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26 US Code 877 & Expatriation to Avoid Tax
26 US Code 877 & Expatriation to Avoid Tax
26 US Code 877 – Expatriation to Avoid Tax: When U.S. Citizens and Long-Term Residents want to give up, abandon, or relinquish their U.S. status, they are considered “Expatriates.” Not all expatriates are considered covered expatriates, but if a person is a covered expatriate, the IRS tax analysis will become very complicated. It includes a mark-to-market analysis for unrealized capital gain, along with computing deemed distributions for certain ineligible deferred compensation and tax deferred investments. The first step in the analysis is determining if 26 USC Section 877 applies and if so — can the exit tax be avoided?
26 U.S. Code 877
We will analyze 26 USC section 877 in pieces for you:
(a) Treatment of Expatriates
(1) In general
Every nonresident alien individual to whom this section applies and who, within the 10-year period immediately preceding the close of the taxable year, lost United States citizenship shall be taxable for such taxable year in the manner provided in subsection (b) if the tax imposed pursuant to such subsection (after any reduction in such tax under the last sentence of such subsection) exceeds the tax which, without regard to this section, is imposed pursuant to section 871. (2)Individuals subject to this section.
This section shall apply to any individual if—
(A) the average annual net income tax (as defined in section 38(c)(1)) of such individual for the period of 5 taxable years ending before the date of the loss of United States citizenship is greater than $124,000,
(B) the net worth of the individual as of such date is $2,000,000 or more, or
(C) such individual fails to certify under penalty of perjury that he has met the requirements of this title for the 5 preceding taxable years or fails to submit such evidence of such compliance as the Secretary may require.
In the case of the loss of United States citizenship in any calendar year after 2004, such $124,000 amount shall be increased by an amount equal to such dollar amount multiplied by the cost-of-living adjustment determined under section 1(f)(3) for such calendar year by substituting “2003” for “1992” in subparagraph (B) thereof. Any increase under the preceding sentence shall be rounded to the nearest multiple of $1,000.”
Are you a Covered Expatriate
In accordance with 877(a), a person will only be subject to the Exit Tax if the section applies. Presuming the person is either a U.S. Citizen or Legal Permanent Resident, the individual qualifies as a Covered Expatriate (and then possibly subject to exit tax), if they meet either of the above-referenced threshold requirements.
*Section (A) above adjusts for inflation. Presumably, (B) adjusts for inflation as well, but $2M has remained constant for several years.
(b) Alternative Tax
“A nonresident alien individual described in subsection (a) shall be taxable for the taxable year as provided in section 1 or 55, except that—
(1) the gross income shall include only the gross income described in section 872(a) (as modified by subsection (d) of this section), and
(2) the deductions shall be allowed if and to the extent that they are connected with the gross income included under this section, except that the capital loss carryover provided by section 1212(b) shall not be allowed; and the proper allocation and apportionment of the deductions for this purpose shall be determined as provided under regulations prescribed by the Secretary.
For purposes of paragraph (2), the deductions allowed by section 873(b) shall be allowed; and the deduction (for losses not connected with the trade or business if incurred in transactions entered into for profit) allowed by section 165(c)(2) shall be allowed, but only if the profit, if such transaction had resulted in a profit, would be included in gross income under this section.
The tax imposed solely by reason of this section shall be reduced (but not below zero) by the amount of any income, war profits, and excess profits taxes (within the meaning of section 903) paid to any foreign country or possession of the United States on any income of the taxpayer on which tax is imposed solely by reason of this section.
How is Exit Tax Applied?
Section (b) further clarifies how a person caught in the web of (a) will be taxed.
- Section 1: Tax Imposed
- Section 55: Alternative Minimum Tax
- Section 872(a): Gross Income
- Section 1212(b): Capital Loss Carry Back and Carry Overs
- Section 873: Deductions
- Section 165: Losses
- Section 903: Credit for Taxes
“(c) Exceptions
(1) In general
Subparagraphs (A) and (B) of subsection (a)(2) shall not apply to an individual described in paragraph (2) or (3).
(2) Dual-Citizens
(A) In general
An individual is described in this paragraph if—
(i) the individual became at birth a citizen of the United States and a citizen of another country and continues to be a citizen of such other country, and
(ii) the individual has had no substantial contacts with the United States.
(B) Substantial contacts
An individual shall be treated as having no substantial contacts with the United States only if the individual— (i) was never a resident of the United States (as defined in section 7701(b)),
(ii) has never held a United States passport, and
(iii) was not present in the United States for more than 30 days during any calendar year which is 1 of the 10 calendar years preceding the individual’s loss of United States citizenship.
(3) Certain minors
An individual is described in this paragraph if—
(A) the individual became at birth a citizen of the United States,
(B) neither parent of such individual was a citizen of the United States at the time of such birth,
(C) the individual’s loss of United States citizenship occurs before such individual attains age 18½, and
(D) the individual was not present in the United States for more than 30 days during any calendar year which is 1 of the 10 calendar years preceding the individual’s loss of United States citizenship.”
Exception to Covered Expatriate Status
Even if a person otherwise qualifies as a Covered Expatriate, they may still be able to avoid the status if they can meet certain requirements.
Specifically, certain dual-citizens (by birth) and minors may qualify for the exceptions identified above.
(d) Special Rules for Income Source, etc.
For purposes of subsection (b)—
(1)Source rules
The following items of gross income shall be treated as income from sources within the United States:
(A) Sale of property Gains on the sale or exchange of property (other than stock or debt obligations) located in the United States.
(B) Stock or debt obligations Gains on the sale or exchange of stock issued by a domestic corporation or debt obligations of United States persons or of the United States, a State or political subdivision thereof, or the District of Columbia.
(C) Income or gain derived from controlled foreign corporation…
Source of Income
The source of income rules are very comprehensive and beyond the scope of the article. But, it is important to keep the source rules in mind when evaluating assets for exit tax.
(e) Lawful Permanent Residents who cease to be taxed as residents
(1) In general
Any long-term resident of the United States who ceases to be a lawful permanent resident of the United States (within the meaning of section 7701(b)(6)) shall be treated for purposes of this section and sections 2107, 2501, and 6039G in the same manner as if such resident were a citizen of the United States who lost United States citizenship on the date of such cessation or commencement.
(2) Long-term resident
For purposes of this subsection, the term “long-term resident” means any individual (other than a citizen of the United States) who is a lawful permanent resident of the United States in at least 8 taxable years during the period of 15 taxable years ending with the taxable year during which the event described in paragraph (1) occurs.
For purposes of the preceding sentence, an individual shall not be treated as a lawful permanent resident for any taxable year if such individual is treated as a resident of a foreign country for the taxable year under the provisions of a tax treaty between the United States and the foreign country and does not waive the benefits of such treaty applicable to residents of the foreign country.
(3) Special rules
(A) Exceptions not to apply Subsection (c) shall not apply to an individual who is treated as provided in paragraph (1).
(B) Step-up in basis
Solely for purposes of determining any tax imposed by reason of this subsection, property which was held by the long-term resident on the date the individual first became a resident of the United States shall be treated as having a basis on such date of not less than the fair market value of such property on such date. The preceding sentence shall not apply if the individual elects not to have such sentence apply.
Such an election, once made, shall be irrevocable.
(4)Authority to exempt individuals
This subsection shall not apply to an individual who is described in a category of individuals prescribed by regulation by the Secretary.
(5) Regulations
The Secretary shall prescribe such regulations as may be appropriate to carry out this subsection, including regulations providing for the application of this subsection in cases where an alien individual becomes a resident of the United States during the 10-year period after being treated as provided in paragraph (1).
Who is a Lawful Permanent Resident?
The section explains that Long-Term Residents are treated the same as U.S. Citizens when it comes to expatriation.
A Long-Term Resident is a Lawful Permanent Resident who had that status for at least eight (8) of the least 15-years.
(f) Burden of Proof
If the Secretary establishes that it is reasonable to believe that an individual’s loss of United States citizenship would, but for this section, result in a substantial reduction for the taxable year in the taxes on his probable income for such year, the burden of proving for such taxable year that such loss of citizenship did not have for one of its principal purposes the avoidance of taxes under this subtitle or subtitle B shall be on such individual.
Tax Avoidance Principal Purpose Burden
If the IRS believes the expatriation resulted in a artificially reduced taxable income in the year of expatriation, it is the burden of the Individual — not the IRS — to substantiate that position.
(g) Physical Presence
(1) In general
This section shall not apply to any individual to whom this section would otherwise apply for any taxable year during the 10-year period referred to in subsection (a) in which such individual is physically present in the United States at any time on more than 30 days in the calendar year ending in such taxable year, and such individual shall be treated for purposes of this title as a citizen or resident of the United States, as the case may be, for such taxable year.
(2) Exception
(A) In general
In the case of an individual described in any of the following subparagraphs of this paragraph, a day of physical presence in the United States shall be disregarded if the individual is performing services in the United States on such day for an employer.
The preceding sentence shall not apply if— (i)such employer is related (within the meaning of section 267 and 707) to such individual, or (ii)such employer fails to meet such requirements as the Secretary may prescribe by regulations to prevent the avoidance of the purposes of this paragraph. Not more than 30 days during any calendar year may be disregarded under this subparagraph.
(B) Individuals with ties to other countries An individual is described in this subparagraph if—
(i) the individual becomes (not later than the close of a reasonable period after loss of United States citizenship or termination of residency) a citizen or resident of the country in which—
(I) such individual was born,
(II) if such individual is married, such individual’s spouse was born, or
(III) either of such individual’s parents were born, and (ii)the individual becomes fully liable for income tax in such country. (C)Minimal prior physical presence in the United States An individual is described in this subparagraph if, for each year in the 10-year period ending on the date of loss of United States citizenship or termination of residency, the individual was physically present in the United States for 30 days or less. The rule of section 7701(b)(3)(D) shall apply for purposes of this subparagraph.
(h) Termination
This section shall not apply to any individual whose expatriation date (as defined in section 877A(g)(3)) is on or after the date of the enactment of this subsection.
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