Why “covered expat” (“covered expatriate”) status matters, even if you have no assets! The “Forever Taint”!

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The point of this post is to explain why “covered expatriate” status does matter, even for those with no assets.  Most people in the world, probably think the tax expatriation provisions only are for the rich, wealthy and worldwide private jet owners.  This is how the press (and members of Congress) typically portray those who renounce U.S. citizenship.  The press articles typically cover the likes of Ms. Tina Turner and Mr. Eduardo Saverin, co-founder of Facebook.  See,Tina Turner – Famous People Who Renounced U.S. Citizenship.

Most articles focus on the “net worth test” (US$2M) and the “income tax liability test” (“US$125K+/-).  See, Revisiting the consequences of becoming a “covered expatriate” for failing to comply with Section 877(a)(2)(C).

Unfortunately, U.S. “expatriation tax law”, applies to the poorest former U.S. citizen (and certain long-term LPRs), wherever they reside if they do not comply with the certification requirements of Section 877(a)(2)(C).  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.

So far so clear?  But you are surely asking yourself, “this does not explain how this costs me any money or taxes, if I have no assets to begin with . . . “?

If the certification requirements are not satisfied, the individual with no assets should have no U.S. income tax to pay as he or she will have no unrealized gains.  If there are no “unrealized gains”, there can be no tax base and hence no income tax caused by the “mark to market regime”.

However, there are two points of potential taxation under the law.  First, when the USC or LPR leaves the U.S. (“expatriates”); which does not cause taxation in this example for the individual without “unrealized gains.”  However, there is second point of taxation, under the law, which arises when a U.S. person receives a covered gift or bequest.  IRC Section 2801.  This might not happen until decades into the future, long after the expatriation event.

Incidentally, someone could have significant assets, without any unrealized gains.  Both individuals (the rich and the poor) would be in the same position as they leave/expatriate from the U.S.; i.e., and have no U.S. income tax to pay.  For instance, USC “A” with US$5,000 in total assets, would have the same income tax to pay ($0) as USC “B” with US$15M of cash in the bank; assuming no other assets.  Neither would have unrealized gains upon which to cause any U.S. tax.  This is because US dollars/”cash” have a tax basis – the same as the currency amount.  Hence, there is no unrealized gains in US dollars-cash.

However, if in this case, assume both individuals (USC “A” and USC “B”) cannot satisfy the certification requirements of Section 877(a)(2)(C), and hence both would be “covered expatriates.”  So what does that mean to them during their lifetimes (what U.S. tax might they have to pay)?

The potential U.S. tax created to both USC “A” and USC “B” in this circumstance, is IF AND WHEN, they were ever to make a future gift or bequest (directly or indirectly – e.g., through trust) to a U.S. person.  At that point in time, the U.S. beneficiary will have to pay effectively a 40% tax on the fair market value of the property received.   This tax is created under Internal Revenue Code Section 2801, that was passed in 2008.  See, The “Hidden Tax” of Expatriation – Section 2801 and its “Forever Taint.”  A common example is a child or sibling who is a dual national, who might inherit assets in the future.

The 40% tax is a lot of tax to pay – as there are virtually no deductions or exemptions from the amount of tax paid.

I have proposed a series of recommendations to the Treasury regarding concepts and provisions that hopefully will be incorporated into their propose regulation project under Section 2801.  More to come on this important topic.

You might say – “I have no future U.S. beneficiaries and/or I have no assets.  Why do I care?”

Very simply, you should care, if –

  1. You may grow your future assets (or inherit assets from others) while not being a U.S. citizen (post-expatriation).  If that is your goal or your lot in life, you might end up with much more in assets than you have today (assuming you are the same as USC “A” in the example), while having virtually no assets today;  and
  2. You may have family and friends who will become U.S. residents, even if none of them are today.

Assume USC “A” renounces citizenship and in 40 years leaves a bequest to a daughter of US$120,000; the daughter has moved to the U.S.  In this case, the U.S. tax law would impose more than a US$40,000 tax on the daughter when she receives the inheritance.   This is a very high tax burden to pay, on what is a relatively modest inheritance.  This is one, of multiple scenarios of why “covered expatriate” status can be so important – over the long run.

In my practice, over the years, I have seen numerous cases where one single family member moves to the U.S. temporarily for work or study, e.g., graduate school, gets married and decides to stay on and live in the U.S., even for a while.  Often times, they will have children, who will be U.S. citizens by birth in the U.S.  Hence, a U.S. person is now part of the family tree.

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