The IRS Increases Individual Expatriation Tax Enforcement

In recent years, the Internal Revenue Service has increased enforcement for compliance-related matters in which the IRS believes it is losing out on significant amounts of revenue. Some of the more recent enforcement priorities include offshore disclosure, cryptocurrency, trust schemes, and expatriation. Expatriation is when a U.S. Citizen or Long Term Lawful Permanent Resident (LTR) voluntarily (usually) terminates their Lawful Permanent Resident status or renounces their U.S. Citizenship. Depending on whether the Taxpayer is considered a covered expatriate is crucial, because covered expatriates may become subject to exit tax. Even though a large component of exit tax is mark-to-market unrealized gains, many different types of assets and income may lead to an exit tax — and the IRS has been finding that Taxpayers are not properly completing the forms and paying taxes they owe. This has contributed to an increase in the tax gap and for the IRS to thwart Taxpayers who may intentionally seek to artificially reduce or eliminate exit tax they have developed enforcement compliance programs and protocols focused specifically on expatriation. Let’s look at what has led to the increase in enforcement and how Taxpayers can prepare.

First, What is Expatriation?

Expatriation is when a U.S. Citizen or Lawful Permanent Resident gives up their U.S. person status. For ‘Long-Term’ Lawful Permanent Residents, they would typically file a Form I-407 whereas U.S. Citizens must go through the process of formally renouncing their U.S. Citizenship in person. This is usually done at one of the consulates abroad and is a much more complicated process than terminating PR status, which generally just requires the filing of a Form I-407. Still, whether the Taxpayer renounces U.S. Citizenship or terminates their lawful permanent resident status, they may be subject to the same exit tax.

Expatriation Audits are on the Rise

Taxpayers who are considered U.S. citizens or long-term lawful permanent residents are required to file IRS Form 8854 in the year of expatriation as well as may be required to file annual forms for several years after they expatriate. The IRS has been finding that Taxpayers are not following the form or filing the form incorrectly, which ultimately results in the IRS losing out on exit tax revenue. Therefore, the IRS increased the enforcement protocols against Taxpayers who expatriate – and this usually begins with an audit of the Taxpayer after filing their exit tax forms with the IRS.

Is the Taxpayer a Covered Expatriate?

Taxpayers may qualify as covered expatriates if they fall into one of three specific categories (and do not qualify for an exception). There is the Net Worth Test, the Net Income Average Tax Liability Test, and the five-year tax compliance test. The most common way that a Taxpayer is considered a covered expatriate is if they meet the net worth test. And, the reason why the IRS has increased enforcement is because they are finding that Taxpayers are not properly calculating their net worth. Unlike the net income average tax liability test, the net worth test does not adjust for inflation, and the value is still set at $2,000,000. Just looking at the increase in house values in recent years, it is not uncommon for Taxpayers to meet the net worth test even though they do not have a high income, based on the value of their home. In addition, Taxpayers who may have worked for several years may have a high 401K and so the IRS believes that many Taxpayers are downplaying their net worth to avoid being considered covered expatriates.

Is the Taxpayer Subject to the Exit Tax?

Another common concern of the IRS is whether the Taxpayer is properly calculating the exit tax. When people think of the exit tax, they often think of mark-to-mark unrealized gain calculations, but that is only one component of the exit tax. Taxpayers may have ownership of foreign trusts, ineligible deferred compensation, specified tax-deferred accounts, etc. — which may all ultimately lead to a potential exit tax implication. In other words, even if the Taxpayer does not have any mark-to-market gain it does not mean that they are out of the woods just yet. The IRS is finding that Taxpayers are failing to take into consideration the value of other assets such as homes and retirement to calculate their exit tax.

Was the Exit Tax Form Calculated Properly?

While Taxpayers are not required to obtain a formal appraisal most of the time for assets they own at the time of expatriation, they still must conduct due diligence and include a fair market value of the assets. For example, sometimes Taxpayers will want to use an alternative valuation which may have a significantly lower value than the fair market value period from an IRS’s perspective the fair market value is what typically dictates the value of the property or asset.

For example, if a Taxpayer owns a property that is worth $2,000,000, then the fact that the appraisal value for real estate taxes is only $500,000 does not mean the property is then worth $500,000 for exit tax purposes — because the fair market value is $2,000,000. The same concept applies to various restricted stock units and other deferred compensation.

Calculation Issues to Consider

When calculating exit tax, Taxpayers should be aware of the following in case they find themselves subject to an audit or examination:

Jointly Owned Property

if property is jointly held then the default position is that it is 50/50 ownership, but this is not always the case. For example, if a Taxpayer has two names on a property but the Taxpayer who is exiting knows that they own 75% of the property then they cannot just take the position that the property is 50/50 when they know that the actual ownership percentage is 75/25.

Ineligible Deferred Compensation

One very common type of ineligible deferred compensation is Taxpayers who may have a foreign pension. Ineligible deferred compensation will typically result in that income source being deemed distributed on the day before exit. For example, if a Taxpayer is exiting the United States but has $1,000,000 in foreign pension, then generally that foreign pension is going to be grossed up in the final tax return even though that income was not distributed. Noting, that Taxpayers may receive a step-up value if they qualify for step-up treatment

Grantor Trust

The ownership of a grantor trust is also includable under the mark-to-market regime and valued under Internal Revenue Code section 2512.

Late Filing Penalties May Be Reduced or Avoided

For Taxpayers who did not timely file their FBAR and other international information-related reporting forms, 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.

*This resource may help Taxpayers seeking to hire offshore tax counsel: How to Hire an Offshore Disclosure Lawyer.

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