly claim the exclusion. The potential tax savings is in the realm of $100,000 (20% long term capital gains rate on up to $500,000 of gain excluded assuming both spouses qualify).
Another issue to consider is the utilization of the gift and estate tax exemption. If one has not used up their full gift and estate tax exemption (currently $5.49 million per person for 2017), they may want to think about making gifts prior to expatriation, even if to do so will not lower your net worth to less than $2 million. Assuming one is a covered expatriate, under the current rules, any gift or inheritance made after you expatriate to a US person will be taxed at 40% and the tax is payable by the recipient US person. Therefore, it makes sense to use up this exemption prior to expatriation.
These are just some of the issues to be aware of when contemplating renunciation of your US citizenship (long term green card holders planning to give up their green card also face the same issues). The exit tax rules are complex and generally require professional tax help. We deal with these issues every day. Contact us if you are planning to renounce your US citizenship.