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The Unforseen Tax Impact of Loss of US Citizenship
Loss of Citizenship US Tax Implications
Loss of Citizenship has US Tax Implications: When a US Citizen renounces their U S citizenship, there are several moving parts they have to consider — with one of the primary concerns being what are the US tax implications for loss of citizenship. Unlike when somebody is a Long-Term Lawful Permanent Resident, in which the Taxpayer already has citizenship in another country — with loss of citizenship, the Taxpayer has to go through various hurdles in order to renounce. And the expatriate should be sure to plan for that renouncement in order to make sure they are not blindsided by possibly unforeseen tax consequences with the IRS. In dealing with loss of citizenship, other common terms or phrases the taxpayer will find during their research is expatriation (formally renouncing US citizenship) and exit tax (a possible tax due on taxpayer’s perceived value at the time of the loss of citizenship). Let’s go through the basics of the US tax implications for loss of citizenship:
What is Loss of Citizenship?
Loss of Citizenship is the equivalent of renouncing US citizenship — which is the process a formerly giving up their US citizenship status. This is usually done outside of the United States by filing certain Department of State Forms and taking an oath of renunciation at one of the consulates outside of the United States.
Pre-Tax Planning Before loss of Citizenship
If a person is going to pursue a loss of citizenship, it is important that they first evaluate their tax situation in order to assess what type of tax implications may impact their worldwide assets when they give up their citizenship.
Here are a few important things to keep in mind:
Exit Tax
For certain taxpayers who qualify as a covered expatriate, they may be subject to an exit tax at the time they renounce their citizenship. But, two very important common misunderstandings about that status or the following:
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Just being a covered expatriate does not mean a person who pursues a loss of citizenship will actually owe any exit tax; and
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Exit tax is not a wealth tax per se
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In other words, just because a person is very wealthy and deemed a covered expatriate does not mean they will have any exit tax due as a result of loss of citizenship. Oftentimes, a person who is less wealthy but has more unrealized/non recognized gain in highly appreciated assets and may actually have a significant exit tax.
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Mark-to-Market Tax
The most common type of exit tax is the mark-to-market. It essentially means that when a taxpayer has unrealized/non-recognized gains on assets, they may be subject to an exit tax at the time of loss of citizenship on the perceived growth value of the asset. (technically, when they file their final tax return and not at the time the expatriating act is performed).
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For example, Rachel came to the United States and acquired stock for $1,000,000. Now that stock is worth $10 million — and so when Rachel exits, she may have an exit tax consequence on the mark-to-market gain.
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You are NOT Actually Required to Sell
The exit tax is based on a make-believe sale or distribution. It is based on the idea that a phantom sale takes place based on the FMV on the day before expatriation and subtracting-out the basis — along with a certain amount of exclusion. But, Rachel does not actually have to sell the asset.
Deemed Distributions – Ineligible Deferred Compensation
When a person pursues loss of citizenship, one common tax scenario they may not have considered is that when a person has ineligible deferred compensation (which is nearly all foreign types of pensions) — and absent any step-up basis — the amount is deemed distributed on the day before expatriation, and grossed up into their income for the final tax year. As with mark-to-market, the person does not actually receive the distribution from the foreign pension but is taxed on it nonetheless (a complete tax atrocity, since oftentimes pension grow tax-free in the source country — such as 401K in the US).
In comparison a 401K is not usually deemed distributed if handled properly, because it is eligible deferred compensation.
Deemed Distributions – Specific Tax Deferred Treatment
For certain types of investments that are not necessarily employment borne 401K — such as non-employment IRAs — the same deemed distribution rules apply in that a taxpayer is deemed to have received the value of the distribution on the day before expatriation. There are some additional complexities involving Roth IRA’s.
Post-Expatriate US Tax Issues
Depending on whether or not the US Person who pursues loss of citizenship is a covered expatriate or not will impact tax implications at a later date such as gifting rules. While the proposed regulations are still ‘proposed,’ the general proposition is that when a covered expatriate gifts money to a US Person (absent spousal gift/estate tax and annual exclusion rules), the recipient is required to pay a gift tax of 40% upon receipt in a form 708 is supposed to be filed, although the 708 form has yet to be published at the time of this Article.
Loss of Citizenship Has US Tax Implications
The main takeaway from this article is that simply giving up US citizenship does not equate necessarily to a clean break from the US tax system — depending on the facts and circumstances of the loss of citizenship. Since unwinding the expatriating act is not an option, it is important for taxpayers to plan before pursuing a loss of citizenship.
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