How to Expatriate from the United States – Part 3: Preparing for the Exit Tax

In this third article in our four-part series, we will discuss post-expatriation tax and financial filing. Read also:

• How to Expatriate from the United States – Part 1: Pre-Expatriation Planning
• How to Expatriate from the United States – Part 2: Renouncing US Citizenship or Green Card Status

Post Expatriation tax and financial filing

When you expatriate from the US (i.e., relinquish or renounce US citizenship or relinquish long-term Green Card status), you are required to declare all of your assets and liabilities and compute your net worth. As we previously discussed, if your net worth is above $2 million, or you have too high of a five-year average of prior annual US federal tax payments, you are a so-called “Covered Expatriate.” However, many people who do not run afoul of either the net worth or average tax-paid tests still find themselves designated as Covered Expatriates because they fail to properly certify their tax compliance for the prior five years on Form IRS 8854

Form 8854

Form 8854 is required of all expatriates for the year in which they expatriate, regardless of whether they are filing a dual-status return, filing a resident return for the full year, or filing a nonresident return for the full year. Form 8854 is filed along with the expatriate’s income tax returns for that year, and has the same due date.

Form 8854 asks for some basic information about the filer, such as when they expatriated, whether they were a citizen or green card holder, etc. It then asks for information that will tell the IRS whether they are Covered Expatriates or not.

Covered Expatriates have to fill out a section of the form about their assets to show the IRS what assets are subject to the “deemed sale” or “mark-to-market” exit tax rules and what assets get a different tax treatment. Non-covered expatriates do not fill out that information but must still file Form 8854.

Lastly, both Covered Expatriates and non-covered expatriates must provide the details of their personal net worth and information about income reported on their US income tax returns.

What goes on your Form 8854 Balance Sheet?

Specifically, what goes on your Form 8854 Expatriation Statement balance sheet?  What, specifically, is an asset you own?

Here’s how you figure it out:

• Assume you are a US citizen or a resident of the United States (as “resident” is defined for estate/gift tax purposes).
• There is an asset that you are wondering about. Should you include it on your balance sheet or not?
• Pretend you gave it away.
• Ask yourself: “In my “pretend” status as a US citizen or (estate/gift tax) resident, would I hypothetically owe US gift tax on that transfer?”

The IRS Viewpoint 

The relevant authority is at Notice 97-19, Section III, published by the US IRS.

Determination of net worth 

For purposes of the net worth test, an individual is considered to own any interest in property that would be taxable as a gift under the US Tax Code if the individual were a citizen or resident of the United States who transferred the interest immediately prior to expatriation¹.

An interest in property includes money or other property, regardless of whether it produces any income or gain. In addition, an interest in the right to use property will be treated as an interest in such property. Thus, a nonexclusive license to use property is treated as an interest in the underlying property attributable to the value of the use of such property.

Notice 97-19 guides expatriates even today under the current post-2008 exit tax rules. Notice 2009-85, Section 2.B tells us to use these ideas for expatriations from 2008 and onwards.

Gift tax rules for green card holders domiciled abroad

This is sometimes tricky to understand for green card holders living abroad. Green card holders living permanently outside the United States are usually treated as residents of the United States for income tax purposes, but as non-domiciliaries of the United States for estate and gift tax purposes.

Non-domiciliaries of the United States (the estate/gift tax definition) can make gifts without US gift tax.

• Residents (the estate/gift tax definition) pay gift tax on gifts of everything, no matter where that thing is.
• Nonresidents (the estate/gift definition) pay gift tax only on gifts of US real estate and gifts of “tangible personal property” located in the United States.

It’s tempting to want to use the liberal gift tax rules for nonresidents (the estate/gift tax definition) when doing your pre-expatriation tax planning, but you should only pursue this strategy upon the advice of qualified counsel.

What is a “significant change” that must be disclosed on Form 8854?

What constitutes a “significant change” in one’s financial situation? This is a question that is asked on Form 8854.

What Form 8854 Wants

Form 8854 has a Balance Sheet requirement, where you report your assets and liabilities. This helps the IRS understand whether your net worth is above or below $2,000,000 — making you a Covered Expatriate (see Part 1) or not a covered expatriate (below). 

The instructions to Form 8854 have an additional requirement, which you will not find in the Internal Revenue Code (and, in fact, we are aware of many tax return preparers who overlook asking this question in preparing Form 8854):

If there have been “significant changes” in your assets and liabilities for the period that began five years before your expatriation and ended on the date that you first filed Form 8854, you must attach a statement explaining the changes. 

Which five years is logical: They are the same five years that apply for the certification test. The fact that the IRS asks for information that is not specified in the Internal Revenue Code is clearly within the bounds of their discretion.

What is “Significant”?

The big question is the meaning of the word “significant”. The answer is that no definition of “significant” exists for this purpose. You have to make up your own rules.

US tax law is full of terms like this: “Material”, “substantial”, and “significant”. Sometimes, there is a helpful definition attached to the word found in the Tax Code or in the US Treasury Regulations. However, for your Form 8854 balance sheet purposes, there is no guidance.

What We Recommend

Here is what we advise our clients to disclose in an attachment to Form 8854:

• If the transfer during the five-year period triggered the requirement to file an IRS Form 709 Gift Tax Return, tell the government about it in the attached statement.
• If the transfer did not trigger a gift tax return but moved you from covered expatriate territory (net worth above $2 million) to non-covered expatriate territory (net worth below $2 million), tell the government about it on the attached statement.
• If the transfer did not trigger a gift tax obligation (e.g., a green card holder permanently living abroad making a gift of non-US situs assets), you probably want to tell the IRS anyway on the attached statement.

Essentially, think of it this way: If you did not tell the IRS and they found out later that you had transferred assets away during the five-year period, what would you say as to why you did not make the disclosure when required to do so?

Be sure that you can never be accused of lying by omission. Where this disclosure becomes difficult for “long-term” green card holders to comprehend is where the individual may be subject to the exit tax when abandoning green card status, but where he or she has already permanently departed the US. These individuals may make gifts of non-US situs assets to reduce their worldwide appreciated assets subject to the exit tax, which are not reported on a US gift tax return. While the actual gift of a US situs asset by a presumed non-US domiciliary is not subject to US gift tax reporting, we believe the sounder position is to, nevertheless, disclose such gift on Form 8854 if made during the five-year period prior to expatriation.

We believe the IRS is looking to see if the taxpayer is being truthful and forthcoming. Are you lying about your net worth? Did you make an undisclosed transfer of assets away from yourself in order to save taxes?  

Dual Status Returns

All individuals who cease to be taxed as US persons file income tax returns to signal that change in status to the IRS. If the expatriate is going to continue to have US source income post-expatriation, he will file a“dual-status” tax return. This means filing for the part of the year of expatriation during which you are a US person reporting your worldwide income on Form 1040, and for the part of the year you are a non-resident of the US reporting only your US-source income on Form 1040NR.

Background on dual-status returns

The United States is one of very few countries in the world that uses a citizenship-based tax system. Citizens and permanent residents (“green card holders”) are taxed on their worldwide income, regardless of where in the world they happen to reside. Nonresidents are taxed only on US-source income.

When someone switches status from US person to non-US person, the rules under which they are taxed in the US change: They go from being taxed on worldwide income to being taxed only on US-source income.

Individuals must file tax returns covering an entire calendar year; it is not possible to file a short-year return. Therefore, when someone switches status from US person to non-US person, they are filing returns for a calendar year in which they are taxed under two different sets of rules. To report their income properly, they file what is called a dual-status return.

Logistics of dual-status return

The IRS does not have a specific form to use for filing a dual-status return. You have to put together your own dual-status return.

The former expatriates use for the dual-status return a nonresident return (Form 1040NR) with a resident return (Form 1040) attached to the back of it. The package typically also includes Form 8854.

The nonresident return is the tax return that the IRS records as the return filed. The resident return is simply a statement attachment that is used to show income for the resident portion of the year – it is technically not a “return” but instead a “statement”.

Here is what IRS Publication 519 (a generally useful publication for expatriates) says to do:

Nonresident at end of year: You must file Form 1040NR or Form 1040NR-EZ if you are a dual-status taxpayer who gives up residence in the United States during the year and who is not a US resident on the last day of the tax year. Write ‘Dual-Status Return’ across the top of the return. Attach a statement to your return to show the income for the part of the year you are a resident. You can use Form 1040 as the statement, but be sure to mark ‘Dual-Status Statement’ across the top.

Residency termination date other than expatriation date

Usually, your expatriation date will be the dividing line between the non-resident portion of the year and the resident portion of the year. However, that is not always the case. It is possible to have a dividing line between the two portions of the year that is different from your expatriation date.

Your expatriation date generally remains fixed regardless of what the dividing line between the resident and nonresident portions of the year turns out to be.

The dividing line between resident and nonresident status is referred to as the “residency termination date”. For those who are exiting the US tax system, IRS Publication 519 has this to say about the residency termination date: 

Last Year of Residency: If you were a US resident in 2022 but are not a US resident during any part of 2023, you cease to be a US resident on your residency termination date. Your residency termination date is December 31, 2022, unless you qualify for an earlier date as discussed next.

Earlier residency termination date: You may qualify for a residency termination date that is earlier than December 31. This date is:

• The last day in 2022 that you are physically present in the United States, if you met the substantial presence test,
• The first day in 2022 that you are no longer a lawful permanent resident of the United States, if you met the green card test, or
• The later of (1) or (2), if you met both tests.

You can use this date only if, for the remainder of 2022, your tax home was in a foreign country and you had a closer connection to that foreign country. 

We will not discuss the physical presence test or the green card test in detail in this article. For our purposes here, it is sufficient to recognize that the date you turn in your green card, which is generally your expatriation date, may not be the same day as your residency termination date.

The same is true for citizens: the date that you terminate your citizenship may not be your residency termination date. Your citizenship termination date is still your expatriation date, but in some situations, you would use a different date as the dividing line between resident and nonresident status.

Paperwork after the year of expatriation

After you expatriate, you will be treated as a nonresident alien for all future years, assuming that you do not get a green card or meet the substantial presence test for any year.

In this article, we assume that the paperwork required after the year of expatriation from the US is for someone who does not become a US taxpayer again, either by obtaining a green card or by meeting the substantial presence test.

US tax returns after expatriation

If you have income from US sources after expatriation, you will most likely need to file a US return (i.e., Form 1040NR). But if you have no assets in the US and receive no income from US sources for the rest of your life, you will never need to file a US tax return again. If this is your objective, you may want to sell off 100% of your US assets and make sure you will no longer receive any US source income before you expatriate.

If you do have US source income, you still might be able to avoid filing a US tax return if you have the “right” types of income and if your tax liability is fully satisfied by withholding. In our experience, however, accomplishing this result can be very difficult, because withholding agents do not always withhold the correct amounts of US tax.

Ultimately the responsibility is on the taxpayer to file the required US tax returns and pay the correct amount of US tax, so more often than not, my nonresident clients continue to file US returns for at least a year or two after expatriation.

Withholding for nonresidents in general

After you cease to be a US person, you need to notify all payors of US-source income that you are a nonresident so that they can withhold the appropriate amounts.

In general, individual nonresidents pay tax at a 30% flat rate on most types of income – basically, everything except income from a US trade or business, or from the sale of US real property.

However, if you live in a country that has a tax treaty with the US, certain types of income may qualify for a lower tax rate. You need to either claim the treaty rate on the withholding forms that you provide to the payor, or you need to make a treaty election on your tax return to qualify for the lower tax rate. This is typically done by attaching IRS Form 8833 to Form 1040NR. Check the treaty for the country where you reside (not the country of your citizenship, if these are different) to see what treaty rates are available.

The form you provide to US payors to inform them of your nonresident status is Form W-8BEN. Send this to financial institutions where your US accounts are held and other payors of US source income as soon as possible after expatriating.

Special withholding for Covered Expatriates only

As discussed in prior articles, if you are a Covered Expatriate, certain US assets — deferred compensation plans (including “pensions”), specified tax-deferred accounts (such as “IRAs”), and beneficial interests in certain trusts — will be taxed.

These assets are typically taxed as you – the Covered Expatriate – receive distributions. The tax is 30% of the amount distributed to you. In some cases, the entire lump sum is taxed to you immediately, however, such as with IRAs.

No matter which method is used to calculate your income tax on these types of assets, you must give the pension plan administrator, the IRA administrator, or the trustee a Form W-8CE. This tells them that you are a Covered Expatriate and that they have an obligation to withhold US income tax from distributions they make to you.

Form W-8CE must be given to them within 30 days after your expatriation date. If you fail to do so within that timeline, then certain assets (e.g., 401(k) accounts) may be taxed to you as a deemed lump sum payment when they would otherwise qualify to be taxed at 30% on distributions only.

Annual Form 8854 for some Covered Expatriates

Some covered expatriates must continue to file Form 8854 each year after they expatriate if they made an election to defer tax for the year in which they expatriated, if they have what is called “eligible deferred compensation” items, or if they have an interest in a non-grantor trust.

There is no quick exit

While leaving the US tax system can result in a significant reduction or even elimination of future US taxation, the strategy must be properly designed. The execution of the strategy takes time and requires a significant amount of properly prepared and timely filed paperwork. There is no shortcut.

Be prepared by familiarizing yourself with the various types of paperwork that will be required for the year of expatriation and in the subsequent years, and engage qualified and experienced advisors to give yourself the comfort of knowing that every “I” is dotted and “T” crossed.

---

End notes:

¹For this purpose, the determination of whether a transfer by gift would be taxable under Chapter 12 of Subtitle B of the Code must be determined without regard to sections 2503(b) through (g), 2513, 2522, 2523, and 2524.