Breaking Free at a Cost: Navigating the IRS Exit Tax on Expatriation

So, you are fed up with paying taxes and want to relinquish your U.S. citizenship or lawful permanent resident status and leave the United States. All you need to do is pack your bags and get on a plane and travel to somewhere exotic. Right? Wrong. Before you leave the Unit ed States and expatriate you may need to pay an exit tax. So, what constitutes expatriation and what is this exit tax? Expatriation is the process of legally relinquishing one’s U.S. citizenship or long term lawful permanent resident status and exiting the U.S. tax system.

In addition to needing to comply with certain immigration laws, there are tax responsibilities that the expatriating individuals needs to comply with, including the filing of a final tax return with the Government. The tax responsibilities of expatriation are found in Internal Revenue Code Section 877A. And, the exit tax is a tax, but it is not a tax on wealth. Rather, it is a U.S. capital gains tax based on whether income or gains have accumulated while you were a U.S. Person but which have not been recognized/realized.

Perhaps the best-known examples of this involve the mark-to-market gains from stock (or other equities) or from specified tax deferred accounts (such as a traditional IRA but not a Roth IRA) you might own which are deemed sold or distributed at the time of expatriation. The exit tax you will need to pay is based upon the value of the asset you own which is treated as if it had been sold at fair market value the day before you expatriate. For example, let’s assume that Guy is a U.S. Citizen who owns 1,000 shares of Apple stock that he purchased for $50,000. On the day before he expatriates the stock is worth $250,000. Depending on whether he meets the necessary criteria to be considered a covered expatriate, Guy may have to pay an exit tax on the deemed sale of his stockholdings.

But, contrast this with the situation involving Gary, Guy’s brother. Gary is a U.S. Citizen who has $1,000,000 of cash in the bank. Even if Gary is considered a covered expatriate, he would not have to pay any exit tax because his assets are in cash. In another example, let’s assume that Guy is a U.S. citizen who owns a traditional IRA (i.e., it has no tax basis since all the contributions were made with pre-tax dollars) that is worth $700,000. When Guy expatriates, he may have to pay an exit tax on the $700,000 depending on whether he is considered an expatriate. So, who may need to pay this exit tax? The exit tax only applies to “covered expatriates.”

Non-covered expatriates are not subject to the exit tax and can ex patriate free of charge. A covered expatriate is either a U.S. Citizen who relinquishes his or her citizenship or a Long-Term Lawful Permanent resident who meets any one of the following three tests: (1) Their average annual net U.S. income tax liabilities for the five years preceding the year of expatriation exceeds $201,000; (2) Their Worldwide net worth (including home) on the day of expatriation equals $2 million or more; and (3) They are unable to certify via Form 8854 that US tax filings (including foreign reporting forms and FACTA requirements such as Foreign Bank Account Reports) have been fully satisfied for the five proceeding years.

Under section 877A, you will need to include in your gross income, and pay a tax on an amount, by which the fair market value of the property exceeds its adjusted basis as if you had sold such property at fair market value the day before you left the country. Fortunately, there are provisions found in section 877A whereby you may be able to elect to defer payment of the mark-to-market tax liability on a property-by-property basis until the relevant property is sold, you die, or you do not provide, or no longer have in place, “adequate security.” There are some exceptions to the above rules. A covered expatriate is not subject to the exit tax charge if they are a dual national from birth, continue to be a citizen of their second country and are taxed as a resident of that country. Also, US citizens who are under the age of 18½ or over the age of 18½ but have not been US tax resident for more than 10 taxable years can relinquish their citizenship tax free.

After you properly expatriate and, if needed, pay the exit tax, you will no longer have to comply with the US tax filing obligations of a citizen or a lawful permanent resident. Then, you can go back to your exotic retirement destination and sip margaritas on a beach while dipping your toes into the glistening blue waters of the ocean, worry-free.

Call Brager Tax Law Group at 310-208-6200 for an initial complimentary 15-minute consultation and one of our former IRS attorneys is ready to assist you with your expatriation tax litigation issues or visit www.bragertaxlaw.com for more information.