Merely contemplating the decision to expatriate can be daunting.
Understanding how to reduce (or potentially eliminate) your expatriation exit tax could be the deciding factor in whether or not you remain a US citizen or long-term resident.
The permanent nature of the decision to expatriate or renounce US citizenship means it cannot be taken lightly.
There are many emotional and quality of life related factors that should be considered. But there’s no denying the importance of the cost.
Below are legitimate strategies available to avoid or reduce the so-called expatriation exit tax. These strategies apply when someone renounces their US citizenship or terminates their long-term US residency.
The so-called expatriation exit tax applies to “covered expatriates.”
Covered expatriates include those with a net worth of $2 mil or more, average annual income tax in excess of $178,000 (over the 5 years prior to the year of expatriation) (2022 amount), and those not in tax compliance.
Everyone else is a “non-covered expatriate.”
The “exit tax” has two primary components:
1. Mark-to-market tax on unrealized gains – essentially, you’re treated as though you sold all assets you own for fair market value on the day before expatriation. While certain restrictions apply, most expatriates can take advantage of the full $767,000 (2022 amount) gain exclusion that is tax-free.
2. Deferred compensation items (like a traditional IRA) are generally treated as distributed on the day before expatriation and taxed as ordinary income.
This blog focuses on the mark-to-market component of the “exit tax.”
Below are 5 strategies available to avoid or reduce the so-called expatriation exit tax. Their effectiveness stems from reducing the amount of wealth that is included in your wealth calculation.
Gifting – Gifts given reduce your net worth. You can gift to anyone, but typically gifts are made to spouses, children, and heirs. It can be very advantageous to gift to a spouse who is not a US person, not expatriating, or is not a covered expatriate. Timing of your gifts in relation to your expatriation is very important. You must also be aware of gift tax exclusion limits.
Philanthropic Giving – Giving money to charity to reduce your net worth.
Charitable Foundation – if you don’t want to give away a sizable amount of wealth all at once, you can establish a charitable foundation to distribute funds over time. While you cannot personally benefit from the funds, you may retain significant control of the funds by holding a certain position at the foundation.
Trust – You may set up a trust for the benefit of others. It MUST be properly structured or the transferred assets will be included in your expatriation exit tax calculations. You must also be aware of gift tax exclusion limits.
Utilizing Valuation Discounts – Interests in legal entities like corporations or LLCs can be worth considerably less than the same percentage ownership in an asset itself. Discounts are often given for lack of control, minority interest, lack of transferability, and lack of marketability.
Here’s an example:
Suppose you own 1/3 of a commercial real estate property worth $10 million.
Each of your two business partners also owns 1/3.
Ostensibly, each person’s “share” is worth $3.33 million.
But suppose that the real estate was owned by an LLC with an operating agreement stating that interests cannot be transferred without the consent of other members (partners).
Because you are not free to transfer your LLC interests, you lack control due to your minority interest, and your interest is not marketable; your 1/3 in the interest in the LLC is worth less than $3.33 million.
Suppose you get a “valuation discount” of 40%.
Your LLC interest is $1.98 million.
If you had no other assets, you would no longer be subject to the expatriation exit tax.
It’s critically important to understand that the availability and usefulness of these strategies greatly depend on your personal circumstances, including, but not limited to, how much of your lifetime gift/estate tax exclusion you’ve used.
It’s my job as an advisor to analyze the numbers with respect to your assets and create a custom plan that achieves your personal goals regarding your wealth, family, heirs, legacy, acceptable tax outcomes, etc.