When you leave the U.S. to live in another country, you essentially have two choices from a tax perspective, both of which can cost you a pretty penny.
First, you can simply leave the country and take up residence elsewhere. But if you choose this option, beware: the U.S. continues to tax you on your worldwide income, no matter where you earn it or derive it from.
Second, you can formally renounce your American citizenship or long-term residency and expatriate. This option is also not without its potential financial pitfalls, because the U.S. may impose an “exit tax” on you before you leave.
The rules behind this exit tax are complex, but whether you will be required to pay it depends largely on whether you are classified for tax purposes as a “covered expatriate.”
Are You a Covered Expatriate?
American citizens and long-term residents can, of course, voluntarily give up their status as citizens or residents and expatriate.
Once you give up your status, the IRS will consider you either an “expatriate” or a “covered expatriate.” If you’re simply an expatriate, the exit tax will not apply, and you’re good to go. There’s really nothing more to it. You still have U.S. assets, and you have to pay U.S. taxes on those assets.
But if the tax law deems you a covered expatriate, you have to pay the exit tax.
In most cases, a covered expatriate is a person who meets one of the following three tests:
- Income tax test. You’ll be deemed a covered expatriate if you paid an average of $190,000 in income tax in the five years before you expatriate.
- Net worth test. You’re also a covered expatriate if your net worth is $2,000,000 or more on the date you give up your U.S. citizenship or long-term residency.
- Compliance test. Finally, if you fail to certify, under penalty of perjury, that you met all your tax obligations for the five years preceding your expatriation, you’re a covered expatriate.
What Is the Exit Tax?
Under the exit tax regime, the government requires you to pay income taxes on the unrealized gain in all your property, subject to a few minor exceptions, as if you sold that property the day before your departure.
In other words, the law deems that you sold all your property at fair market value on the date of your departure, even though you did not. You then pay taxes on this imaginary gain.
Mercifully, under today’s law, you can exit in 2023 and exclude up to $821,000 of gain (adjusted annually for inflation).
You Can Pay Later, But…
In the mark-to-market deemed sale of your assets, you didn’t collect any cash, so you might be short of the cash needed to pay your taxes. The U.S. government might help you by allowing you to pay later if you can post “adequate” security as collateral for the debt, such as a bond. The following rules also apply to this payment deferral election:
- Once you make the election, it’s irrevocable.
- You can elect to defer tax on some pieces of property but not others.
- You must waive any right under any U.S. treaty that would otherwise prevent collection of the taxes.
- You pay interest on any taxes you defer.
- You or your estate must pay the expatriate taxes due when you dispose of the property or die.
Easing the Pain
To ease the pain slightly, eligible deferred compensation items, such as IRAs, pensions, and stock option plans, are not part of the deemed sale, and thus are not taxed at the time of expatriation.
Rather, the government makes the payor withhold 30 percent on any taxable payment made to a covered expatriate.
Note that to qualify for this temporary relief, the deferred compensation must be “eligible.” That means
- the payor of the deferred compensation must be a U.S. entity or a foreign entity that has agreed to submit to U.S. withholding and other requirements;
- you tell the payor that you are no longer an American citizen; and
- you permanently waive any claims you might otherwise have had to the reduction or elimination of the tax under a tax treaty.
I’m a Covered Expatriate—What Can I Do?
Though the situation is certainly a sticky wicket, all hope may not be lost.
According to the net worth test, you are a covered expatriate only if your net worth is $2,000,000 or more. With some thoughtful planning, you might structure your assets to avoid this classification.
Depending on the circumstances, direct gifting before expatriation might be one solution. Another solution might be through the creation of trusts before the big day.
You need to exercise extreme care in any such effort. It’s best to use a tax professional who understands expatriation.
If you need help preparing for your departure, contact us today.