Many residents of Canada have connections to the US, ranging from business interests, ownership of recreational or retirement properties, children attending US colleges, etc. Furthermore, there are many US individuals residing in Canada, also for reasons of work, recreation, education, etc. In our practice, we deal with many individuals that have IRS issues or concerns. One questions that has become more of an issue in recent years, is the question of expatriation tax implications of renouncing US citizenship or the surrendering a green card.
In that regard, I recently read an articles that I was very impressed with, that clearly and in a detailed manner, set out the issues of the expatriation tax implications of renouncing US citizenship or the surrendering a green card. If those issues are or could be relevant to you, this article will be of interest.
The following was prepared by Ali Khan, CPA of The Brunton-McCarthy CPA Firm, in Boca Raton, Florida. Mr. Khan’s contact details are set out at the bottom of this article.
The increasing complexity of US cross-border reporting requirements, the substantial penalties for related non-compliance, the increased IRS attention given to US citizens living abroad, and the enactment of the FATCA legislation, have all caused many US citizens (and some green holders) living abroad to consider renouncing US citizenship (or abandoning their green card). The process is normally referred to as expatriation.
“Not so fast”, as they say. It may first be important to know the tax consequences of expatriation. If you become a “covered expatriate” (see below) you may be subject to the expatriation tax (see below).
The tax rules related to expatriation, explained below, apply also to green card holders who are “Long Term Residents” (LTRs), and who abandon their green cards. Note that an LTR will be considered to have abandoned his/her green card for expatriation tax purposes, even if he/she just files a US tax return claiming to be a resident of another country under a tax treaty.
An LTR is an individual who held a green card for at least 8 of the last 15 years. In counting the 8 years, the individual may exclude any year in which he/she was treated as resident of a foreign country under a tax treaty, and did not waive treaty benefits applicable to residents of that country.
To evaluate the tax consequences of your expatriation you must first determine whether you are a “covered expatriate”. It is not good to be a covered expatriate! Unless an exception applies, you are a covered expatriate if you are a US citizen or LTR, and you renounce citizenship (or give up the green card), and:
- You do not filethe prescribed IRS expatriation statement, or
- You fail to certify on the expatriation statementthat you have been compliant with all federal tax obligations for the previous 5 years, or
- Your net worth is $2 million or more, or
- Your average US income tax liability for the previous 5 years exceeded $162,000 (as adjusted by inflation for 2017).
Exceptions. Nonetheless, provided you file the expatriation statement, you are not a covered expatriate if:
1.a) You became at birth a citizen of the US and another country, and you continue to be a citizen of, and taxed as a resident of, that other country, and
- b) You have not been a US resident for more than 10 of the last 15 years, or
2.a) You are less than 18 ½ years old, and
- b) You have not been a US resident for more than 10 years prior to the expatriation.
If you file the IRS expatriation statement, and you are not otherwise a covered expatriate, the tax process is relatively simple. On the IRS expatriation statement, you:
- Enter your income tax liability for the previous 5 years,
- Enter your worldwide net worth at the date of expatriation,
- Certify that you have complied with all your US tax obligations for the previous 5 years,
- Provide a balance sheet of your worldwide assets at the date of expatiation, and
- Provide an income statement for the year of expatriation.
There is a potential $10,000 penalty if the IRS expatriation statement is not filed by the due date of your tax return.
However, if you are a covered expatriate (which includes an individual who fails to file the IRS expatriation statement), two undesirable tax results may occur:
- You may be subject to the expatriation tax, and
- Any US citizen or US resident (domiciled in the US) who receives a gift or inheritance from you in the future may be subject to a 40% tax on the amount. (See “Tax on Gifts or Bequests” below).
There can be chilling aspects of the expatiation tax rules. Simplistically, you are deemed to have sold all of your worldwide assets at fair market value on the date you expatriate. Among other assets, this could include marketable securities, US and foreign real estate, and US and foreign businesses.
US tax is payable on any net deemed capital gain, subject to an inflation adjusted exemption ($699,000 for 2017). This may result in double tax. For example, if you presently live in the US and then move to a foreign county you may be taxed in the foreign country on a subsequent sale of the property. An exception may apply if the foreign country provides for a “step up in cost base” when moving to that country. Alternatively, if you already live in the foreign country, a tax treaty may provide for a simultaneous deemed sale election for tax purposes, in the foreign country.
An election can be made to defer payment of the tax if security is provided, but there is an interest charge.
Exceptions. There are separate and different rules, for each of the following assets/items:
- Deferred Compensation Items (Including Foreign Pension Plans and Certain Stock Options).
- a) “Eligible” Deferred Compensation Items.If the item (e.g. a pension plan) is either a domestic plan, or a foreign pension plan that files an election with the IRS to be treated as a US pension planfor US expatriation withholding tax purposes, and you notify the payor that you are a covered expatriate by providing certain documentation within 30 days of expatriating, and make a prescribed tax treaty waiver, then that plan is referred to as an “eligible” deferred compensation plan.
Then, you are not subject to the deemed sale rule. But you are subject to 30% US withholding tax on subsequent payments to you, except for payments that are in respect of work performed outside the US, when you were not a US citizen, or US resident.
If you are taxed in the foreign country on the payments as they are received, you may be able to claim a foreign tax credit in that country. Also, when filing your subsequent US nonresident income tax returns, with respect to receipt of such payments, you may be able to pay tax at graduated rates, and possibly claim a refund, and/or any relevant treaty benefits, on that return. Further, at that time, on your US nonresident tax return, any payments attributable to work performed outside the US may be “foreign source income” and not taxable on the US tax return.
The IRS has not yet issued regulations on the IRS election procedure required on a foreign item. In any event, a foreign pension plan payor may be reluctant to make the required election. Unfortunately, if all the requirements are not complied with, the item becomes an “ineligible” deferred compensation item. Thus, many foreign pension plans, for example, will be “ineligible deferred compensation items”.
- b) “Ineligible” Deferred Compensation Items.If all the requirements described above are not complied with, a pension plan, or other deferred compensation item, becomes an “ineligible” deferred compensation item.
In this case, the net present value of the plan must be included in your income on your US tax return for the year of expatriation, except for the portion attributable to work performed outside the US while you were not a US citizen or resident. Neither the exemption ($699,000 for 2017), nor the deferral election, are available.
Thus, some US citizens and LTRs may be subject to US expatriation tax on foreign pensions. Of course, the individual may have some “cost base” in the plan. However, there may be double tax, if the individual is subsequently subject to tax in a foreign country, on the future payments. Relief may be available under a tax treaty that provides for a simultaneous deemed disposition election for tax purposes, in the foreign country.
- Specified Tax Deferred Accounts.You are treated as receiving a distribution of your entire interest in your Coverdell education savings accounts, health savings accounts, Archer medical savings accounts, and certain individual retirement plans, (excluding most IRAs) on the day before you expatriate.
- Non-Grantor Trusts.If you receive a distribution from a non-grantor trust, you will be subject to 30% withholding tax on each future distribution, without any treaty benefits. However, when you file your subsequent US nonresident income tax returns, you may be able to pay tax at graduated rates, and possibly claim a refund, and/or any relevant treaty benefits.
If you wish, you can instead make an election to pay tax as if you received the full value of your interest in the trust the day before you expatriated. But you must obtain IRS approval to make the election. The benefit of this election could be to cap your US tax liability, an important consideration if you expect future appreciation in the value of your interest in the trust.
TAX ON GIFTS OR BEQUESTS
If you are a US citizen or US resident (domiciled in the US), and you receive a gift or inheritance from a “covered expatriate”, you are subject to US tax on the amount, at the highest US estate tax rate (currently 40%). Thus, for example, if you are such a person and you receive a gift (or inheritance) from a father who had renounced US citizenship, you may be subject to 40% tax. Several exceptions and special tax credits apply, including transfers to US citizen spouses and charities, and property that had already been subject to US gift tax, or US estate tax. An additional penalty up to 25% of the amount of gift or bequest may apply for failure to file IRS Form 3520 to report the gift or bequest, if it exceeds $100,000.
The IRS has included in proposed regulations that it will be publishing Form 708 for use of reporting and paying the tax once the proposed regulations are finalized.
Mr. Khan can be reached at:
Ali Khan, CPA
The Brunton-McCarthy CPA Firm, Chartered
4710 NW Boca Raton Blvd., Suite 101
Boca Raton, FL 33431
Tel: (561) 241-9991
Fax: (561) 826-9299