The Effect of the Tax Cuts and Jobs Act of 2017 on Expatriation
Affluent U.S. citizens and long-term legal permanent residents (i.e., green card holders) looking to expatriate from the United States can face a daunting financial obstacle in the form of the exit tax regime imposed by IRC section 877A. While the recently enacted tax law leaves IRC section 877A unchanged, it effects other changes to the IRC that can make it easier for those seeking to expatriate to get out from under IRC section 877A penalties.
IRC section 877A imposes a number of taxes on “covered expatriates,” defined as follows:
a U.S. citizen or a legal permanent resident who has held a green card for more than seven years who:
(1) has had an average U.S. income tax liability of approximately $162,000 or more over the previous five years;
(2) has a net worth of $2 million or more; or
(3) has not certified compliance with U.S. tax laws for the previous 5 years.
Note that the income threshold represents the 2017 figure.The IRS has yet to announce the figures for 2018 as calculated using the new inflation adjustment under the Tax Cuts and Jobs Act of 2017.
Covered expatriates must pay a mark-to-market tax on all unrealized capital gains and an immediate tax in certain tax-deferred accounts. Covered expatriates are also subject to a gift or estate tax on all assets transferred to a U.S. beneficiary, which is problematic for expatriating parents who have or expect to have children who may wish to live in the United States in the future.
The best way for clients to avoid the consequences of IRC section 877A is to structure their finances such that they fall outside the definition of a covered expatriate. The new tax law makes this easier on two fronts. First, the law lowers the tax rate on affluent taxpayers from 39.6% to 37% and reduces taxes on owners of pass-through businesses by 20%, making it less likely that an expatriating taxpayer’s average U.S. income tax liability reaches the applicable threshold. Second, and more significantly, the law’s increase in the gift and estate tax exemption to over $11 million expands opportunities to reduce a client’s net worth to under $2 million by transferring large amounts of wealth to family members or to a trust for the benefit of family members. Both of these changes sunset at the end of 2025.
To illustrate how the increased gift and estate tax exemption could benefit an expatriating client, suppose Client A, a U.S. citizen, is married to a legal permanent resident who has held a Green Card for six years. They have two children and a combined net worth of $13 million: $11 million in Client A’s name and $2 million in the spouse’s name. Their average income tax liability for the last five years was $150,000.
Client A and her spouse have decided to permanently relocate to the spouse’s native country. When they consult their accountant, they are informed that they will have to continue to pay U.S. income taxes after relocating unless they formally expatriate, which would result in a hefty mark-to-market tax. Furthermore, if their children decided to move back to the United States at some point, a 40% tax would be imposed on any assets the children inherited or received as gifts from their parents.
To avoid this result, Client A transfers $9.1 million to her spouse, who does not qualify as a covered expatriate because he has not held a Green Card for more than seven years. Because the spouse is not a U.S. citizen, Client A uses part of her $11 million gift and estate tax exemption to transfer the money. (If the spouse were a U.S. citizen, the transfer would be free of gift and estate tax implications, but it would cause the spouse to qualify as a covered expatriate).
After the transfer, Client A’s net worth drops to $1.9 million, so that she no longer falls under the definition of a covered expatriate. Their family can relocate, terminate their U.S. income tax obligations, avoid paying any exit tax, and their children’s inheritance would be free of U.S. gift and estate tax, even if the children moved back to the United States.
Client A could also transfer the money to a trust for her family and, potentially, to a self-settled assets protection trust. Note, however, that the IRS has taken the position that beneficial interests in a trust could count toward an expatriating individual’s net worth. (See IRS Notice 97-19). This could pose a problem for certain trust beneficiaries. There is some question as to whether beneficial interests in a trust can lawfully be counted as a taxpayer’s property. (See ACTEC’s comments to address issues presented by the current version of Form 8854.)
While these strategies were viable prior to the 2017 law, the new temporary gift and estate tax exemption has expanded their potential use to clients who are far more affluent. Affluent clients considering expatriation should think about taking advantage of this window of opportunity.
