Covered vs Non-Covered Expatriate: Tax Implications 2023

Covered Expatriate

Covered Expatriate 

Covered Expatriate Definition: When a US Person gets ready to expatriate from the United States and formally relinquish their US person status, their research might take them to the term “covered expatriate.” A covered expatriate is an expatriate who is deemed by the IRS to be “covered” under the US tax code — and therefore may become subject to exit tax at the time of expatriation. Oftentimes, there are misconceptions regarding what is a covered expatriate, who may be subject to exit tax — and what is the process of expatriation. Only when an expatriate is “covered” may they possibly be subject to exit tax — but even if an expatriate is covered — they may not be subject to the exit tax.  

What is an Expatriate?

Not all taxpayers who formerly give up their U.S. status are considered to be expatriates (for U.S. tax expatriation filing purposes). And, not all taxpayers who formally expatriate are considered ‘covered.’ An expatriate is a US person who is either a US citizen or a Long-Term Lawful Permanent Resident, which means that they have been a lawful permanent resident for eight of the last 15 years — excluding any year in which they claimed Form 8833 treaty benefits to be treated as a foreign resident.

What are the Different Tests?

An expatriate is considered to be covered when they fall into one of the two categories identified above and they meet any of the three covered expatriate tests below.

The three (3) tests are as summarized below*:

• • • Net-Worth Test: Net worth is more than $2,000,000 (does not adjust for inflation);

    • Net-Income Tax Liability Test: Net income tax liability is more than prior five-year allowable average (adjusts for inflation); or

    • Noncompliance with Taxes: Unable to prove tax compliance for the past five years.

*Taxpayer only has to meet one of the tests to be considered a covered expatriate.

What Happens if you are Covered?

If a person is considered a covered expatriate, they may become subject to Exit Tax. And, in order to assess the tax damage, the main (and most complicated) part is to conduct a mark-to-market analysis of the realized, but unrecognized capital gains. In addition, they must determine if there are any specified tax deferred income, deemed distributions from ineligible compensation sources, and grantor/non-grantor trust ownership.

Covered Expatriate Does Not Mean Exit Tax

One very important takeaway is that just because a person is covered does not mean they owe any exit tax — here are two examples:

No Exit Tax

• • • Michelle is a US Citizen who is going to expatriate.

    • She has a net worth of $250,000,000.

    • All of Michelle’s money is in cash. She has no retirement; trusts; or tax-deferred investments — Michelle is old-school and rolls in cold-hard-cash only.

      • At the time Michelle expatriates there will be no exit tax — because there is no mark to market gain on the cash.

Exit Tax

• • • Miranda has been a US Permanent Resident for the last 10-years.

    • She has stock worth $4 million that she purchased after becoming a US person.

      • Her basis in the stock is only $50,000. Therefore, based on the mark to market gain on the realized but unrecognized gains — she will presumably have an exit tax consequence.

Exceptions

There are a few different exceptions for individuals who would otherwise be considered covered. If they meet one of the exceptions, they will not have to conduct the exit tax analysis.

Why is Being Covered Bad?

The main deterrent to being covered is that certain transactions the nonresident alien-covered covered expatriate has with a US person (after the expatriation date) are still taxable.  This is no truer than in situations involving covered gifts and bequests to a US person — which may result in an immediate income tax consequence upwards of 40% tax rate.   Those rules fall under Internal Revenue Code 2801 and Form 708 — only the proposed regulations for section 2801 are still proposed — and form 708 has yet to be published.

Exit Tax Planning to Avoid Expatriation Exit Tax

In conclusion, when a US person is going to expatriate — they should try their best to avoid the covered expatriate status. Sometimes, it is just not possible to avoid covered expatriate status. In these situations, the expatriate may be able to perform some pre-exit tax planning to minimize or avoid exit tax. Typically, this needs to be done before the expatriating act (relinquishing permanent residents or renouncing citizenship).

Do You Need Offshore Disclosure First?

When a person is either considered a U.S. citizen or a Long Term Lawful Permanent Resident (LTR), the formal process of either renouncing US citizenship or relinquishing a green card is referred to as expatriation. When a taxpayer expatriates from the United States there are various tax and immigration requirements that they must be aware of to ensure that the process goes smoothly. One of the biggest hurdles for some taxpayers is that they are not in IRS tax compliance for the five prior years at the time that they expatriate. As a result, this may lead to the taxpayer having to pay an exit tax when they may have avoided attacks if they had been tax-compliant at the time that they expatriated. Let’s look at four common issues involving offshore disclosure with expatriation.

Are You a Covered Expatriate?

When a person is considered a covered expatriate, it means that they may be subject to the exit tax. When at all possible, taxpayers will try to avoid the covered expatriate status – and there are three (3) tests to determine covered expatriate status. If a taxpayer qualifies for either the net worth test, the net income average tax liability test, or the tax compliance test, they will be deemed a covered expatriate — unless an exception or exclusion applies. Thus, taxpayers who would only be considered to be covered expatriates because of the five-year tax compliance rule should be sure they are in tax compliance before they expatriate. This is because it can lead to an exit tax for items such as mark-to-market unrecognized gains; specified tax-deferred accounts, and ineligible deferred compensation (foreign pension). For taxpayers who have unreported foreign accounts, assets, investments, or income they will want to consider one of the offshore disclosure programs otherwise known as international tax amnesty.

Tax Audits of Expatriates

Some taxpayers are under the impression that once they expatriate, they are no longer subject to U.S. taxes. While they may not be subject to US taxes on their worldwide income, their prior-year tax returns that are still within the statutory time may be audited even after they expatriate, including their final year of tax filings. In other words, simply expatriating from the United States does not protect the taxpayer against the IRS auditing them for prior years. If a taxpayer is audited and the IRS determines that they did not properly expatriate because they did not actually meet the tax compliance rule it could lead to extensive fines and penalties after the fact.

U.S./Foreign Assets May be Subject to Levy/Lien

Even after a person expatriates from the United States, they can still be subject to examination and if the IRS determines that taxes or penalties are owed, then the IRS can lean or levy their bank accounts and other US-based assets, along with foreign assets in conjunction with cooperation clauses contained in tax treaties and FATCA agreements.

401K Withholding

 An additional potential tax pitfall is 401K and other eligible deferred compensation that is not subject to exit tax at the time of expatriation for non-covered expatriates. If the person is later determined to be a covered expatriate it will impact their 401K withholding because taxpayers who are determined to be covered expatriates are subject to a 30% withholding and even if the taxpayer is in a treaty country, they cannot take advantage of the treaty election if they are considered a covered expatriate.

Late Filing Penalties May be Reduced or Avoided

For Taxpayers who did not timely file their FBAR and other international information-related reporting forms and do not qualify for an exception or exclusion to FBAR filing, the IRS has developed many different offshore amnesty programs to assist taxpayers with safely getting into compliance. These programs may reduce or even eliminate international reporting penalties.

Current Year vs Prior Year Non-Compliance

Once a taxpayer missed the tax and reporting (such as FBAR and FATCA) requirements for prior years, they will want to be careful before submitting their information to the IRS in the current year. That is because they may risk making a quiet disclosure if they just begin filing forward in the current year and/or mass filing previous year forms without doing so under one of the approved IRS offshore submission procedures. Before filing prior untimely foreign reporting forms, taxpayers should consider speaking with a Board-Certified Tax Law Specialist who specializes exclusively in these types of offshore disclosure matters.

Avoid False Offshore Disclosure Submissions (Willful vs Non-Willful)

In recent years, the IRS has increased the level of scrutiny for certain streamlined procedure submissions. When a person is non-willful, they have an excellent chance of making a successful submission to Streamlined Procedures. If they are willful, they would submit to the IRS Voluntary Disclosure Program instead. But, if a willful Taxpayer submits an intentionally false narrative under the Streamlined Procedures (and gets caught), they may become subject to significant fines and penalties. 

Need Help Finding an Experienced Offshore Tax Attorney?

When it comes to hiring an experienced international tax attorney to represent you for unreported foreign and offshore account reporting, it can become overwhelming for taxpayers trying to trek through all the false information and nonsense they will find in their online research. There are only a handful of attorneys worldwide who are Board-Certified Tax Specialists and who specialize exclusively in offshore disclosure and international tax amnesty reporting. 

Golding & Golding: About Our International Tax Law Firm

Golding & Golding specializes exclusively in international tax, specifically IRS offshore disclosure. 

Contact our firm today for assistance.