Tax-Expatriation

The “Hidden Tax” of Expatriation – Section 2801 and its “Forever Taint.”

Posted on April 10, 2014 Updated on April 25, 2015

The principle focus of most discussions about the U.S. “expatriation tax” is typically on the “mark to market” rules for income tax purposes.

However, the law has two different types of taxes.  First, there is the “mark to market” tax on phantom income from the deemed sale of worldwide assets.  Second, and often not considered in detail, if at all, there is a tax on the recipient of “covered gifts” or “covered bequests” of 40% of the value of the property received.  See, Joint Committee Reports – 2008 Report re: HEROES Act – Mark to Market Regime – New Section 877A (55 pages)

It is this second tax under Section 2801 on gifts and bequests that is the focus of this discussion – which I call the “forever taint”!

Most individuals think the mark-to-market tax upon expatriation is only applicable to rich, wealthy or otherwise individuals with high levels of income and unrealized gains.  See, Accidental Americans” – Rush to Renounce U.S. Citizenship to Avoid the Ugly U.S. Tax Web” International Tax Journal, CCH Wolters Kluwer, Nov./Dec. 2012, Vol. 38 Issue 6, p45.

This is often the case, as far as the logic goes as it relates to the former U.S. citizen or LPR and the application (or not) of the “mark to market” tax.  Accordingly, many of these former U.S. citizen and LPRs think they should not be concerned if they do not have significant assets with lots of unrealized gain.  Unfortunately, the lack of attention to Section 2801 can be very nearsighted.

The idea that only wealthy individuals with assets should be concerned about being a “covered expatriate” is misplaced.  The former U.S. citizen or LPR should not lose sight of the U.S. tax costs to their future beneficiaries of their estate, trusts they fund in the future, or future gifts.  For instance, if the spouse  or one or more of the children are U.S. citizens (or even unborn grandchildren or great grandchildren), there might be an unforeseen tax to pay many years in the future.  The tax under Section 2801 is currently 40% of the gross value of the “covered gift” or “covered bequest.”  The recipient pays this tax, not the former U.S. citizen or LPR.  Plus, the rate of this tax at 40% of the gross value, is always much higher than the “mark-to’market” income tax (only applicable to the income or gain – and not the full value of the property) as the person leaves the U.S.

The application of Section 2801 requires anyone contemplating renouncing (or proving a prior relinquishment) of citizenship to strategically consider the long-term consequences to his or her family and friends.

For instance, trusts formed under the laws outside the U.S., which are funded by a “covered expatriate” that may benefit future generations, which include a U.S. citizen or resident, will have to pay the tax – currently 40%.  This tax lives on forever, as long as there are assets from the former U.S. citizen or LPR that have been funded or set aside for family or friends who are “U.S. persons” in the tax sense.

To demonstrate an extreme example, a husband/wife U.S. citizens who have $3M of cash (as their only assets) when they renounce citizenship, will have no “mark to market” tax to pay, as there will be no phantom income.  Cash has no unrealized gain.  However, if the former citizens then grow a successful business while living in their home country, such that all wealth of this business was created as non-U.S. persons outside the U.S., any future gifts or bequests to U.S. persons would be subject to a 40% tax at current tax rates.  For instance if this same person grows the company so he and his wife’s complete estate is worth US$10M at their deaths, and then bequeaths these assets to their three dual national (including U.S. citizen) children, the children will have to pay US$4M in taxes under current rates.  This is true even if none of the children live in the U.S.

This would be a very bad tax result, since if they had remained U.S. citizens, there would be no U.S. estate taxes to them under current law and the children would have received the US$10M free from all U.S. federal taxation.

Finally, this “forever taint” could live on for multiple generations.   For instance, in the above example, if the former U.S. citizens funded the US$10M in trust for the benefit  of their children, grandchildren and great-grandchildren, all of whom have dual citizenship (including U.S.), these descendents will be paying the tax under Section 2801, even if some of these family members are yet to be born on the date (i) the trust is funded, or (ii) the death of husband and wife.  This is the “forever taint.”

While the expatriate might be delighted they have no future U.S. income tax obligations during their lifetimes, if they have friends and family who will be beneficiaries of their estate, they should keep their eye on Section 2801 and its “forever taint”.

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