Expatriation Taxes: Basics and Strategies

Expatriation Taxes: Basics and Strategies
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Expatriation Taxes

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Planning is critically important to a successful expatriation – especially when it comes to minimizing or eliminating expatriation taxes.

What Is Expatriation?

Expatriating from the US means to renounce your US citizenship.

What Are Expatriation Taxes?

The IRS has two classifications for expatriates: “covered” and “non-covered.”

“Covered” expatriates are subject to a so-called “exit tax” or “expatriation tax.”

What’s The Difference Between Covered and Non-Covered Expatriates?

Covered expatriates include anyone who:

·  fails to certify that they have been in tax compliance for the five years prior to the expatriation

·  Has a net-worth of $2 million USD or more

·  Had an average net annual income tax liability of $172,000 for the five years prior to the expatriation

Uncovered expatriates include everyone not meeting one of the criteria above.

How Are Expatriation Taxes Calculated?

The exit tax / expatriation tax is a mark-to-market tax on the value of unrealized gains and deferred compensation items (like IRAs and other retirement plans).

Essentially, you are treated as if you sold all of your assets on the day before expatriation and you are responsible for tax on the hypothetical gains and income.

Is Anything Excluded From Expatriation Taxes?

Yes, there is a $744,000 gain exclusion amount for 2021. This amount only applies to gains and not ordinary income items like deferred compensation.

Are There Any Tax Breaks On Deferred Compensation Items?

Yes, you are not subject to the 10% early distribution penalty if you are not yet 59 ½ years of age on the day you expatriate.

How Expatrition Can Change Your Plans For Making Gifts?

Gifts made in excess of the gift and estate tax are subject to taxation. 

Ordinarily, the donor (the person making the gift) is responsible for paying the tax.

However, this is not necessarily true when 

US persons receiving gifts from a “covered expatriate” are subject to gift and estate tax at the highest possible rate – meaning, the recipient of the gift is responsible for paying the tax… NOT the donor. 

Exit Tax Example

Matt is a single man with $4 million in assets. He does not have any deferred compensation items.

Because his net worth is above the $2 million threshold, Matt is a “covered” expatriate.

Suppose Matt has a $1.5 million “basis” in the assets that are worth $4 million.

$4 million assets – $1.5 million basis = a gain of $2.5 million.

Now we need to account for the $744,000 exclusion amount.

$2.5 million gain – $744,000 exclusion amount = $1,756,000 adjusted gain.

This adjusted gain of $1,756,000 is subject to the long-term capital gains tax rate of 20%.

$1,756,000 x 0.37 = $351,200

Matt owes $351,200 for the “exit tax.”

Strategies to Minimize Expatriation Taxes

There are two primary strategies to minimize and possibly eliminate the taxes due upon expatriation.

The first involves making gifts.

The second strategy involves structuring your assets inside of privately held companies to achieve certain “valuation” discounts. In short, assets are less valuable than they might appear.

Gifting Strategies

Making gifts can minimize or eliminate the exit tax by shrinking your net worth. By reducing your net worth, you will either reduce the amount subject to the exit tax or turning you from a “covered” to an “uncovered” expatriate.

You can reduce your net worth by simply making gifts to other persons, including family members.

It’s generally advisable to maximize your lifetime gift and estate tax exclusion. At present, the exclusion amount is $11.58 million per person or $23.16 million per married couple. However, it seems likely that the exemption amount will be lowered during the Biden/Harris administration.

Suppose there is a married couple – the husband is not an American and the wife is a US citizen.

Further suppose the wife has a net worth of $8 million.

She could gift her husband $6.1 million. Her net worth would then be $1.9 million. Thus, she would become an “uncovered” expatriate.”

It’s important to note that the $2 million threshold for “covered” expatriates is per-person.

Suppose you have a husband and a wife. He has a net worth of $3.8 million and she has a net worth of $100,000.

The husband could gift $1.85 million to his wife.

Each would then have a net worth of $1.95 million and would therefore be “uncovered” expatriates and not subject to the exit tax.

Here’s another strategic “gift” strategy – if you have minor children who will remain US citizens, it’s possible to form a US irrevocable trust (prior to expatriation) and name them as the beneficiaries.

All of these gifting strategies involve careful planning. The IRS takes a “substance over form” approach to analyzing these gifts – meaning, they look at facts and circumstances of a gift and often focus on the end result of a gift rather than the individual steps in the gift giving process.

You cannot make a gift to someone and have a secret agreement for them to return the gifted assets to you after your expatriation is complete.

There is another matter to consider – gifts made in excess of the gift and estate tax exemption are subject to taxation.

Ordinarily, the donor (the person making the gift) is responsible for paying the tax.

However, this is not necessarily true after someone expatriates. 

US persons receiving gifts from a “covered expatriate” are responsible for paying taxes on the gift at the highest possible rate.

Yes, the recipient of the gift is responsible for paying the tax, not the person making the gift.

Devaluation Strategies

It’s often difficult to assess the value of shares in privately held businesses. They are not always directly proportional to the assets held by the company.

Consider the following example.

Suppose that a private company owns a piece of real estate valued at $10 million.

You own 30% of this company.

Your brother owns 35%.

Your mom owns 35%.

Your initial instinct would be that your shares in this company are worth $3 million (30% of $10 million).

But it’s not easy to sell shares in a private company in general. It’s even more difficult to sell a minority interest in a family run business.

Very few people will want to buy your shares. As a result, you will get a “marketability” discount on your shares.

They might only be worth $1.8 million rather than $3 million.

Such a discount would reclassify you from a “covered” to a “uncovered’ expatriate.

Additionally, some private companies place heavy restrictions on shares. For example, your shares in this company might have no voting rights and/or no rights to distributions for several years.

The inability to vote or receive distributions reduces the number of people potentially willing to buy your shares.

Such restrictions on your shares would further reduce the “marketability” of your shares and decrease their value further still.

Some privately held companies restrict shareholders from selling their shares without the approval of the board or other shareholders.

If you do not have the authority to transfer shares, they naturally become less valuable.

Your shares in this company might receive a “transferability” discount in addition to the “marketability” discounts described above.

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