Avoid U.S. Exit Tax with Pre-Expatriation Gifts: Not So Fast
Can You Avoid U.S. Exit Tax with Pre-Expatriation Gifts?
TL; DR
The IRS has previously determined that a covered expatriate’s final tax calculation is made as if he or she died the day before expatriation. (see Notice 2009-85, Section 3). Thus, the three-year pullback may apply to certain gifts made within 3 years of expatriation.
Can You Avoid U.S. Exit Tax with Pre-Expatriation Gifts?
When some U.S. citizens and lawful permanent residents are ready to renounce their US citizenship or terminate their Long-Term Lawful Permanent Residency (LTR) status, they may become subject to an ‘exit tax’ if they are considered a covered expatriate. There are three (3) separate tests to determine whether a taxpayer is considered a covered expatriate, and if the taxpayer meets any one of the three tests (presuming no exceptions apply), then they are deemed a covered expatriate and have to pay an exit tax.
The main category that sucks people into the covered expatriate matrix is that they are considered a high-net-worth individual. This means that their total net worth is above $2,000,000 (unlike the net income average tax liability test, the net worth test has not adjusted for inflation). To try to reduce their net worth, some taxpayers consider giving gifts.
A common question that arises is whether the three-year pullback applies to pre-expatriation gifts to non-spouses.
Section 877A, 2801, 2512, and 2035
When it comes to gifts and expatriation, there are four main statutes to consider:
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IRC 877A: Tax responsibilities of expatriation
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IRC 2035: Adjustments for certain gifts made within 3 years of decedent’s death
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IRC 2512: Valuation of gifts
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IRC 2801: Imposition of tax
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Expatriation, in General
It is important to take a step back and look at the general concept of expatriation.
The US government does not want covered expatriate taxpayers who accumulated a significant amount of wealth while they were U.S. persons to exit the United States without having to pay tax on that growth. From a baseline perspective, the IRS takes the position that most growth and earnings during that time period are part of the general pot used to determine if a person meets any of the three covered expatriate tests, and if so, what the exit tax may be.
Does 2035 Apply to Expatriation?
The key issue becomes whether a taxpayer must apply Section 2035 to expatriation. Technically, section 2035 refers to gifts that are pulled back into an estate within three years of a person’s death.
Section 2035
In pertinent part —
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(a) Inclusion of certain property in gross estate If—
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(1) the decedent made a transfer (by trust or otherwise) of an interest in any property, or relinquished a power with respect to any property, during the 3-year period ending on the date of the decedent’s death, and
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(2) the value of such property (or an interest therein) would have been included in the decedent’s gross estate under section 2036, 2037, 2038, or 2042 if such transferred interest or relinquished power had been retained by the decedent on the date of his death, the value of the gross estate shall include the value of any property (or interest therein) which would have been so included.
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(c) Other rules relating to transfers within 3 years of death
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(3) Marital and small transfers Paragraph (1) shall not apply to any transfer (other than a transfer with respect to a life insurance policy) made during a calendar year to any donee if the decedent was not required by section 6019 (other than by reason of section 6019(2)) to file any gift tax return for such year with respect to transfers to such donee.
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Death vs Expatriation
One key issue that arises often in the IRC 2035 vs IRC 877A analysis is that expatriation is not the same as death, and IRC 2035 refers to the pullback within three years of death, and not specifically to expatriation.
What does the IRS say about it?
The IRS does not provide a direct explanation or roadmap as to whether the pullback rule applies to expatriation the same as it does for death, but there is a Notice 2009-85 (Guidance for Expatriates Under Section 877A)
Notice 2009-85 Section 3 — Identification of a covered expatriate’s property and determination of fair market value:
Here’s the example provided in the notice 2009-85 (Section 3)
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“For purposes of the mark-to-market regime, the covered expatriate is deemed to have sold any interest in property that he or she is considered to own under the rules of this paragraph other than property described in section 877A(c). For purposes of computing the tax liability under the mark-to-market regime, a covered expatriate is considered to own any interest in property that would be taxable as part of his or her gross estate for Federal estate tax purposes under Chapter 11 of Subtitle B of the Code as if he or she had died on the day before the expatriation date as a citizen or resident of the United States…Specifically, fair market value will be determined under section 2031 and the regulations thereunder, but without regard to sections 2032 and 2032A, as if the covered expatriate had died as a citizen or resident of the United States on the day before the expatriation date.”
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While this statement can be ambiguous and derived from an IRS Notice and not a regulation, it is crucial for understanding the IRS’s conceptual framework when it comes to expatriation. Using this as the baseline, the IRS may take the position that the treatment of assets and income on the date before expatriation is the same as if he or she had died. And, if the day before expatriation is considered to be equivalent to if the taxpayer had died, then any gifts that were given within three years before expatriation could be pulled back into the expatriation estate to determine fair market value (subject to any 2035 exceptions).
Covered Expatriates Should Be Careful
While the 2035/877A is not conclusive or definitive, Taxpayers considering giving gifts within 3 years to non-spouses should be careful, because planning mistakes or missteps can be (very) expensive.
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