Should I Stay or Should I Go: U.S. Tax Implications of Expatriation and Citizenship Renouncement

November 2012 By Joshua A. Ehrenfeld
Tennessee Corporate Newsletter

As the clock ticks on the expiration of the Bush tax cuts and the harsh reality of across the board tax increases sets in[1], an increasing number of U.S. taxpayers are renouncing their citizenship[2] to flee the country for greener pastures.[3]  Many taxpayers willing to take this dramatic step have put patriotism aside and instead focused purely on the economic benefits available to them in the form of drastically lower tax rates outside the U.S.[4]  Yet, it is unsurprising that simply handing over one’s U.S. passport to the nearest customs agent is not quite sufficient to escape the I.R.S.  Indeed, while the long term foreign tax ramifications of citizenship renouncement may be positive, the U.S. tax implications are more likely to dampen one’s spirits—or at least slow the stampede towards the foreign consulate.

Renunciation Incentives: The U.S. Worldwide Taxation Mechanism

The decision to leave behind one’s U.S. citizenship generally stems from a comparison of U.S. and foreign tax rates, as well as their application to U.S. and non-U.S. citizens.  Because the U.S. is the only country that taxes its citizens on any income earned worldwide,[5] U.S. citizens living abroad in low-tax jurisdictions find themselves in the bizarre position of watching their overseas neighbors, colleagues and brethren pay taxes at rates significantly lower than their own.  Instead of the worldwide system of taxation that the U.S. imposes, other countries only tax their citizens on income earned in the country in which they reside.  Thus, a Singapore resident living and working in Hong Kong would be subject only to Hong Kong taxes, not to Singaporean taxes, whereas a U.S. citizen working in Hong Kong would be subject to Hong Kong taxes as well as U.S. taxes.  For many U.S. citizens living abroad, this is the functional equivalent of paying twice as much for a Big Mac as the next customer in line simply because your passport is a different color than the person standing next to you.  Further, when one considers the possibility that U.S. tax rates might increase at the end of 2012, it becomes clear why a U.S. citizen might suddenly desire to renounce his or her citizenship.

Once one determines to cross this proverbial Rubicon, the implications of citizenship renouncement come into focus and the soon-to-be expatriate will face some harsh truths.  First of all, in order to successfully leave behind one’s citizenship, the U.S. government requires the payment of an “exit tax.”[6]  In addition to this immediate tax, the expatriate may encounter issues regarding deferred compensation and estate and gift taxes.[7]  Moreover, successfully renouncing one’s citizenship also requires handling administrative details.  In addition to technicalities, such as submitting to an interview with a U.S. consulate and obtaining a new country of citizenship, expatriates must submit to the I.R.S. certain forms prior to renunciation being deemed effective.[8]  Finally, the I.R.S. publishes quarterly a list of every individual who renounces his or her U.S. citizenship.[9]  Only after traversing each of these potential minefields will the individual be free of the U.S. tax regime.    

The Exit Tax

The most burdensome tax issue facing potential expatriates—and consequently greatest barrier to completing the process—is the so called “exit tax.” [10]  Under the current law, the U.S. government treats citizenship renouncement as a taxable event.[11]  Thus, a citizen attempting to renounce is deemed to have sold all his property as of the day before expatriation, and is taxed immediately upon any gains realized from such theoretical sale.[12]  As a practical matter this entails marking to market any property held by the expatriate and paying an immediate tax to the extent any gain has been created by the adjustment.[13]  Although the code does provide some assistance in the form of a statutory exemption of up to $651,000,[14] the tax nonetheless can lead to liquidity issues (assuming the expatriate is unwilling to sell off his property in anticipation of his move).  In order to help alleviate the liquidity issue, the I.R.S. also provides a deferral option, whereby an expatriate can elect to defer payment of the exit tax by agreeing to pay interest charges during the deferred period and posting a form of “adequate” security as collateral.[15]  Although the overall intent of the exit tax is to seek net tax neutrality when one gives up U.S. citizenship, the impact is more likely to dissuade citizens from renouncing simply due to the onerous costs of having to pay tax on gains that have accrued, yet have not been effectively monetized.             

Deferred Compensation, Estate and Gift Taxes and U.S. Sourced Income

If being subjected to a hypothetical forced sale of assets is not sufficient to dissuade potential renouncements, the tax treatment of deferred compensation, gifts and bequests might do the trick.  To the extent any deferred compensation is not includible in the expatriate’s immediate income for exit tax purposes, such compensation will be subject to a withholding tax of 30% when paid out in the future.[16]  In addition, the I.R.S. will impose estate and gift taxes on U.S. citizens who are recipients of certain gifts and bequests made by expatriates.[17]  Although these estate and gift taxes may not directly burden the expatriate once citizenship is renounced, such gifts or bequests can subject friends and family members of the expatriate to unwanted and unexpected U.S. tax burdens.  Thus, the impact of each of these provisions is that the renouncement of citizenship will still not be sufficient to completely prevent the U.S. from taxing certain forms of future income, as well as gifts and testamentary bequests (potentially made using assets previously subject to the exit tax).  Finally, once renunciation is successful, expatriates (like all other non-U.S. residents) will still be liable for U.S. taxes on certain forms of U.S. source income.[18]                         

Conclusion

From a practical standpoint, renouncing one’s U.S. citizenship is more of a financial burden than an administrative one.  If a taxpayer is seeking to live in a low-tax jurisdiction free from the U.S. worldwide taxation regime, renouncing his citizenship is eminently feasible—provided he has the means (and inclination) to pay the exit tax and accept the limits on deferred compensation, gifts and bequests.  For those willing to put patriotic feelings aside, the decision can be rationalized through a purely economic lens.  Nonetheless, for most citizens, expatriation is a drastic decision with long term implications that are likely to show up in more places than simply on a tax return or a passport cover.

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[1] The tax cuts signed into law by President Bush in the Economic Growth and Tax Reconciliation Act of 2001, 115 Stat. 38, and the Jobs and Growth Tax Relief Reconciliation Act of 2003, 117 Stat. 752, were scheduled to sunset on December 31, 2010.  Per the Tax Relief, Unemployment Reauthorization, and Job Creation Act of 2010, signed into law December 17, 2010, 124 Stat. 3296, these tax cuts were extended until December 31, 2012 at which time they will expire absent Congressional action.

[2] The Code refers to an “expatriate” as a U.S. citizen who has relinquished his or her citizenship, or a long term resident who ceases to be a permanent resident of the U.S.  I.R.C. § 877A(g). 

[3] The number of U.S. citizens who have expatriated has increased from 742 in 2009 to 1781 in 2011 and is expected to increase further in 2012.  See Renouncing the U.S., Wall Street Journal, May 18, 2012, on-line edition,  http://online.wsj.com
/article/SB10001424052702303879604577410021186373802.html#project%3DRENOUNCECHART1205%26articleTabs%3Dinteractive.  

[4] For example, the top marginal tax rate in the U.S. is scheduled to increase to 39.6%, whereas the similar top rate in Singapore is 20%.

[5] See Boris I. Bittker and Lawrence Lokken, Federal Taxation of Income, Estates and Gifts, ¶65.1.2 (3rd ed).

[6] Not all expatriates are subjected to the exit tax.  Pursuant to I.R.C. §877A(g)(1) and §877(a), the exit tax only applies to: a) individuals with an average annual net income tax of $151,000 for the period of five years ending before the date of loss of U.S. citizenship; b) individuals with a net worth of $2,000,000 as of the day before the loss of citizenship; or c) individuals who fail to certify that they have met their U.S. tax obligations for each of the five preceding years.  I.R.C. §§877(a)(2), 877A; Rev. Proc. 2011-52, Section 3.26. 

[7] See I.R.C. § 877A(d); I.R.C. § 2801.

[8] For example, I.R.S. Forms 8854 and W-8CE are required to ensure compliance, filing and payment of the exit tax and withholding for any deferred compensation.

[9] See Quarterly Publication of Individuals, Who Have Chosen To Expatriate, Federal Register, April 30, 2012, https://www.federalregister.gov/articles/2012/04/30/2012-10274/quarterly-publication-of-individuals-who-have-chosen-to-expatriate.

[10] See I.R.C. § 877A.

[11] See I.R.S. Notice 2009-85.

[12] I.R.C. §877A(a).

[13] Id

[14] Exemption amount for 2012, and is adjusted annually for inflation.  See Rev. Proc. 2011-52, Section 3.27.

[15] I.R.C. §877A(b).

[16] I.R.C. §§877A(c),(d). 

[17] I.R.C. §2801.

[18] Dividends paid by a U.S corporation to a foreign shareholder, for example, are subject to a 30% withholding tax.  See I.R.C. §871(a).

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