Tax-Expatriation

IRA Distributions – (Counter-intuitive Results) U.S. Tax Consequences to Former USCs and Long Term Residents (LPRs)

Posted on July 21, 2014 Updated on July 21, 2014

IRA Distributions –  (Counter-intuitive Results) U.S. Tax Consequences to Former USCs and Long Term Residents (LPRs)

Those USCs who have renounced citizenship (or who are contemplating renunciation) and those LPRs who (were/are/will) fall into the category of “long-term residents” who have qualified retirement accounts, known as “Individual Retirement Arrangement” (“IRAs”) have special considerations to consider under IRC Sections 877, et. seq.  For more details on how IRAs work and the deduction limits, see the IRS website explanation.

In short, if an individual is a “covered expatriate” upon renunciation (or LPR abandonment), they will generally be subject to U.S. income taxation on the entire amount of the IRA (along with all other assets with unrealized gains), reduced by the exemption amount (currently US$680,000 for the year 2014).

Unfortunately, it is fairly easy to become a “covered expatriate” even if the asset or tax liability tests are not satisfied, simply if the individual fails to satisfy the certification requirement under Section 877(a)(2)(C).  There are multiple posts that address this important certification requirement of Section 877(a)(2)(C), irrespective of how poor or how few of assets might be held by the individual.  See, Certification Requirement of Section 877(a)(2)(C) – (5 Years of Tax Compliance) and Important Timing Considerations per the Statute, also see Can the Certification Requirement of Section 877(a)(2)(C) be Satisfied “After the Fact”?

Plus, the topic is covered yet further in More on “PFICs” and their Complications for USCs and LPRs Living Outside the U.S. -(What if there are No Records?)

Generally “covered expatriate” status is to be avoided, give the various adverse tax consequences.  See, for instance,  Why “covered expat” (“covered expatriate”) status matters, even if you have no assets! The “Forever Taint”!

However, since the U.S. tax law is complex and oftentimes full of unintended consequences, there may be times when “covered expatriate” status is desirable in any particular circumstance.  I have seen and advised on several; including scenarios, where some planning steps can help get a much better U.S. tax result in various cases.

Assume a former USC does not meet the certification requirement (e.g., since they neglected to properly file a complete and accurate IRS Form 8854, or they otherwise did not comply with Title 26 for one or more of the five years preceding the renunciation/abandonment).  Further, let us assume, she has an IRA with a total value of US$1.4M and all of her other assets have no unrealized gain (e.g., Euros in a bank in Europe and an apartment she purchased in her country of residence in Europe that continues to have depressed real estate prices).   These other assets, the apartment and Euros are US$500,000 in value; hence, less than the US$2M net worth threshold.  However, we will assume she did not timely comply with the certification requirements under the law.

In such an “unfortunate” case, she would have to accelerate all of the income (gain) from her IRA in the year she has her “date of expatriation”.   This would cause a U.S. federal income tax liability of about US$260,000 that would become immediately due and payable.  This amount is calculated as follows: US$1.4M total IRA, less the $680,000 exclusion amount, for a total taxable income of about $720,000 (which will generate an approximate US$260,000 income tax for someone who is not married filing jointly.  This represents an effective tax rate of approximately 36% on the taxable income portion (US$260,000/US$720,000).  Remember, however, $680,000 escapes taxation under the exclusion amount.  Hence, the effective tax rate on the entire IRA portion is actually only about 18.6% in this case.  This amount is calculated as total IRA income of US$1.4M against tax of US$260,000 (i.e., $260,000/$1.4M= 18.6%).

An 18.6% tax rate is generally a very “attractive” U.S. individual income tax rate for those who have high amounts of income, as is this case with US$1.4M.

If instead, she is not a “covered expatriate” at the time she renounces her citizenship in 2014 (as she did comply with the certification requirements and otherwise would not meet the $2M net worth and her average annual net income tax liability for the preceding 5 years did not exceed $157,000) she would have a very different tax result.  In short, she would not have to accelerate the entire tax liability.  That sounds like good news, until one considers the U.S. tax rate on future IRA distributions to her after she ceases to be a U.S. citizen.  Absent, an income tax treaty, she would have a 30% tax withheld at source (i.e., by the U.S. payer – trustee of the IRA) on each distribution made.  If all US$1.4M is distributed out in one lump sum, there will be a tax of US$420,00 (US$1.4M X 30%); much more than the $260,000 for the “covered expatriate” scenario above.  See calculations in this table:

Also, if she prefers to defer the IRA distributions (e.g., to make 14 annual distributions of US$100,000), she will have the same 30% tax withheld on each payment; hence, a total tax of US$420,00.

Obviously, a 30% tax is much worse than an 18.6% tax.  Accordingly, this is a scenario where an individual may prefer to be a “covered expatriate” as opposed to avoiding such status.  A bunch of factual analysis and strategic considerations would need to be considered in her case (e..g, where are her future heirs, what other income might she receive, will she receive any future gifts of inheritances herself, etc. etc.?).

Indeed, in this particular case, I can imagine a scenario (if accompanied by some focused tax planning), she could pay no more than a total effective tax rate of 12.2% on her income.  Of course,  12.2% is better than 18.6% and 30%.

Finally, there is one more important wrinkle that can modify these results yet further; a particular income tax treaty with the U.S. that has a specific tax result that is better than the statutory 30% rate on distributions from an IRA to a non-resident alien.  The U.S. has numerous income tax treaties with numerous countries, almost all of which have different terms and conditions.  See, Countries with U.S. Income Tax Treaties & Lawful Permanent Residents (“Oops – Did I Expatriate”?)