The Heroes Earnings Assistance and Relief Tax Act of 2008 (the "Act") was signed into law on June 17, 2008, marking a dramatic change for those individuals who choose to relinquish US citizenship or terminate status as a long-term US permanent resident. New Internal Revenue Code §§877A and 2801 are effective immediately, affecting certain US citizens who expatriate and certain long-term US residents who terminate US residency on or after June 17, 2008. For ease of reference, individuals who fall into either category are referred to herein as "expatriates."
Unlike the situation under current law, in which an expatriating individual can often make financial and other arrangements to avoid additional US taxes, under the new law the imposition of US taxes upon and following expatriation will be unavoidable in many cases (particularly with respect to covered expatriates with substantial unrealized gain in their investment portfolios and heirs who are either US citizens or residents).
The most notable changes effectuated by the new law are as follows: (1) imposition of a new "mark-to-market" exit tax; (2) elimination of the 10-year alternate income, gift and estate tax regimes that formerly applied to expatriates; and (3) imposition of a new transfer tax payable by US citizens and residents who receive gifts or bequests from expatriates.
I. Summary of Prior Law
Generally, under Code §877, expatriates who met certain conditions were subject to an alternate US income tax regime for a 10-year period after the date of expatriation, during which they were required to file annual information returns and pay US tax on certain items of income not otherwise taxable to nonresident aliens (e.g., capital gains on the sale of US stock). In addition, such expatriates were subject during the 10-year post-expatriation period to US gift and estate tax on the transfer of a broader array of assets than other nonresident aliens.
Also, under prior law, if any such expatriate were physically present in the US for more than 30 days in any given year during the 10-year post-expatriation period, he or she would be treated for tax purposes as a US citizen or resident for that taxable year. As a result, such individual would be subject to (1) US income tax on worldwide income earned that year, (2) US gift tax if he or she transferred any worldwide assets by gift that year, and (3) US estate tax on worldwide assets if he or she died that year.
These rules will continue to apply to individuals who expatriated from the US prior to June 17, 2008. They will not apply, however, to individuals who expatriate from the US on or after that date.
II. Summary of New Law
A. Applicability of New Law
The new law applies to so-called "covered expatriates," who are defined under new Code §877A as individuals who (1) are either US citizens who relinquish US citizenship or long-term US residents (i.e., individuals holding a green card for at least 8 of the prior 15 years) who terminate US residency, and (2) meet one of the following requirements:
- Failure to certify under penalties of perjury that he or she has complied with all US federal tax obligations for the preceding five years, or failure to submit such evidence of compliance as the Secretary may require.
The various instances in which a US citizen will be deemed to have relinquished US citizenship are set forth in Code §877A(g)(4). A long-term US resident will be treated as having terminated his or her US residency if his or her green card is revoked, if it is administratively or judicially determined that he or she has abandoned lawful permanent resident status, and in certain other unique circumstances.
Certain individuals who either are born with dual citizenship or who relinquish US citizenship prior to age 18½ are exempt from covered expatriate status, provided they meet certain additional requirements.
B. Exit Tax
1. General Description
Under the new law, covered expatriates are not subject to the above-described 10-year alternate US income, gift and estate tax regimes, and will not be deemed to be US residents for tax purposes if they are physically present in the US for more than 30 days in any given year following expatriation.
Instead, covered expatriates will now be subject to "mark-to-market" deemed sale rules under which they will be treated as if they sold their worldwide assets for fair market value on the day before expatriation.
Gain from the deemed sale is taken into account at the time of expatriation without regard to other Code provisions. Loss is also taken into account at that time to the extent otherwise provided in the Code, except that the wash sale rules of Code §1091 do not apply. Net gain on the deemed sale is taxable to the extent that it exceeds $600,000 (indexed for inflation). For example:
If a covered expatriate owns $5,000,000 in total assets with an aggregate income tax basis of $1,000,000, then such individual will be required to pay tax on a deemed gain of $3,400,000 (i.e., $4,000,000 gain minus the $600,000 exemption) in connection with his or her expatriation.
It is unclear under the new law whether expatriates will be required to pay the exit tax upon departure from the US, or with a tax return timely filed during the calendar year following expatriation.
For purposes of determining the tax imposed under the mark-to-market rules, assets held by an individual on the day that he or she became a US resident shall be treated as having a basis on that date of not less than the fair market value of such assets on that date. A covered expatriate can make an irrevocable election for this particular rule not to apply. It appears that this rule will apply retroactively to individuals who became US residents before the effective date of the Act.
2. Election to Defer Exit Tax
A covered expatriate may elect to defer payment of the exit tax imposed on the deemed sale of property, so long as he or she furnishes a bond or other adequate security to the IRS. Interest is charged for the deferral period at the rate normally applicable to individual underpayments. The election is irrevocable and is made on a property-by-property basis.
3. Special Rules
a. Deferred Compensation Items
If a covered expatriate holds an interest in an "eligible deferred compensation item," the payor must deduct and withhold from a "taxable payment" to the expatriate a tax equal to 30% of such payment. This withholding requirement replaces any withholding requirement under prior law.
An "eligible deferred compensation item" is any deferred compensation item with respect to which (1) the payor is either a US person or a non-US person who elects to be treated as a US person for purposes of withholding and meets other requirements, and (2) the covered expatriate notifies the payor of his status as a covered expatriate and irrevocably waives any claim of withholding reduction under any treaty with the US.
If the deferred compensation item is not an eligible deferred compensation item, an amount equal to the present value of the covered expatriate's deferred compensation item is treated as having been received by him or her on the day before the expatriation date. Adjustments are made for subsequent distributions to take into account this treatment. Furthermore, such deemed distributions are not subject to early distribution tax.
b. Tax Deferred Accounts
If a covered expatriate holds any interest in a specified tax deferred account (e.g., an IRA, 529 Plan, etc.) prior to expatriation, such covered expatriate is treated as having received a distribution of his or her entire interest in such account on the day before the expatriation date. Again, appropriate adjustments are made for subsequent distributions to take into account this treatment, and the deemed distributions are not subject to early distribution tax.
c. Interests in Trusts
(i) Grantor Trusts
The assets held by any portion of a trust that is a grantor trust for income tax purposes with respect to a covered expatriate are subject to the mark-to-market exit tax.
(ii) Nongrantor Trusts
The exit tax does not apply to the portion of a trust that is a nongrantor trust for income tax purposes. Instead, with respect to any direct or indirect distribution from such trust to a covered expatriate, the trustee must deduct and withhold from the distribution an amount equal to 30% of the portion of the distribution that would have been includible in the gross income of the covered expatriate if the covered expatriate had not expatriated. If the nongrantor trust distributes appreciated property to a covered expatriate, the trust must recognize gain as if the property were then sold to the covered expatriate at its fair market value. It is not clear how these provisions will apply to foreign nongrantor trusts.
C. Transfer Tax
Under new Code §2801, US citizens and residents who receive any bequests, or any gifts in excess of the annual gift tax exclusion amount, from a covered expatriate will be liable for a transfer tax at the highest applicable estate or gift tax rate.
Note, however, that the transfer tax does not apply with respect to transfers (1) reported on a timely filed US gift or estate tax return, or (2) for which a marital or charitable deduction would otherwise be allowed.
Special rules apply to transfers in trust. If a covered expatriate makes a gift or bequest to a domestic trust, the trust must pay the transfer tax. If, in contrast, a covered expatriate makes a gift or bequest to a foreign trust, the foreign trust is not subject to the transfer tax; rather, the transfer tax will be payable if and when assets attributable to the gift or bequest made by the covered expatriate to the foreign trust are distributed to a recipient who is a US citizen or resident.
The new expatriation law represents a substantial change from prior law. Accordingly, any individuals who are thinking about relinquishing their US citizenship or residency, and their advisors, should familiarize themselves with the new rules before proceeding.