American Exceptionalism

How to Successfully Expatriate from the United States – Part 1: Pre-Expatriation Planning


American Exceptionalism

Two seasoned veterans in the world of US tax and expatriation law discuss investment migration questions that uniquely impact Americans.


Every quarter, the US government publishes a list containing the names of a select group of American citizens and Green Card holders who have expatriates; who have legally given up their citizenship or long-term resident status. This list of Covered Expatriates only contains those who exceeded the minimum threshold of over US$2 million in worldwide assets and/or who have paid average annual federal tax over the last five years of at least US$190,000 (2023 threshold indexed for inflation).

In practice, this type of tax burden requires a federal taxable income greater than US$5-600,000 a year. Once an individual exceeds the net worth or tax paid threshold, there is no further indication of whether their net worth was $2 million or $2 billion or whether their average federal tax burden was $190,000 or $1.9 million.

Over the past 17 years, the total number of Covered Expatriates each year has ranged from a low of 278 in 2006 to a high of 6,705 in 2020, at a yearly average of 2,717 as of the end of 2022. Almost invariably (with the exception of the Covid years, when the US government made expatriation almost impossible in most cases), that average has kept moving upward year by year.

You are probably already asking yourself the same question we do each quarter: Why is this happening?  

Unfortunately, the US government does not provide much information that might shed some light on this question. Although published quarterly, the names that appear are not the names of those who expatriated in the prior quarter. Instead, the names appear at least 12 months after their corresponding renunciations actually took place. In the case of one current mutual client of ours, his name has still not appeared, despite his expatriating in April 2021 - almost 24 months ago!

Moreover, no explanation or commentary is provided along with the list. No reasons for increases or decreases. Nothing. It's almost as if the government doesn’t want to shed any light on this increasingly common occurrence.  

It is to provide insight and explanation that we are pleased to introduce the Lesperance US Expatriation Index. Every quarter, we will track the Covered Expatriate List and plot the results. Every quarter, we will provide our insights into why more or fewer people are expatriating, identify trends, discuss implications, and provide some general guidance to potential future Covered Expatriates on what they might want to do now in order to give themselves the option of departure from the US tax system at some point. It never hurts to have options.

Another question we often receive from Americans who are in the same financial category as the Covered Expatriates is whether having an expatriation strategy makes sense for them.

To answer this question, Mel Warshaw and I have teamed up to provide a four-part series for IMI on the interesting and complex topic of expatriation. Interesting because each application to renounce represents real people with complicated and successful lives and well-considered reasons for expatriating. Complex because there are potentially severe and impactful implications of renouncing that must be carefully and thoroughly considered and addressed, such as: 

  • Pre-expatriation tax planning; 
  • The specific processes you need to follow to successfully renounce or relinquish US citizenship or to relinquish Green Card status; 
  • Post-expatriation tax filings and compliance; and
  • Future travel to the US. 

Our four-part How to Successfully Expatriate from the United States series for IMI will explore these four areas so that you - or your wealthy American clients - can determine whether to add the optionality of an expatriation strategy to your tax and succession planning.

In the first installment of the series, we look at the triggering of the US expatriation tax regimes, the underlying exit and inheritance tax rules, and some strategies to minimize and possibly even avoid these taxes.

In the second installment, we will walk through the mechanics of relinquishing and renouncing US citizenship and relinquishing green card status.

In the third installment, we discuss post-expatriation tax filing issues.

In the fourth and final installment, we will discuss future travel to the US. 


Part 1 - Pre-Expatriation Planning

The Expatriation Tax Regimes

Every year, more and more US citizens renounce their citizenship, and green card holders give up their visa status. These actions could well trigger a tax problem: the US Expatriation Tax Regimes.

The Expatriation Tax Regimes has two significant underlying components; the "Exit Tax” (IRC s.877a) and the “Inheritance Tax” (IRC s. 2801). 

The US Expatriation Tax Regime Exit Tax rules impose an income tax on certain people called “Covered Expatriates” who have made their exits from the US tax system. The defining feature of the Exit Tax is that all worldwide appreciated assets are treated “as if” they are sold on the day before citizenship or resident status is terminated. If applicable, net capital gain (after an exclusion amount of roughly $821,000 in 2023) from the deemed sale is taxed when the expatriate’s final US tax return for the year of expatriation is filed.

There are other rules that accelerate income for a person leaving the United States. These other rules apply to items such as IRAs, pensions, deferred compensation plans, and beneficial interests in trusts.

The Inheritance Tax Rules impose a liability on US citizens or tax residents who are the recipients of a gift or bequest from a Covered Expatriate in excess of a de minimis annual exclusion amount. The tax burden of 40% is on the recipient, and not on the donor, of the gift or bequest.

Citizenship-Based Taxation

The United States is not alone in having an Expatriation Tax Regime containing an Exit Tax. Other countries have exit taxes, too. The United States is unique, however, in tying its Exit Tax to a change in visa or citizenship status. This is called “citizenship-based taxation”. If you are a US citizen or resident alien, you are taxed on worldwide income. If you are a US citizen or domiciliary, you are subject to US gift, estate, and generation-skipping tax on worldwide assets in excess of currently extraordinarily generous but temporary lifetime exclusion amounts.

Every other country on earth (except Eritrea and a few other limited-case exceptions) follows a “residence-based taxation” system. If you are a resident (however defined) of that country, you are taxed. If you are a nonresident (however defined), you are not taxed. In these cases, what usually triggers an Exit Tax is a change in tax residence status. This is why it is easy for Canada (residence-based taxation) to allow its citizens to live abroad and be taxed as nonresidents, while it is impossible for the United States (citizenship-based taxation) to do so.

The citizenship-based tax principles are part of the DNA of the US Internal Revenue Code and are the reason that giving up citizenship or residence is a tax recognition event. They're also the reason the Expatriation Tax Regimes exist in the US in the first place. Some US tax commentators suggest that the Expatriation Tax Regime reflects the lack of a sympathetic lobby in Congress. But fair or not, it is the law.

Who Should Worry About the Expatriation Tax Regimes?

The Expatriation Tax Regime applies to two categories of people:

  • US citizens: Who terminate their citizenship; and
  • Long-term residents: Lawful permanent residents of the US (green card holders) who terminate that status after holding it for many years.

If you do not fall into one of those two categories, you needn't worry further about the Expatriation Tax Regime and its exit and inheritance tax rules. Thus, for instance, someone living for decades in the United States under other visas (student, H-1B, L-1A, etc.) will never have a concern about paying exit or inheritance tax following a departure from the US.

Citizens

Citizens of the United States - when they voluntarily or involuntarily terminate that status - may trigger the US Expatriation Tax Regimes. By giving up citizenship at a formal final renunciation interview at a US consulate, he or she becomes an “expatriate” under the Internal Revenue Code.

It is usually simple to determine US citizenship. If you are born in the United States (and not the child of a diplomat or foreign service woman or man), you are a US citizen. It is sometimes a bit complex to determine whether someone born outside the United States (with US citizen parents) is a citizen or not. A naturalized citizen will have a vivid memory – and some paperwork – to prove the acquisition of US citizenship. People will almost always know whether they are citizens of the United States or not.

Dual citizenship does not matter. Simply acquiring citizenship of a second country will not in itself terminate US citizenship. 

Long-Term Residents

People who are not citizens of the United States may also be subject to the US Expatriation Tax Regimes if they are long-term residents of the United States.

  • Resident status means that they are lawful permanent residents of the United States. In normal conversation, we call these people green card holders.
  • Long-term means that they have held lawful permanent resident status - even for a split-second of time - in at least eight out of the last 15 years (sometimes known as the “8 out of 15 test”). In satisfying this “8 out of 15 test,” there are special rules for disregarding years in which these people lived abroad and filed US income tax returns claiming non-resident status under the terms of an applicable income tax treaty. This is done by attaching Form 8833 to Form 1040NR for the tax year, claiming a permanent home and center of vital family, business, and economic interests in another country that has a tax treaty with the US. Electing under a tax treaty not to be treated as a US tax resident for a year has the effect of suspending and possibly ignoring the counting of that year for purposes of determining whether a person satisfies the “8 out of 15 test” as of the year of expatriation. 

What Actions Trigger the Expatriation Tax Regime?

You are not subjected to the Expatriation Tax Regime simply because you are a citizen or a long-term resident. You must do something to trigger the application of the US exit and inheritance tax: Renounce your citizenship or abandon your long-term resident status.

US Citizens Renounce/Relinquish Citizenship

US citizens can choose to give up citizenship, or have it taken away from them. Losing citizenship makes a (former) US citizen an expatriate under the US Expatriation Tax Regimes.

Long-Term Residents Give Up Visa Status

Green card holders are also affected by the US Expatriation Tax Regimes.

A green card holder must have been a lawful permanent resident in 8 of the 15 years ending with the year of expatriation. In other words, the green card holder is a long-term resident (a defined term in the Code). Only green card holders who are long-term residents are affected by the exit tax rules. If you are a “substantial presence” taxpayer but never held a green card, you cannot be subject to the US Expatriation Tax Regimes.

Example

You become a lawful permanent resident in 2018. In 2022, you have been a lawful permanent resident for five out of fifteen years. You are not a long-term resident, so you need not worry about the exit tax rules if you decide to give up your visa and leave the United States.

Once the long-term resident status is attained, there are three ways a green card holder can trigger the US Expatriation Tax Regimes:

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  • First, the green card holder can voluntarily abandon the visa status.
  • Second, the government may forcibly cancel the visa.
  • Third, the green card holder can make a treaty election.

These events cause the long-term resident to become an expatriate and potentially subject to the US Expatriation Tax Regime. 

Green Card status is voluntarily abandoned by filing Form I-407 with the US Citizenship and Immigration Service (USCIS). The effective date is the date that is stamped on your Form I-407 confirming receipt of the form by the US government. Green Card status is involuntarily taken away as of the date you became subject to a final administrative order that you abandoned your lawful permanent resident status (or, if such order has been appealed, the date of a final judicial order issued in connection with such administrative order).

It could also be the date you became subject to a final administrative or judicial order for your removal from the United States under the Immigration and Nationality Act.

Finally, the long-term resident may trigger the Expatriation Tax Regime (i.e., become an expatriate) by making a treaty election to be a nonresident of the US, thereby ceasing to be a permanent resident for tax purposes. The green card holder makes this election by filing a Form 1040NR for the year in question, with the treaty election on an attached Form 8833.

The election, if made after the green card holder becomes a long-term resident, will cause the individual to be an expatriate despite his still holding the immigration status of a lawful permanent resident. Many long-time lawful permanent residents are ignorant and unaware of this highly technical provision, which could spell disaster to a carefully conceived plan of expatriation from the US.

Are You a Covered Expatriate or Not?

Once you have determined that you have expatriated (given up citizenship for citizens, abandoned visa status or elected nonresident tax status for long-term residents), the next task is to figure out the consequences of that event.

The US Expatriation Tax Regimes will create two possible income tax consequences for citizens and long-term residents who expatriate:

  • paperwork only, or
  • paperwork plus tax.

“Covered Expatriates” face the prospect of paperwork plus tax liability. In contrast, noncovered expatriates bear the paperwork burden only.

US persons who receive gifts or bequests from Covered Expatriates also suffer further US inheritance tax burdens. Such US recipients of “covered gifts” or “covered bequests” from a Covered Expatriate pay a tax when receiving a wealth transfer from a Covered Expatriate.

In addition, the receipt of material gifts and bequests and all distributions from a foreign trust must be reported on an annual informational tax return.

Further compounding the complexity of the inheritance tax is that although the inheritance tax was enacted in 2008, the IRS has yet to issue Form 708 so US heirs are in a holding pattern pending issuance of the final inheritance tax regulations.

Covered Expatriate vs. Non-Covered Expatriate

The term “Covered Expatriate” is defined in the Internal Revenue Code. It means someone who:

  • is an expatriate (a citizen who has relinquished citizenship, or a long-term resident who has given up green card visa status or has made a treaty election to be a nonresident); and
  • has failed (or passed, depending on perspective) one of the following three tests:

The Net Worth Test

The first way to become a Covered Expatriate is to have a net worth of US$2 million or more on the date of expatriation. The amount is not indexed for inflation.

The Net Tax Liability Test

The second way to become a Covered Expatriate is to have a high-enough average net federal income tax liability for the five tax years before the year of expatriation. The threshold amount for expatriations in 2023 is $190,000, and it is indexed for inflation.

The Certification Test

The final way to become a covered expatriate is to be non-compliant with any US tax obligations for the five tax years before the expatriation year. Complete compliance with all US tax filing obligations is demanded. You must certify full compliance under penalty of perjury and, if audited, prove it. Full compliance with US income tax returns and forms is not sufficient; the individual must also be fully compliant with any US gift tax and employment tax returns that were required to be filed.

The three criteria are designed to identify people who are either relatively wealthy (in the eyes of the Internal Revenue Code) or non-compliant with US tax law. These people are Covered Expatriates. Expatriates who are fully tax-compliant and of relatively more modest means (from the Code’s point of view) are not Covered Expatriates. The Code does not give these people a name, but for clarity’s sake, they are informally referred to as “non-covered expatriates”.

Two Exceptions to Covered Expatriate Status

There are two categories of expatriates for whom the Net Worth Test and the Net Tax Liability Test will not apply:

  • Dual citizens who acquired US and another citizenship at birth; and
  • People who expatriate before age 18 1/2.

For those who qualify for one of the exceptions, personal wealth and prior years’ income tax liability will not cause the individuals to be covered expatriates. However, the taxpayers will still be required to satisfy the Certification Test, and failure to do so will make them Covered Expatriates.

How Covered Expatriates are Taxed

Covered Expatriates face the prospect of being forced to pay US Exit Tax in return for being allowed to leave the US tax system’s worldwide tax reach. The general principles are easy to understand:

  • Pay tax as you receive income. If the IRS can rely on tax withholding rules to ensure full collection of income tax, the Covered Expatriate pays tax at a 30% rate on US source income as it is received.
  • Pay tax on everything now. If the IRS cannot be assured of timely collection of tax at the source, the US exit tax rules impose a deemed sale of worldwide appreciated assets under the so-called “mark-to-market” exit tax regime or deemed distribution (from an IRA, for example) for certain ineligible deferred compensation. Both force immediate recognition and taxation of unrealized income and capital gains while the individual is still a US taxpayer and must be reported on the individual’s final US tax return.

The Code lays this out by identifying three categories of income for which special exit tax rules have been written. Everything else is subjected to a mark-to-market system that causes a deemed sale of assets at fair market value.

Specified Tax-Deferred Accounts

Specified tax-deferred accounts are things like IRAs or Health Savings Accounts. If the Covered Expatriate has any of these accounts, they are deemed to have received a full distribution on the day before expatriation. Early distribution penalties are not applied.

Deferred Compensation

Deferred compensation means pensions as well as other deferred compensation arrangements. If the covered expatriate has any of these, expatriation will trigger tax liability.

Pay-as-you-go. Some deferred compensation arrangements are taxed to the Covered Expatriate on a 30% pay-as-you-go arrangement. These are “eligible” deferred compensation arrangements. “Eligible” deferred compensation plans are those where the payor is a US person. There is a simple reason why the government is willing to collect 30% as benefits are paid.

The presence of a US plan administrator or custodian means that there is a US withholding agent in place. If a US withholding agent fails to undertake the required tax withholding, they are personally liable to the IRS for the tax that should have been withheld but was not. The US IRS generally will not receive tax from the taxpayer (if withholding is done correctly by the US plan administrator or custodian). 

However, be forewarned that in order to elect this “pay as you go” method for “eligible” deferred compensation, such as 401(k) accounts, the expatriate must comply with very stringent time requirements to provide notice of their expatriation to the US plan administrator. Failure to comply with these tight deadlines will force the expatriate to use the more punitive “lump sum” system (see below) and lose continued US tax deferral on their 401(k) account. 

Lump sum. “Ineligible” deferred compensation arrangements are those where the payor is not a US person. A foreign pension plan is a simple example of this. Here, the IRS cannot rely on a withholding agent to act, in effect, as a guarantor of tax payments. A foreign pension plan administrator, making a pension distribution to a foreign person (the covered expatriate) might not feel any particular compunction to satisfy an IRS request for tax withholding compliance. For “ineligible” deferred compensation arrangements, a Covered Expatriate is treated as having received a lump sum distribution on the day before expatriation equal to the present value of the accrued plan benefits.

Beneficiaries of Non-Grantor Trusts

Covered Expatriates who are beneficiaries of non-grantor trusts must pay a 30% tax on the taxable portion of trust distributions they receive.

Mark-to-Market Rules

Everything that falls outside of these three special categories will be taxed according to “mark-to-market” tax principles. All worldwide assets are deemed sold on the day before expatriation at fair market value. Capital gain or loss is computed in the usual way. A special exemption amount (US$821,000 for expatriations in 2023; indexed for inflation) is applied, and any net capital gain above the exemption amount is taxed using the usual capital gain tax rates. The 3.8% net investment income tax (“NII”) is added to the amount of gain since the taxpayers are generally US persons on the day before expatriation.

The Expatriation Tax Regime Paperwork

Predictably, the Expatriation Tax Regime has resulted in special-purpose US IRS tax forms.

  • Form 8854. Form 8854 is the main tax form. This form is due on the normal income tax filing deadline for the year of expatriation. Both Covered Expatriates and noncovered expatriates are required to file this form. Form 8854 captures all of the information that the Service needs to determine whether the taxpayer is a Covered Expatriate or not by requiring the submission of a Balance Sheet of all assets owned on the day before expatriation. For Covered Expatriates, this form provides the details of the taxable income triggered by the event of expatriation and where that income is reflected on the income tax return. 
    • Note that the instructions to Form 8854 require the taxpayer to also disclose to the IRS by an attachment a statement of all significant changes in assets and liabilities for the five years preceding the year of expatriation. Our experience is that many seasoned tax return preparers are unaware of this disclosure requirement and never raise it with the client when preparing Form 8854. If an individual fails to include the attachment and therefore fails to disclose significant changes in assets and liabilities in the pre-expatriation period, we presume this is an incomplete Form 8854, which should result in the expatriate flunking the Certification Test. An outcome of lifetime Covered Expatriate status would be a shock to an otherwise tax-compliant client. We have worked on remediating clients who fall into this category.
  • Form W-8CE. A special Form W-8CE must be submitted by Covered Expatriates to US plan administrators of “eligible deferred compensation” or trustees of non-grantor trusts. The Covered Expatriate gives the Form W-8CE to retirement plan administrators, pension and deferred compensation plan administrators, and trustees of non-grantor trusts where the Covered Expatriate is a beneficiary. This notifies the payor of the taxable income of the recipient’s Covered Expatriate status so that the correct tax withholding can be applied. The recipient is also required to provide specified information to assist the Covered Expatriate’s calculation of the exit tax. For instance, an IRA custodian must report the value of an IRA on the day before expatriation so that the Covered Expatriate can treat that amount as a deemed distribution of the entire balance prior to expatriation.
  • Form 708. This Form will eventually relate to the tax liabilities under the inheritance tax and will be published whenever the IRS issues final regulations in this area. . Form 708 will be filed by US citizens or green card recipients of so-called “covered gifts” or “covered bequests” from a Covered Expatriate. The recipients pay US inheritance tax at the highest gift tax rate on amounts received from Covered Expatriates. There are only a few exceptions, and the US inheritance may be imposed on US recipients years after the Covered Expatriate departed the US as well as many years after the Covered Expatriate has died.  Status as a Covered Expatriate is determined on the day before expatriation and remains with the individual for life.

Guidance for Would-Be Expatriates

Avoid Expatriate Status

When considering expatriation, the first line of defense against the US exit tax is to avoid becoming an expatriate in the first place. This is impossible for citizens, but for green card holders, the strategy is to avoid becoming a “long-term” resident. Leave the United States and abandon the green card visa before the eighth year of holding that visa status.

Avoid Covered Expatriate Status

If expatriate status is unavoidable, paperwork burdens are unavoidable. But it may be possible to eliminate the tax cost of expatriation. This might be possible by reconfiguring your daily life to eliminate Covered Expatriate status. Find ways to properly bring your net worth below $2,000,000, but this is impractical for most very wealthy expatriates. For corporate executives, find ways to bring your average income tax liability for the previous five years to a number below the inflation-adjusted threshold that applies to you. And, most important of all, fix any noncompliance in tax returns for the five prior years by remediation through an IRS-approved voluntary compliance program. 

Typically, remediation may be undertaken by the eligible individual in a so-called Streamlined Domestic Offshore Procedures submission (for US residents) or Streamlined Foreign Offshore Procedures submission (for non-US residents). In our experience, many clients believe they prepared and filed correct US income tax returns, but a significant number of American taxpayers, especially those who live abroad, have missed something when filing their tax returns.

Minimize Capital Gains

If Covered Expatriate status is unavoidable, you should plan to try and reconfigure your asset holdings to minimize capital gain that will be subject to the mark-to-market rules. Holding $1,000,000 of cash assets yields zero capital gain when applying “mark-to-market” principles. Holding appreciated real estate or stock will generate a capital gain. Perhaps, for instance, you can engineer asset transfers via gifts so that an expatriating spouse can take full ownership of a $1,000,000 joint bank account while a non-expatriating spouse receives full ownership of the $1,000,000 family home. An important note is that while the US Exit Tax can be reduced by proper gifting just prior to expatriation, to reduce your net worth to below the $2M net worth test until further clarification from the IRS, a pending expatriate is best advised that the gift must be made in the year prior to the expatriation. 

Another oft-overlooked strategy is to take advantage of valuation discounts of non-publicly traded or illiquid assets for US gift tax purposes.

Remember, though, a non-US citizen grad student or young entrepreneur whose sole asset is $3M in cash and who has young children born in the US would not incur a US Exit Tax. However, such an individual would be classified as a Covered Expatriate for US Inheritance Tax purposes. If the individual leaves the US and thereafter acquires or creates a fortune, the inheritance tax will apply to the fortune left to his or her US children.

Use of Pre-expatriation Trusts

The best solution may be to set up a pre-expatriation trust a calendar year before the year of expatriation. In the ideal situation, the would-be expatriate should make gifts of highly appreciating assets for which a valuation discount is available to an irrevocable completed gift trust undertaken in a US state that has adopted asset protection legislation. Often the expatriate-settlor of the pre-expatriation trust will not be a permissible beneficiary of the trust. The pre-expatriation trust should be a non-grantor trust taxed as a separate US taxpayer and must remain a US domestic trust forever. 

The pre-expatriation trust accomplishes at least two objectives. First, assets held in the pre-expatriation trust should not be subject to the “mark-to-market” US Exit Tax. Second, any future trust distributions from the pre-expatriation trust to US persons should avoid the US Inheritance Tax because, at the time of the gift to the pre-expatriation trust, the expatriate-settlor was not yet classified as a Covered Expatriate for life.