It is no surprise that some Americans who reside abroad are giving up their U.S. citizenship in light of the IRS' stricter enforcement of offshore income tax and bank account reporting compliance. For those who have resided abroad and have no intention of residing in the United States in the future, expatriation may be a good option. Due to potential tax implications, a U.S. person should make the following considerations before expatriating. This includes the potential for an "exit tax" for "covered expatriates."
Who is a covered expatriate?
There are three ways to qualify as a covered expatriate:
1. Net income tax test - Your annual net income tax for the 5 years ending before the expatriation date is more than a specified amount. This amount is adjusted ever year for inflation. For 2014, it is $157,000;
2. Net worth test - The net worth of the individual is $2,000,000 or more on the date of expatriation; or
3. Compliance test - Such individuals fail to certify that they have met the requirements of the income tax code for the previous five years.
There are several exceptions for the first two points ("net income tax test" and "net worth test") including being a dual citizen, having "substantial contacts" with a foreign country and being under a certain age. If you believe you qualify as a covered expatriate under the two above tests, contact a qualified tax professional to determine whether any exceptions apply.
The third test bears no exception. Therefore, if you find yourself not in tax compliance for the last 5 years prior to the year of expatriation, you might consider contacting a tax professional to determine what the "exit tax" might be or other methods of asset protection prior to expatriation.
How is the "exit tax" calculated?
If an "exit tax" is unavoidable, the IRS applies tax on the deemed gain as if the person's worldwide assets were sold on the day prior to the expatriation date. The value of these assets is calculated on a mark-to-market regime, and the individual gets a stepped-up basis in the item. This deemed sale produces a gain that is reported and taxed by the IRS. For those with significant worldwide assets whose value has increased from the date of purchase or acquisition, it can produce a large tax that the individual did not anticipate.
It is helpful to note that the IRS allows an exemption from tax of $680,000. This amount is adjusted for inflation every year. Therefore, if the deemed sale produces tax of under $680,000, you must report the gain on your return but you will pay no tax on the deemed sale as the exemption would offset any tax assessed. The exemption is allocated ratably between assets. Any losses may also be used. In addition, the IRS offers an election to defer the tax but collateral must be secured. With the deferral, interest will accrue.
If you are considering expatriation, contact Kundra & Associates for professional guidance about the tax implications of this action.