In this third and final installment of a three-part series, Mel Warshaw and David Lesperance discuss the issues that arise if a US taxpayer considers using Portugal as part of a plan to expatriate from the US tax system. Read Part 1 and Part 2.
Issue #8 – Using Portugal as part of a plan to expatriate from the US
As previously noted, an American citizen who merely moves permanently to Portugal will nevertheless retain his US tax obligations. However, after five years as a permanent resident of Portugal, he can apply for and obtain Portuguese citizenship. He may also acquire another citizenship before obtaining Portuguese citizenship through either investment, birth (if a naturalized American), or lineage. With either a Portuguese or other citizenship in hand, the US taxpayer has the ability to consider renouncing US citizenship as part of an expatriation tax plan.
An important lifestyle consideration in contemplating an expatriation tax plan is ensuring that the expatriate does not spend too much time in the US in the future and inadvertently reacquire US taxpayer status. The basic test for US income tax residency is the Substantial Presence Test. To meet this objective test, you must be physically present in the United States (US) on at least:
- 31 days during the current year; and
- 183 days during the three-year period that includes the current year and the two years immediately before that, counting:
- All the days you were present in the current year; and
- 1/3 of the days you were present in the first year before the current year; and
- 1/6 of the days you were present in the second year before the current year.
Along with being able to reproduce in Portugal the lifestyle he enjoyed in the US, an expatriate can also choose to extend the number of days that he is physically present in the US without reacquiring US taxpayer status by using either the Portugal-United States Tax Treaty or another exception to the Substantial Presence Test, both of which are discussed below.
Closer Connection Exception
One important exception to the Substantial Presence Test that is of great importance to non-US individuals who are compelled to spend more time in the United States, perhaps due to unforeseen illness, is known as the “Closer Connection Exception.”
This exception applies where an individual is present in the United States for fewer than 183 days during the current year, but the weighted average formula (described above) equals or exceeds 183 days (due to the individual’s presence in the United States in the two preceding years). This exception is basically available for individuals who will spend anywhere from four to six months but no more in the US. For this exception to apply, it must be established that, for the current year, the individual has (i) a “tax home” in a country other than the US and (ii) “closer connections” to that other country than to the United States.
The Treasury Regulations provide that an individual’s tax home is the individual’s regular or principal (if there is more than one regular) place of business. If the individual has no regular or principal place of business because of the nature of the individual’s business or because the individual is retired and not engaged in carrying on a trade or business, the individual’s tax home is their “regular place of abode in a real and substantial sense.”
An individual must file IRS Form 8840 (Closer Connection Exception Statement for Aliens) by the applicable deadline to claim this exception
Treaty Tie-Breaker Claim
Even if an individual meets the substantial presence test (and is, therefore, a US income tax resident under the Code), if the individual continues to also be a tax resident in a country that is party to an income tax treaty with the United States (referred to herein as a “treaty party country”), he may be able to avoid being taxed as a US income tax resident under relief provided by the applicable treaty.
This relief provision, often referred to as a “Treaty Tie-Breaker” provision, allows an individual who is deemed a tax resident of both the United States and a treaty party country (i.e., Portugal) to only be subject to tax as a resident of one of the two countries, based on a set of rules that determine in which of the two countries the individual is deemed a tax resident. In order to obtain Treaty Tie-Breaker relief to be taxed as a resident of the treaty party country (Portugal) rather than the United States, the individual would have to meet certain requirements set forth in the applicable treaty, which often involves having certain closer ties to the treaty party country (Portugal) than to the United States.
If an individual were to claim Treaty Tie-breaker relief, the individual would calculate his US income tax liability as if he were a nonresident alien. This would potentially allow the individual to avoid worldwide US federal income taxation.
However, unlike the Closer Connection Exception, an individual who seeks relief under a treaty must make a Treaty Tie-Breaker election and would have to file IRS Form 1040NR (US Nonresident Alien Income Tax Return) and attach an IRS Form 8833 (Treaty-Based Return Position Disclosure). However, an individual electing Treaty Tie-Breaker status is subject to many of the reporting requirements that are applicable to US income tax residents (for example, the Treaty Tie-Breaker taxpayer must report certain ownership of non-US entities, financial interests, or signature authority over non-US financial accounts for FBAR purposes, gifts from a nonresident alien, etc.).
When contemplating an expatriation tax plan, the most important question will be to determine whether or not the individual is a “Covered Expatriate” as of the day before the date of the final renunciation interview. If the expatriate satisfies any one of the following requirements, he will be classified as a “covered expatriate” for exit and inheritance tax purposes:
- A net worth above $2M (Net Worth Test); or
- An average federal income tax liability over $178,000 over the last five years (for 2023)(Average Income Tax Test): or
- A failure to certify on Form 8854 Expatriation Statement that he has been fully US tax compliant for the five years before expatriation.
Note: There are a couple of exceptions for minors and for dual citizens of the US and another country from birth, which we will describe in greater detail in future columns. We will also be discussing strategies to avoid triggering the Net Worth Test and for properly completing Form 8854.
If an individual is a “covered expatriate,” he is subject to the US exit tax (IRC s. 877a), and his US-person heirs may be subject to US inheritance tax (IRC Section 2801).
The so-called “mark-to-market” exit tax regime under IRC Section 877A is by far the best known and broadest in scope. As of the day before the date of the final renunciation interview at a US mission, the expatriate is “deemed” to have sold his or her worldwide appreciated assets in a taxable sale.
After a roughly $767,000 (2023) one-time special exemption amount, the excess is generally subject to US tax, at rates ranging from 23.8% to over 40%, depending on whether or not the expatriate has held the asset for more than 12 months.
In addition, all tax-qualified retirement plans, IRAs, and deferred compensation is subject to a different special exit tax regime. In the case of an IRA, regardless of age, the expatriate is deemed to have a lump sum distribution of the entire balance in such IRA, which is all taxed at ordinary income rates of up to 37% or more. In future columns, we will be going into detail on the exit tax issues surrounding all of these assets.
Since 2008, the US has also adopted a pernicious inheritance tax on gifts and bequests received by US citizens or residents from a “covered expatriate.” Certain aspects of the inheritance tax make it draconian.
First, the US recipient of the property from the “covered expatriate” cannot apply any portion of their lifetime gift tax exclusion amount ($12.93M in 2023) from gift tax to the receipt of the gift. This means that after a $16,000 annual exclusion amount, the balance is subject to a 40% tax.
Second, the amount subject to inheritance tax is not capped as of the date of expatriation. This means that if an individual had a $3M net worth all in cash when he or she renounced US citizenship, such an individual would not be subject to exit tax because he or she did not own any appreciated assets as of the expatriation date.
However, such an individual is classified as a “covered expatriate” for life because he or she had a net worth in excess of $2M at the date of expatriation. If the “covered expatriate” acquires offshore an additional $100M through inheritance or as an entrepreneur long after leaving the U.S and leaves a $103M estate to his US heirs, the US heirs must report the receipt of such “covered bequests” as subject to US inheritance tax and pay the 40% tax.
Third, it is worth noting that the burden is on the US recipient of assets from a “covered expatriate” to demonstrate to the IRS that the transferor of property was not classified a “covered expatriate” when he expatriated. Obtaining records that could go back one or more generations may be very difficult. The US recipient of the gift or bequest from the covered expatriate or his or her estate is obligated to file Form 708 reporting such gift or bequest. Given that IRS Form 708 has yet to be published by the US Treasury, the inheritance tax will be due beginning when the IRS actually publishes Form 708.
Finally, there is no statute of limitations or time limit on when the property is acquired from the “covered expatriate” or their estate.
Issue #9 – US Tax Considerations Following Expatriation
Once an individual has renounced US citizenship, there are still numerous US tax considerations. Here are but three examples:
Notification of change from US taxpayer status
The individual will need to provide US payers or any financial institution with evidence of his foreign status as a non-resident alien (NRA) of the US. This is done by filing a Form W-8BEN with the US custodian for any US stocks or other investment assets. The individual would have the opportunity in Part II of Form W-8BEN to claim a reduction in the dividend withholding rate under the US – Portugal income tax treaty.
Foreign tax credits in future non-US tax returns
It is worth noting that actual US exit tax is paid on a deemed disposition of a non-US asset. When that same non-US asset is actually sold, the individual will not receive a credit for the previous tax paid to the US. The outcome is the potential partial double tax of the same asset since the US “mark-to-market” exit tax regime mandates a “deemed” sale of all worldwide appreciated assets as of the day before the date of renunciation of US citizenship.
US Estate tax on US-based assets owned by an expatriate
Here are some preliminary comments on the very complex topic of avoiding US estate tax on those US-based assets:
While foreign holding companies established in a no-tax, often English-speaking jurisdiction such as the British Virgin Islands (BVI) or the Cayman Islands are generally recommended for certain long-held US real estate or stock in US companies, there are several situations where a so-called Non-Citizen, Non-Domiciliary (NCND) of the US may not require a foreign holding company to own US situs property as an effective estate tax blocker.
The first situation where a foreign holding company need not be utilized is where the US Code provides a statutory exclusion for the asset in question, such as in the case of life insurance based on the life of the NCND decedent or most US Treasury obligations or publicly-traded corporate bonds.
The second situation where a foreign holding company is not needed is where a US estate tax treaty provides for a higher estate tax exemption amount than the normal $60,000 applicable to the estate of an NCND, and such exemption provides a shield against US estate tax on all US situs property. Unfortunately, the US does not have an estate tax treaty with Portugal, so this situation is inapplicable to those moving permanently to Portugal from the US.
The third situation is where the asset is an intangible, or wrapped inside a US entity (such as a US LLC) where the intangible is an LLC member interest that is considered personal property and, under the US gift tax rules, will be transferred out of the estate by way of a completed gift. This is feasible where the NCND is young and/or healthy and is confident that the transfer will be completed several years before death.
An irrevocable foreign trust may shield US situs assets from US estate tax provided the trust creator (i.e., settlor or grantor) relinquishes all control over the trust assets and is unable to decide which beneficiaries can enjoy the trust income and principal. A revocable foreign trust which owns US situs assets will not prevent US estate tax at the death of the trust creator because the Code provides that property transferred in trust during the lifetime of the decedent is included in his or her gross estate if he or she retains at death the power to “alter, amend, revoke or terminate” the rights of the record owner of the property.
This means that where an NCND holds the power to revoke a foreign trust of which he or she is the trust creator and which owns US situs property, such US property is included in the gross estate of such NCND. For this reason, an NCND needs to arrange for the acquisition of all US real estate by a foreign holding company, perhaps owned by the foreign trust.
Further, the NCND could transfer intangible property (e.g., stock in US companies) to the foreign trust or possibly to the foreign holding company. As noted, if the individual were classified as a “covered expatriate” as of their expatriation date, special US tax considerations are required. Such individuals must not make other than nominal gifts or bequests to US heirs. Otherwise, the heirs will likely have a US inheritance tax problem.
Issue #10 – Using the Portuguese Non-Habitual Tax Regime Post Expatriation
Clearly, an expatiate wants to avoid jumping out of the US tax pot and into the Portuguese tax fire. As noted in Part 2 of this series, Portugal has a very favorable tax planning regime for Non-Habitual residents, which exempts most Portuguese taxation for ten years on income earned abroad from pensions, investments like 401(k) plans, capital gains, and rental income or work outside of Portugal.
For Americans who own US real estate, such as a former primary residence following expatriation, such property will be subject to US taxation under the FIRPTA rules, and there will be a US withholding obligation. While the appreciation in the former primary residence in the US was subject to the “mark-to-market” tax regime on expatriation and is entitled to a corresponding basis step up to fair value on the day before the formal renunciation interview, any subsequent post-expatriation appreciation would be subject to US capital gains tax. Since there would be some US tax paid on the disposition of the former primary residence in the US, the NHR tax regime should be preserved, and there should be no tax in Portugal.
On the other hand, if the former US citizen owned portfolio assets as of the day before the date of the formal renunciation and there is a corresponding basis step-up to such date, any post-expatriation should not be subject to US tax since there is no US capital gain tax to NRAs who sell portfolio assets. Accordingly, the consequence of not paying tax on the sale of the portfolio assets in the US is that the NHR tax regime requirements in Portugal are not met, and the NHR tax regime may not be claimed since the individual will not incur a tax in the US. Portugal would have the right to impose its capital gains tax without regard to the basis step-up on renunciation. In such cases, some additional planning, such as a Maltese structure, should be considered to avoid this outcome.
Residence in Portugal can be a viable and critical part of an effective and tax-efficient backup plan for Americans. However, as this three-part article has hopefully demonstrated, the acquisition of a second residence or second citizenship presents unique issues for American taxpayers. Failure to recognize and appropriately deal with these issues can turn the acquisition of such a status into a financial disaster. Truly, America is exceptional in the complexity of its tax and securities regime.