Covered Expatriates May Owe U.S. Expatriation Tax
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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?
Only expatriates can be considered covered expatriates — makes sense, right?
Not all taxpayers who formerly give up their US Status are considered to be expatriates. And, not all expatriates 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*:
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Net-Worth Test: Net worth is more than $2,000,000 (does not adjust for inflation);
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Net-Income Tax Liability Test: Net income tax liability is more than prior five-year allowable average (adjusts for inflation); or
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Noncompliance with Taxes: Unable to prove tax compliance for the past five years.
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*Taxpayer only has to meet one of the tests —
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 deemed distributions.
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
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Michelle is a US Citizen who is going to expatriate.
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She has a net worth of $250,000,000.
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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.
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At the time Michelle expatriates there will be no exit tax — because there is no mark to market gain on the cash.
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Exit Tax
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Miranda has been a US Permanent Resident for the last 10-years.
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She has stock worth $4 million that she purchased after becoming a US person.
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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.
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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).
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