US Expatriation Planning: Income, Estate and Gift Tax Consequences

Two years after the Heroes Earnings Assistance and Relief Tax Act or ‘HEART’ legislation was passed in the United States, wealthy multinationals are still debating the pros and cons of expatriation. Since the law was effective for those leaving the US on or after June 16, 2008, many have expatriated, but many were too late to even consider giving up US citizenship or one’s US green card at the time the law was passed. Some, fortunately, have the time to decide if expatriation is a viable option and what US income, estate and gift tax consequences will result.

While much focus has been placed on the exit tax promulgated by the HEART legislation, the provisions governing gifts and bequests to US beneficiaries of ‘covered expatriates’ (those individuals subject to the HEART legislation) has been overlooked. For planning purposes, it is crucial to determine if a would-be ‘covered expatriate’ is leaving US beneficiaries behind, and if so, should this factor warrant planning prior to expatriating.

Net Wealth Test

In order to determine if one is considered a ‘covered expatriate’ under the HEART legislation, an individual must first meet one of three elements that give them a presumption of leaving the US for tax avoidance purposes. The three possible elements are: a) an average annual net tax due of US$145,000 or greater (adjusted for inflation) for the five years prior to expatriation from the US, or b) a net worth of US$2 million or more, or c) failure to comply with expatriation filing requirements for the five years prior to leaving the US. If only one of these three elements of the ‘net wealth test’ are met, the individual is considered wealthy enough when leaving the US to subject them to the HEART legislation’s tax consequences. However, more elements must be met in order for a wealthy individual to be considered a ‘covered expatriate’.

Immigration Status

A “lawful permanent resident” is an individual who has been afforded the privilege of residing permanently in the US as an immigrant, in accordance with immigration laws – in other words, green card holders[1]. Once a former lawful permanent resident has met the ‘net wealth test’, they must also have been a lawful permanent resident for at least eight of the prior 15 taxable years in order to be considered “covered expatriates” under the HEART rules. The year of expatriation is included as the last year of the 15 year period[2].

A US citizen who meets the ‘net wealth test’ and gives up citizenship will be subject to the HEART legislation, as well. There is an exception to the imposition of the HEART legislation for certain US citizens, however. If 1) an individual became a US citizen at birth and a citizen of another country and, as of the expatriation date continues to be a citizen of, and is taxed as a resident of, such other country; and 2) the individual has been a resident of the US for not more than 10 taxable years, during the 15-taxable year period ending with the taxable year during which the expatriation date occurs, then the HEART legislation does not apply[3].

Date of Departure

An individual’s date of departure from the US will also dictate the application of the HEART legislation. Expatriates and legal residents who severed ties with the US prior to June 16, 2008 are instead subject to a ‘10-year rule’[4]. In summary, these former citizens and former legal residents were presumed to be leaving the US for tax avoidance reasons, if they met the ‘net wealth test’. For the next 10 years after expatriation, these individuals remained subject to the US federal estate tax on any US situs property upon death (such as US real estate and stock of US corporations), and afforded only a US$60,000 federal estate tax exemption amount. If they returned to the US for any 30 days within a calendar year, and died within that same year, they resumed their status as a US resident and were afforded the same federal estate tax exemption as US citizens and residents against all property wherever situated in the world. Once 10 years have passed, however, these individuals are no longer under the taxing jurisdiction of the US.

The provisions of HEART may no longer apply to those same individuals who would have been subject to the ‘10-year rule’. While both US resident holding green cards or not were subject to the 10-year rule, only green card holders are subject to HEART. Those US residents leaving the US on or after June 16, 2008 who are not green card holders do not find themselves subject to either the 10-year rule or the HEART legislation. This change in the law prompts those establishing ties with the United States to reconsider obtaining a green card here. Instead, one should consult with a US immigration attorney to determine if a visa is perhaps a better, more tax-efficient alternative for someone working in the US but ultimately planning on returning to his or her country of origin to avoid any exit tax.

US Income Tax Consequences

Once determined to be a ‘covered expatriate’, the former US person is subject to the ‘mark to market’ exit tax, which operates as a trigger of capital gain on all worldwide property[5].   There is an exclusion on the capital gain up to US$600,000, which is adjusted for inflation[6]. The basis for capital gain purposes is the date at which the taxpayer became a resident for federal income tax purposes[7]. Practitioners advising wealthy multinationals may automatically assume that this is a tax to avoid, however, there may be a silver lining in the unfortunate economic and market conditions over the previous eight to 15 years. A wealthy multinational client may not have enough built-in capital gain to meet the threshold, or may have a small enough amount over the threshold to warrant triggering the exit tax.

US Estate and Gift Tax Consequences

A ‘covered expatriate’ with US beneficiaries has a very important consideration in deciding whether to expatriate from the US. The HEART legislation creates a new category of taxation, never before seen in the federal transfer tax system, in Section 2801 of the Internal Revenue Code. Individuals who receive gifts from covered expatriates and those beneficiaries of the estate of a covered expatriate owe a tax on the gift or bequest. If ‘covered expatriates’ leave assets to US beneficiaries, upon their death, no matter how long after expatriation death occurs, an estate tax, at a flat rate equal to the highest estate tax rate in effect at the time of death, is imposed[8]. There is a vital exception to this rule, however. For any amount in the covered expatriate’s estate otherwise subject to the US estate tax, the Section 2801 estate tax will not apply. So, for a covered expatriate who still owns a home situated in the US, for instance, the estate tax for a non-resident alien would apply. The fact that the value of the home is passing to US beneficiaries will negate the beneficiaries’ tax liability under the new Section 2801. The beneficiaries will still owe Section 2801 estate tax on all remaining assets passing to them.

A similar exception applies to transfers during life for US gift tax purposes, as well. If a covered expatriate transfers assets during life to a US beneficiary, a gift tax, at a flat rate equal to the highest gift tax rate in effect at the time of the gift, is imposed[9]. Any transfer already subject to the US federal gift tax, which is reported on a timely filed gift tax return, is not subject against under Section 2801.

The IRS reported that they would be announcing guidance involving the new tax and unveiling a new Form 708, which will report and impose the tax on gift recipients and estate beneficiaries of covered expatriates.

Planning Considerations

For a non-resident alien, a non-US person who has never been a citizen or resident of the US (NRA), pre-immigration planning prior to establishing a relationship with the US is important. The NRA should consider making asset transfers prior to establishing residency in the US. The transferred multinational executive, for instance may plan to live in the US until retirement from a US company or until minor children have graduated from high school or college in the US. It is likely that the multinational executive may venture from the US to pursue other employment ventures or to return to the country of origin, leaving now-grown children behind in the US. Having transferred assets to a US trust, for instance, prior to establishing ties with the US in the first place, would avoid both the transfer tax limitations on US citizens and US residents and would avoid the Section 2801 inheritance tax on their US beneficiaries and gift recipients. Such a situation may be difficult to predict so far in advance, but for the wealthy client, pre-immigration transfers will avoid a transfer tax system that former green card holders are now subject to indefinitely.

Another way to plan ahead for avoiding implications of HEART, is for an NRA to reconsider obtaining a green card upon entry to the US, since it will begin the eight to15 year timeframe subjecting the individual to covered expatriate status. If the multinational is able to stay in the US without beginning the clock for the eight to 15 year timeframe, by obtaining a visa instead, for instance, it may enable the client more flexibility.

For those clients who have been in the US for many years with a green card, a change in immigration status may serve as an important estate planning technique. One may consider becoming a US citizen, for instance. Such an individual avoids the exit tax when leaving the US and still has the freedom to live abroad as a US citizen, utilizing any transfer tax treaties to avoid double taxation between countries. One may also try to give up a green card prior to the eight-year requirement passing and remain in the US on a visa, which may be obtained in an employment-related immigration category.

For those individuals who are planning to leave the US to avoid ‘covered expatriate’ status, the creation and funding of a US trust and the use of any remaining US federal gift tax exemption may be the best way to avoid the trigger of the exit tax, and the US federal estate or gift tax under Section 2801 in the future. The lifetime gift tax exemption is now US$5 million for US citizens and US residents (including green card holders, generally) under the new law passed on December 17, 2011. This new exemption amount will stay in place through to the end of 2012[10]. Prior to renouncing US citizenship or residency, the individual should transfer the extent of the remaining gift tax exemption to an irrevocable US dynasty trust, in a jurisdiction that has repealed any rule against perpetuities, enabling the transferor to benefit as many generations as they have descendants.

Once the extent of the US gift tax exemption amount is transferred and the US citizen or resident gives up his or her status as a US person, the next step in planning would be to identify any remaining US situs assets. Now that the individual has status as an NRA, he or she remains subject to the US federal estate tax on any US situs property upon death (such as US real estate and stock in US corporations), and is afforded only a US$60,000 federal estate tax exemption amount. US real estate can be transferred to a foreign entity in order to convert it to an intangible asset no longer within the reach of the US estate tax. Ownership in stock of US corporations can also be transferred to a foreign ‘wrapper’, or, over time, diversified into non-US investments.

Further planning would focus on any US beneficiaries of a multinational individual’s estate upon death. Instead of leaving assets directly to said US beneficiary, implicating the provisions of Section 2801 and incurring US estate tax even on foreign property, the multinational individual should plan, within their new country’s transfer tax laws, to create trusts or entities in addition to the US trust already created, to benefit US beneficiaries. Upon the death of said individual, the US estate tax ordinarily applicable under Section 2801 will not apply since there is no bequest coming directly from the individual’s estate.

The passage of the HEART legislation has resulted in the need for multinational individuals to engage in an additional layer of complex planning. Ideally the timing of this planning would take place prior to establishing a relationship with the US. However, realistically, practitioners are able to plan around the US income, estate and gift tax consequences of those persons who have been in the US for enough years or with the immigration status that categorizes them as ‘covered expatriates’. Fortunately, there are many avenues to pursue to fit the unique circumstance of the multinational individual.

[1] 26 USC.A. §7701 (b)(6), Treas. Reg § 301.7701(b)-1(b)

[2] 26 USC.A. § 877 (e)(2)

[3] 26 USC.A. §877A (g)(1)(B)(i)

[4] 26 USC.A. §877

[5] 26 USC.A. §877A (a)

[6] 26 USC.A. §877A (a)(3)

[7] 26 USC.A. §877A (h)(2)

[8] 26 USC.A. §2801(a)(1)

[9] 26 USC.A. §2801(a)(1)

[10] 26 USC.A. §2010(c)