Want to Leave the U.S.? You May Have to Pay These TaxesTax Planning
When you leave the U.S. to live in another country, you essentially have two choices from a tax perspective, both of which can cost you a pretty penny.
First, you can simply leave the country and take up residence elsewhere. But if you choose this option, beware: the U.S. continues to tax you on your worldwide income, no matter where you earn it or derive it from.
Second, you can formally renounce your American citizenship or long-term residency and expatriate. This option is also not without its potential financial pitfalls, because the U.S. may impose an “exit tax” on you before you leave.
The rules behind this exit tax are complex, but whether you will be required to pay it depends largely on whether you are classified for tax purposes as a covered expatriate.
Are You a Covered Expatriate?
American citizens and long-term residents can, of course, voluntarily give up their status as citizens or residents and expatriate.
Once you give up your status, the IRS will consider you either an “expatriate” or a “covered expatriate.” If you’re simply an expatriate, the exit tax will not apply, and you’re good to go. There’s really nothing more to it. You still have U.S. assets, and you have to pay U.S. taxes on those assets.
But if the tax law deems you a covered expatriate, you have to pay the exit tax.
A covered expatriate is a person who meets one of the following three tests:
- Income tax test. You’ll be deemed a covered expatriate if you paid an average of $190,000 annually in income tax in the five years before you expatriate.
- Net worth test. You’re also a covered expatriate if your net worth is $2,000,000 or more on the date you give up your U.S. citizenship or long-term residency.
- Compliance test. Finally, if you fail to certify, under penalty of perjury, that you met all your tax obligations for the five years preceding your expatriation, you’re a covered expatriate.
A narrow exception to the income tax and net worth tests applies for purposes of the exit tax if
- you received dual citizenship, of both the U.S. and another country, when you were born,
- you still hold your citizenship in that other country,
- you pay income taxes there, and
- you have been a resident of the U.S. for no more than 10 of the 15 years before you surrender your American citizenship.
You’ll also avoid covered expatriate status if you’re a minor who gives up your citizenship before you turn 18 ½ and you did not reside in the U.S. for more than 10 years.
What Is the Exit Tax?
Under the exit tax regime, the government requires you to pay income taxes on the unrealized gain in all your property, subject to a few minor exceptions, as if you sold that property the day before your departure.
In other words, the law deems that you sold all your property at fair market value on the date of your departure, even though you did not. You then pay taxes on this imaginary gain.
Mercifully, under today’s law, you can exit in 2023 and exclude up to $821,000 of gain (adjusted annually for inflation).
This mark-to-market deemed gain is taxable even if it would not have been taxable otherwise.
Also, you must allocate the exclusion amount pro rata to the assets that have a built-in gain.
Say you give up your citizenship on November 15, 2023. On November 14, you owned three assets:
- Asset 1, carrying a fair market value of $2,000,000 and an adjusted basis of $200,000
- Asset 2, with a fair market value of $1,000,000 and an adjusted basis of $800,000
- Asset 3, with a fair market value of $500,000 and an adjusted basis of $800,000
Step 1. Calculate the built-in gain on each asset on November 14 by subtracting its adjusted basis from its fair market value:
Step 2. Ignore the loss assets. Compare the gain with the exclusion amount. Since the total gain exceeds the exclusion, determine the part of the exclusion to allocate to each gain asset. You do this by multiplying the exclusion amount by a ratio, the numerator of which is each asset’s built-in gain and the denominator of which is the total built-in gain from all gain assets:
Step 3. Find the amount to include in income for each gain asset by subtracting the exclusion amount allocated to it from the asset’s imaginary built-in gain:
You Can Pay Later, But…
In the mark-to-market deemed sale of your assets, you didn’t collect any cash, so you might be short of the cash needed to pay your taxes. The U.S. government might help you by allowing you to pay later if you can post
“adequate” security as collateral for the debt, such as a bond.14 The following rules also apply to this payment
Once you make the election, it’s irrevocable.
You can elect to defer tax on some pieces of property but not others.
You must waive any right under any U.S. treaty that would otherwise prevent collection of the
You pay interest on any taxes you defer.
You or your estate must pay the expatriate taxes due when you dispose of the property or die.
Easing the Pain
To ease the pain slightly, eligible deferred compensation items, such as IRAs, pensions, and stock option plans, are not part of the deemed sale, and thus are not taxed at the time of expatriation.
Rather, the government makes the payor withhold 30 percent on any taxable payment made to a covered expatriate.
Note that to qualify for this temporary relief, the deferred compensation must be “eligible.” That means
- the payor of the deferred compensation must be a U.S. entity or a foreign entity that has agreed to submit to U.S. withholding and other requirements;
- you tell the payor that you are no longer an American citizen; and
- you permanently waive any claims you might otherwise have had to the reduction or elimination of the tax under a tax treaty.
If you or the payor do not meet these requirements, you subject the deferred compensation to the asset test as explained in the three steps above.
Non-grantor trusts that pay distributions after you give up your citizenship must collect and remit to the U.S. government the 30 percent withholding tax.
I’m a Covered Expatriate—What Can I Do?
Though the situation is certainly a sticky wicket, all hope may not be lost.
According to the net worth test, you are a covered expatriate only if your net worth is $2,000,000 or more. With some thoughtful planning, you might structure your assets to avoid this classification.
Depending on the circumstances, direct gifting before expatriation might be one solution. Another solution might be through the creation of trusts before the big day.
You need to exercise extreme care in any such effort. It’s best to use a tax professional who understands expatriation.
If you have assets that are subject to the expatriate tax, you can’t simply fold your tent and become a resident of another country without taking care of some tax payments to the IRS on your mark-to-market deemed sale of assets.
The government wants to make sure that you pay taxes on the assets and income you accrued as a citizen. You don’t double-pay any taxes, because you get a step-up in basis on the assets that were subject to the exit tax.
Also, your step-up in basis includes the non-taxable exclusion. That’s a nice benefit—actually, a good deal.
And if you don’t have the cash to pay the taxes, you can arrange a secured loan with the U.S. government that allows you to pay the taxes later—with interest, of course.