Consider this hypothetical scenario. Bob and his wife Ann are planning on expatriating; they are going to renounce their U.S. citizenship. They have found another country that is more appealing in terms of, cost of living, climate, and opportunity. Unfortunately, Bob has some unfinished business with the IRS, including an unfiled 2014 tax return and an outstanding audit. What Bob and his wife thought would be a new dream life has now turned into a nightmare.
Why? Because expatriating (relinquishing U.S. citizenship or terminating your long-term residency) can have dire tax consequences if you are not 100% tax compliant. There is a common misconception that if you expatriate, all of your past and future tax problems will magically disappear. This is not the case.
If, like Bob and Ann above, you have not been tax compliant for the five years prior to expatriation, you will be considered a “covered expatriate.” What does this mean? It means that you may have to pay an exit tax that you otherwise wouldn’t have had to pay.
For example, you will be taxed on your unrealized gains over and above the current exclusion amount of $680,000. For example, consider you own a house worth $500,000 but your basis is only $300,000, an unrealized gain of $200,000. In this example the gain is below the gain exclusion so no tax would be due, but if it were more, then tax would be due.
In addition, most deferred compensation items (retirement accounts, annuities, etc.) will be treated as distributed on the day before you expatriate, while other deferred compensation items will be subject to a 30% withholding tax when it is distributed or it can be included in your income in the year of your expatriation.
Being a covered expatriate, also means that any gifts or bequests (inheritances) to any U.S. persons will be subject to gift or estate at the highest gift or estate tax rate then in affect (40% in 2016). And, it is the RECIPIENT of the gift or inheritance that has to pay the tax!
We have seen too many non-tax compliant people rush to expatriate thinking that their all their tax problems will be solved. Nope! The IRS has the power to require that you file any unfiled returns and pay any unpaid taxes, along with any penalties and interest allowed under the IRS Tax Code. In fact, in a recent case the Justice Department successfully prosecuted an expatriate for tax evasion after he was no longer a U.S. person!
The Department of State cannot require you to submit tax forms as a condition of expatriation. You are allowed to expatriate even if you have unresolved tax issues. However, (and this is big), if you expatriate without being tax compliant for the past 5 years, you will be faced with some or all of the above consequences. You also have to separately notify the IRS that you have expatriated by filing Form 8854 or you will continue to be taxed as a U.S. person.
On another note, we have had many clients ask us if they can expatriate their kids. You are not allowed to expatriate a minor or incompetent. The only way for them to expatriate is for them to go before a U.S. diplomat or consular officer and explain that: 1) they understand what they are doing, 2) they are not being forced to make this decision, and 3) that they understand what their future consequences might be for expatriating. Most embassies will won’t allow children under 14 to expatriate, which means they remain U.S. citizens until that time.
As you can see, expatriating is not as simple as just turning in your passport. If you are considering expatriation, get guidance from a qualified tax expert who can counsel you on the potential tax ramifications of your decision, as well as help with pre-expatriation tax planning to reduce or eliminate any negative tax consequences.