Covered Gifts and Bequests
Finally – Proposed Regulations for “Covered Gifts” and “Covered Bequests” Issued by Treasury Last Week (Be Careful What You Ask For!)
The U.S. Treasury department has issued proposed regulations implementing the tax on “covered gifts” and “covered bequests.” There have been numerous posts about this tax that was first created in 2008 by new IRC Section 2801 (which has it’s own chapter in Title 26 – aka the Internal Revenue Code or “IRC”: Chapter 15, Gifts and Bequests from Expatriates). The regulations can be reviewed here – Guidance under Section 2801 Regarding the Imposition of Tax on Certain Gifts and Bequests from Covered Expatriates
See prior posts, When does “Covered Expatriate” Status -NOT- matter?, (May 2015); See, The “Hidden Tax” of Expatriation – Section 2801 and its “Forever Taint.” (April 2014) and Proposal to U.S. Treasury and IRS: awaits Final Regulations on “Covered Gifts” and “Covered Bequests” (December 2014).
The tax is levied currently at 40% and can be a big surprise to U.S. beneficiaries who receive so-called “covered gifts” and “covered bequests.” The actual implementation of the tax and its enforcement was suspended until Treasury issued regulations. That day has now come and final regulations will follow shortly.
The proposed regulations create an ingenious mechanism by which assets that are received from foreign trusts (which make an election to be taxed as domestic trusts) cannot escape the 40% taxation. Specifically, there was concern expressed to me by Treasury officials drafting the regulations, when I had submitted a proposal to the U.S. Treasury on the subject in May of 2014. See, COVERED GIFTS & BEQUESTS: THE NEED FOR GUIDANCE (5+ YEARS OUT)
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There was concern by the U.S. Treasury that U.S. persons could escape the tax when assets are received by foreign trusts which elect to be taxed as domestic trusts. In those cases, the statute imposes the tax liability on the trust and not the U.S. beneficiary. Hence, the concern expressed by some of the key drafters at U.S. Treasury of the regulations, was that a foreign trust would make the election and purposefully NOT pay the tax imposed by the statute, since the trustee would be outside the U.S. and largely outside the jurisdiction of the IRS.
The proposed regulations create a mechanism by which the trustee cannot slip away so easily, as they will NOT be treated as a domestic trust (versus a foreign trust) in such circumstances where the tax is not actually paid. In those cases, the U.S. beneficiary will be liable for the tax.
It also has some unique concepts that are not necessarily intuitive under the law. For instance, those individuals who are not U.S. citizens, yet live in the U.S. on a nearly full time basis, might still be able to avoid the application of the tax (at least in certain circumstances) if they are not “domiciled” in the U.S. The term “domicile” is a key estate and gift tax term of tax residency, that is not tied to the number of days an individual spend in the U.S. Rather, it is tied to the subjective intention of whether they expect to spend the rest of their lives in the U.S. See, Section 28.2801-2(b) of the proposed regulations which defines residents as those under “Chapter 11” and “Chapter 12”; which are the rules of “domicile” for transfer tax purposes. These are different from the rules of income tax residency found in IRC Section 7701.
The operative definition is found in (b)(1) of the Regulations: 26 CFR 20.0-1 – Introduction.:
“A person acquires a domicile in a place by living there, for even a brief period of time, with no definite present intention of later removing therefrom. Residence without the requisite intention to remain indefinitely will not suffice to constitute domicile, nor will intention to change domicile effect such a change unless accompanied by actual removal.”
Notice, there is no reference to the number of days physically spent in the U.S.
More to be discussed on the proposed regulations in later posts.
Maybe this question, “When does “Covered Expatriate” Status -NOT- matter?” sounds more like a philosophical question?
What does “matter” mean in this context? !?!?!?
Back to being a bit more practical and serious . . . 😉
Assuming the point of the discussion is taxes, and whether additional taxes will ever be owing, being a “covered expatriate” can have adverse tax consequences. Sometimes, however, being a “covered expatriate” will cause no additional taxation to either (1) the “covered expatriate” or (2) future beneficiaries.
It all depends upon the facts of the particular circumstances.
“Covered expatriate” status is the “general rule” for U.S. expatriation tax rules. There are some exceptions (income tax liability, net worth, and dual nationality exceptions), which hopefully a particular U.S. citizen (“USC”) or long-term resident can fall into, so as to avoid the adverse tax consequences of “covered expatriate” status.
Those adverse tax consequences can be summarized into two categories of taxes:
- “Mark to Market” taxation on unrealized gains of worldwide assets, arising from the renunciation of U.S. citizenship (i.e., the so-called “exit tax”); See, Inflation Adjusted Exclusion Amounts Since Inception of 2008 “Mark to Market” Expatriation Tax Law: Example and
- The tax payable by U.S. beneficiaries whenever they receive so-called “covered gifts” and/or “covered bequests.” See, The “Hidden Tax” of Expatriation – Section 2801 and its “Forever Taint.”
The first tax is what most people talk and write about.
The second tax, can often times be the most costly over the long-run and is little understood for lots of reasons; the least of which is the Treasury and IRS have still not issued required regulations. See, Proposal to U.S. Treasury and IRS: awaits Final Regulations on “Covered Gifts” and “Covered Bequests”
People of modest means often think they have nothing to worry about if they are a “covered expatriate” at the time they cease being a USC or a long-term resident. This is where they may be deeply mistaken; if they have any future U.S. beneficiaries (e.g., children who were born in the U.S. or who might move to the U.S. many years out into the future). Moreover, these U.S. beneficiaries do not need to receive substantial assets, in order to be subject to sizable U.S. taxes in the future.
The first “mark to market” tax is not an issue, if the USC has relatively little assets and relatively little “unrealized gains” in those assets. For instance in 2015, the unrealized gains excluded from taxation is US$690,000. See, The “Phantom” Gain Exclusion from the “Mark to Market” Tax – Increases to US$690,000 for the Year 2015 (15 November 2014). Only individuals with assets of significant value, i.e., with unrealized gains greater than US$690,000 would be concerned with this first tax.
However, those former USCs who have future U.S. beneficiaries who might receive gifts or bequests, will be subject to the second tax that is currently 40% of the amount of the gift or bequest received. This imposes the tax at effectively the highest estate and gift tax rate, which is currently 40%.
If, the covered expatriate has no unrealized gains of greater than US$690,000 and no future U.S. beneficiaries, they probably will not be too concerned with their status as a “covered expatriate.”
The problem is that someone today may have little or no idea that although today, she or he has no U.S. beneficiaries, they may have one more in the future.
In other words, someone might renounce their citizenship today with no U.S. citizen or resident children. However, in the future, one of those children might move to the U.S., might marry a U.S. citizen and have U.S. citizen children (grandchildren to the “covered expatriate”) or become a naturalized U.S. citizen.
If that were to be the case, the former U.S. citizen (e.g., mom or dad) might be reluctant to leave any assets for their child who later moves to the U.S., knowing that effectively 40% of the value of those assets will go to Uncle Sam for the tax under IRC Section 2801.
As stated earlier, it all depends upon the facts of the particular family and life circumstances; some of which might change in the future in unforeseeable ways.
Proposal to U.S. Treasury and IRS: awaits Final Regulations on “Covered Gifts” and “Covered Bequests”
When people write about the taxes from expatriation, the focus seems to be on the income tax provisions. Maybe that is normal, since an income tax can be immediately triggered with reference to the “expatriation date” as defined in the law.
However, the most costly tax will often be the tax on “Covered Gifts” and “Covered Bequests” which went into effect in 2008, but is awaiting Treasury regulations for publication.
Proposed regulations are in the works and presumably were going to be released before the end of the year. In May of this year, I presented a set of formal recommendations to the U.S. Treasury and IRS on this topic in a paper entitled:
COVERED GIFTS & BEQUESTS: THE NEED FOR GUIDANCE (5+ YEARS OUT)
This proposal can be read in its entirety here, and the executive summary is set out below:
The reason these regulations are so important, is due to the tax cost of taxes upon U.S. beneficiaries. See, The “Hidden Tax” of Expatriation – Section 2801 and its “Forever Taint.”
The tax is currently levied at a 40% rate on basically the full vale of the asset upon the gift or bequest. It also continues on for potentially generations into the future; e.g., if U.S. beneficiaries receive property held in trust that was funded by a “covered expatriate.” For instance, to demonstrate the consequences, we can assume a former U.S. citizen who is a “covered expatriate” (e.g., for failure to properly certify under Section 877(a)(2)(C) and file IRS Form 8854, even though the income tax or asset tests are not satisfied) funds a trust in a foreign country for her grandchildren and great grandchildren. See, How many former U.S. citizens and long-term lawful permanent residents have filed (or will file) IRS Form 8854?
Over time, the value of those trust assets grow substantially and 30 years after her death (e.g., the year 2055), the trust starts distributing US$100,000 annually to several U.S. citizen grandchildren and grandchildren. Under the current law, each time the distribution is received, a 40% tax should be levied on each distribution. The law leaves many unanswered questions, until the proposed regulations are issued.