Should I renounce my U.S. citizenship (expatriate)? This is a question I get asked a lot. The answer is: it depends.
People expatriate for a multitude of reasons. Some expatriate because they are obtaining citizenship from a country that doesn’t allow dual citizenship. Some expatriate for tax reasons. Others for political or philosophical reasons. And, others, like myself, expatriated for security and business reasons.
Whatever your reason is, in evaluating whether or not to expatriate, you need to consider how expatriation will impact you financially. Planning is critically important to a successful expatriation—especially when it comes to minimizing or eliminating potential exit taxes.
For those who don’t know, expatriation is the act of relinquishing or renouncing your U.S. citizenship or terminating long-term residency. A long-term resident is an individual who has been a lawful Permanent Resident of the U.S. (green card holder) in at least 8 taxable years during the period of 15 taxable years ending with the taxable year that includes the expatriation date.
What are the Tax Consequences of Expatriation?
The first thing you need to do is figure out if you are a “covered expatriate” or not. This is important because covered expatriates are:
- Subject to an exit tax; and
- U.S. persons who receive gifts or inheritances from covered expatriates are subject to gift or estate tax at the highest rate in effect at the time of the gift or inheritance.
Who is a Covered Expatriate?
Covered expatriates are those who:
- Fail to certify that they have tax compliant for the five years prior to expatriation (certification test test);
- Have a net worth of $2 million USD or more (net worth test); or
- Had an average net annual income tax liability of $178,000 (2022 number, indexed for inflation annually) for the five years prior to expatriation (tax liability test).
Everyone else is a non-covered expatriate.
Are There Exceptions to Covered Expatriate Status?
Yes, for some covered expatriates, an exception to covered expatriation status may apply. There are two exceptions to the net worth and the tax liability tests. If met, an otherwise covered expatriate becomes a non-covered expatriate.
Exceptions to the net worth and tax liability tests:
- You were a dual-citizen at birth and you continue to be a citizen of, and taxed as a resident of, the other country AND you have not been a resident of the U.S. for more than 10 of the last 15 tax years (including the year of your expatriation); or
- You were under age 181/2 on the date you expatriated and have not been a U.S. resident for more than 10 tax years.
There are no exceptions to the tax compliance test. If you fail the tax compliance test, you are always a covered expatriate. If you aren’t tax compliant, I recommend getting tax compliant before you expatriate so you can certify your tax compliance.
Find Out If You Are a Covered Expatriate and Estimate Your Exit Tax
You can find out if you are a covered expatriate and estimate your exit tax (if any) by downloading our “Expatriation Tax Calculator Tool”. I developed this tool and use it myself to determine the covered expatriate status of my private clients and estimate their exit tax.
Click here to download the guide.
If you are not a covered expatriate, congratulations! You are not subject to exit tax and U.S. persons who receive gifts or inheritances from you will not be subject to gift or estate tax on gifts or inheritances they receive from you.
If you are a covered expatriate, that sucks. The first thing we need to do is figure out if there is any way we can convert you into a non-covered expatriate. With proper pre-expatriation planning, it is often possible to turn a covered expatriate into a non-covered expatriate, even if they don’t qualify for one of the exceptions discussed above.
In either case, however, any U.S. income or assets will be taxed differently once you have expatriated. If you own U.S. assets or have U.S. income, planning for how to deal with them post-expatriation should be done pre-expatriation. There are advantageous tax strategies that can be put in place before you expatriate that can’t be put in place after you expatriate.
If there is no way to avoid covered expatriate status, you will be subject to an exit tax and U.S. persons who receive gifts or inheritances from you will be subject to the highest gift or estate tax at the highest rate then in effect.
How Is Exit Tax Calculated for Covered Expatriates?
The exit tax is comprised of two parts:
- A mark-to-market tax on unrealized gains; and
- Deferred compensation items being treated as distributed.
There is a mark-to-market tax on your unrealized gains. Essentially, you are treated as if you sold all your assets on the day before your expatriation date. You are responsible for tax on the hypothetical gains.
There is, however, a gain exclusion of $767,000 (2022 amount, indexed for inflation annually). If your gains do not exceed this amount, you won’t be liable for any mark-to-market tax. The gain exclusion only applies to gains and not ordinary income items like deferred compensation.
Deferred compensation items, like IRAs and other retirement plans, are treated as distributed on the day before your expatriation date and are generally subject to tax at ordinary income tax rates. Note, however, that certain types of retirement plans, like SEP IRAs, are excluded from this treatment. Rather than being treated as distributed on the day before you expatriation date and subject to tax, they are taxed when actually distributed and subject to withholding tax, generally at a rate of 30%.
The only reprieve is that amounts deemed or actually distributed are not subject to the 10% early distribution penalty, even if you are not yet 59 ½ years old.
Exit Tax Example
Matt is a single man with $4 million in assets. He does not qualify for any exceptions to covered expatriate status. He does not have any deferred compensation items. Because Matt’s 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. Further assume that he has owned the assets for more than 1 year subjecting them to the lower long-term capital gains tax rate.
$4 million assets – $1.5 million basis = a gain of $2.5 million.
Now we need to account for the $767,000 gain exclusion amount. $2.5 million gain – $767,000 exclusion amount = $1,733,000 adjusted gain.
His adjusted gain of $1,733,000 is subject to the long-term capital gains tax rate of 20%. $1,733,000 x 0.20 = $346,600
Matt owes $346,600 in “exit tax”. NOTE: This amount does not include the net investment income tax or any state or local income taxes that may apply. It also doesn’t take in to account any losses Matt may have to offset his deemed gain.
How Are Gifts and Inheritances Received by U.S. Persons From Covered Expatriates Taxed?
Ordinarily, in the U.S., the donor (the person making the gift) is responsible for paying any gift tax. Likewise, the estate of a decedent is responsible for paying any estate tax. This is flip flopped when the donor or descendent is a covered expatriate.
U.S. persons receiving gifts or inheritances from a covered expatriate are subject to gift or estate tax at the highest possible rate; currently 40%.
Estate Tax Example
Assume Matt (our covered expatriate from above) had a single heir; a son, who is a U.S. citizen.
When Matt dies and leaves his estate to his son, his son, not Matt’s estate, will be subject to U.S. estate tax at the highest rate because Matt was a covered expatriate.
For purposes of this example, Matt had an estate of $2 million when he died.
$2 million x 0.40 = $800,000 in estate taxes. Ouch!
Renouncing your U.S. citizenship can have many benefits, including tax benefits, but it is not a decision that should be taken lightly. It must be carefully planned in order to maximize its benefits. Remember, you only get one shot at doing it right as renouncing your U.S. citizenship is irrevocable.
We’ve helped countless clients expatriate since the change in the expatriation law back in 2008. In fact, I expatriated myself in 2016 so I have an intimate understanding of how it works, not just from the technical and tax aspect, but also from the emotional aspect.
If you have any expatriation questions or are interested in expatriation, please don’t hesitate to contact us here.