Have you ever seen one of those movies where someone finds out they had a long-lost relative who died and left their entire estate to them? Did you ever dream how nice it would be if you discovered a long-lost relative left you a fortune? As with many things, taxes can sometimes turn a dream into a nightmare!
Let’s assume for a second you are contacted by a lawyer in London, England who tells you that your long lost second cousin, twice removed, Jeeves, passed away and you are the closest living relative. You are going to receive his entire estate of $150K. You are, of course, sad that you had never met Jeeves and that he had passed away, but delighted about receiving an unexpected windfall. Being the responsible taxpayer you are, you call your accountant and ask him about the tax implications of this windfall. Your responsible accountant tells you that he is not familiar with international tax issues and refers you to an international tax consultant, like Esquire Group.
You immediately set up an appointment to speak with one of Esquire Group’s international tax advisors. During the consultation, you explain your situation and ask about the potential tax consequences. The first question the advisor, Jimmy, asks you is of what country or countries Jeeves was a citizen. Your response to Jimmy is that Jeeves was a U.K. citizen; you knew this from your conversation with the lawyer who informed you of the inheritance. Jimmy then informs you that generally gifts or inheritances from foreigners are not taxable, however, they must be reported on Form 3520.
You are delighted until Jimmy asks his next question. Do you know if Jeeves ever expatriated from the U.S.; expatriation is renouncing U.S. citizenship or terminating long-term residency. And, if so, was he a covered expatriate. “A covered what”, you ask? You answer Jimmy that you have no idea, you never even met Jeeves for goodness sake!
Well, the IRS requires you to know! Why? Because if Jeeves was a covered expatriate the IRS wants to tax that inheritance you are going to receive at the highest estate tax rate of 40%!!! Any U.S. person that receives a gift or bequest (inheritance) from a covered expatriate is required to pay tax on the inheritance at the highest estate or gift tax rate currently in effect.
Under proposed regulations a U.S. person—in this case, you—would have to determine if the person you received the gift or bequest from was a covered expatriate. A covered expatriate is an individual who either renounces or relinquishes their U.S. citizenship or terminates their long-term residency status after June 16, 2008, and:
- Has a net worth of at least $2 million on the date of expatriation (“Net worth test”)
- Has an average annual income tax liability of $160,000 (2015) or more for the five years prior to expatriation (“Income tax test”)
- Or has not been in tax compliance for the five years prior to the date of expatriation.
To make matters more complicated (we know the IRS loves to do this), regulations apply to both direct and indirect gifts or bequests. A direct gift or bequest is pretty straightforward; it is a gift or bequest directly from the person or their estate to you. An indirect gift is a bit more convoluted. A good example of an indirect gift or bequest is one given through a trust. In this scenario, you would need to know if the person who put the assets in trust was a covered expatriate.
If the person didn’t share this information with you, how can you find out? There is no list of covered expatriates. The person’s tax records are confidential and can’t be released to a third-party without the taxpayer’s permission, which will be nearly impossible if the taxpayer is deceased.
In the above hypothetical scenario, pursuant to the proposed regulations, you would need to pay $60K estate tax on the inheritance you receive since you can’t determine whether or not Jeeves was a covered expatriate. How can this be avoided? The easiest way is for anyone who expatriates to carefully document their status and make arrangements that this information is conveyed to any U.S. recipients of gifts or bequests.
Esquire Group has developed an Expatriate Package that contains relevant tax and other documents proving the expatriate’s status as covered or uncovered. If you are interested in putting an Expatriate Package together for your actual or potential U.S. heirs, contact our office and we will be happy to help you.