The United States is the only major country that imposes tax on a citizen's worldwide income, no matter where that citizen lives.
If you live in England, Ireland, Japan, or almost any other country, all you need to do to avoid the obligation to pay tax on your worldwide income is to leave. After an extended period—normally one year or longer—you no longer have any obligation to pay taxes on your income outside that country (although you may continue to be subject to gift and estate taxes).
But not the USA. To permanently disconnect from U.S. tax obligations, a U.S. citizen must not only leave the United States, but also take the radical step of giving up U.S. citizenship. This process (from a U.S. standpoint) is called expatriation.
The income tax savings from expatriation can be huge. But for truly wealthy U.S. citizens, the biggest savings from expatriation don't come until death. The $1 billion estate if an Irish citizen dying in 2008 that didn't live in Ireland pays zero gift and estate tax for all bequests outside of Ireland. The $1 billion estate of an US citizen dying in 2008 who lived anywhere in the world pays a maximum combined gift and estate tax burden of exceeding $450 million.
The arithmetic is almost as compelling for smaller estates. An entrepreneur with a $20 million estate could save over $8 million in estate and gift taxes by giving up U.S. citizenship.
However, the image of wealthy former U.S. citizens living tax-free in tropical paradises is an irresistible populist target. The result has been a series of increasingly stringent laws that penalize U.S. citizens who give up their U.S. citizenship with "tax avoidance" as a principal purpose.
Leave the USA, Pay an "Exit Tax"
Congress has now once again amended these "anti-expatriation" provisions in a new bill both houses approved unanimously, and sent to President Bush for his signature.
The primary purpose of the Heroes Earnings Assistance and Relief Tax Act of 2008 is to provide a range of tax breaks for veterans. But the law also imposes the first-ever "exit tax" on even moderately wealthy expatriates.
Once President Bush signs this bill, future expatriates will be required to pay a tax on all unrealized gains of their worldwide estate, including most offshore trusts. And the tax applies not only to former U.S. citizens, but also to long-term green-card holders who have resided in the United States for at least eight of the 15 years preceding expatriation. (Fortunately, long-term residents can "opt out" of the exit tax, as I'll explain in a moment.)
How are you supposed to pay the tax without selling your assets? That's your problem—not the IRS's—although the bill permits deferral in certain circumstances.
You Don't Need to be "Rich" to Pay the Exit Tax
It would be one thing if the exit tax only affected billionaires. But, with only a few exceptions for dual nationals and others with strong ties to another country, the law applies to any expatriate that:
(1) has an average annual net income tax liability for the five preceding years ending before the date of the loss of U.S. citizenship or residency termination that exceeds $139,000, adjusted annually for inflation; or
(2) has a net worth ofS$2 million or more on such date; or
(3) fails to certify under penalties of perjury that he or she has complied with all U.S. federal tax obligations for the preceding five years or fails to submit any proof of compliance the IRS demands.
If you qualify under any of these criteria, you may be subject to the exit tax. The good new—if there is any—is that the first $600,000 of gains is excluded. This exclusion doubles to $1.2 million for a married couple filing jointly, both of whom expatriate. This exclusion will increase by a cost of living adjustment factor after 2008.
Gains will be calculated "mark-to-market"; i.e., the difference between the market value on the date of expatriation and the market value at acquisition. Expatriates who were not born in the United States may elect to value their property at its fair market value on the date they first became U.S.-resident, rather than when they first acquired it.
This phantom gain will presumably be taxed as ordinary income (at rates as high as 35%) or capital gains (at either a 15%, 25%, or 28% rate), as provided under current law. When you actually sell the assets, no additional U.S. tax is due. However, your adopted country might tax the gain a second time, leading to double taxation on the same income.
Your Retirement Plan Takes a 30%–or Higher–Haircut
And now for the really bad news: once you expatriate, you'll pay up to a 30% tax on distributions most retirement plans and most other forms of deferred compensation. If there's a silver lining, it's that the tax isn't due until you actually receive payments from the plan.
Plans covered by this provision include:
- Qualified pension, profit sharing, and stock bonus plans
- Qualified annuity plans
- Federal pension plans
- Simplified employee pension plans
- Simplified retirement accounts
The news is even worse for most IRAs: they terminate upon expatriation if you're "covered." That means you pay tax on the distribution at your marginal tax rate–up to 35%, and more if you live in a state with an income tax. Fortunately, no "early distribution" tax applies if you're under age 59 1/2.
Similar rules (but with some added complexities) apply for distributions from non-grantor trusts; i.e., trusts for which an expatriate is not treated as the owner under the grantor trust rules.
Don't Make a Gift or Bequest to the United States!
You'd think the United States would encourage wealthy foreigners to make payments to persons in the United States. After all, that money would presumably be spent on U.S. goods and services.
But if you're a covered expatriate, and you make a gift or bequest to a U.S. person 10, 15, or even 50 years after your expatriation, the recipient must withhold tax at the highest marginal gift or estate tax rate in effect. The tax on is reduced by the amount of gift or estate tax paid to a foreign country with respect to that gift or bequest.
I suspect this provision will be impossible to enforce years after-the-fact. Many recipients won't even be aware that they're obligated to pay the tax. Time will tell!
How to Avoid the Exit Tax
If your net worth is only a little over $2 million ($4 million for a married couple expatriating at the same time), the most obvious way to avoid the exit tax is to spend enough money to get your net worth under these thresholds.
Take a trip around the world. Blow some money in Las Vegas. Throw a really big party. You can also contribute your excess funds to a qualified charity, or give away up to $1 million over your lifetime to anyone else without triggering a gift tax liability.
If you've paid more than an average of $139,000 annually for the previous five years, however, this strategy won't work. And if you don't have sufficient cash to pay the exit tax, your best option may be to elect to defer payment. You'll pay interest for the period tax is deferred, and you may be required to post a bond with the Treasury Department.
Fortunately, you can make this election (which is irrevocable) on a property-by-property basis. For instance, it appears as if you could pay the exit tax on all assets outside your IRA, and defer it for the assets in the IRA.
If you weren't born in the United States, you have a couple additional options.
- If you were born with citizenship both in the United States and another country, you may not be subject to the exit tax. To qualify for this exemption, when you expatriate, you must also be a citizen of another country (and taxed by another country), and not been a U.S. resident for more than 10 years during the 15-year period prior to your expatriation.
- If you're a green card holder, you can opt out of the exit tax. To do so, you must become resident for tax purposes in a foreign country that has a tax treaty with the United States. You must also inform the IRS of your intention not to waive the benefits of the tax treaty applicable to that country.
The bottom line: with the exit tax, Congress has made the most significant change to the anti-expatriation rules since their inception in 1966. In doing so, it's sent wealthy U.S. citizens and long-term residents a clear message: you're slaves on our plantation. And if you want to exercise your right to leave, you'll pay dearly for the privilege.
Is expatriation for you? The decision to give up U.S. citizenship is a serious one. It requires that you obtain a passport from another country, leave the United States permanently, and set up residence in a suitable jurisdiction. It's a step you should take only after consulting with your family and professional advisors. But it's the only way that U.S. citizens and long-term residents can eliminate U.S. tax liability on their non-U.S. income, wherever they live. And it's a tax avoidance option that Congress has now made much more difficult.
Copyright © 2008 by Mark Nestmann
(An earlier version of this post was published by The Sovereign Society.)