The ever increasing complexity of the US tax system, particularly as it impacts US citizens overseas, has resulted in an ever increasing number of citizens giving up their citizenship. However, giving up one’s citizenship can be quite costly, as the US imposes an “exit tax” on the renouncing of citizenship under certain circumstances (referred to as “covered expats”).
The exit tax applies if, at the time of renunciation, the taxpayer has a net worth in excess of $2 million, has failed to comply with the tax filing obligations for the last five years, or has had an average income tax liability for the last five years of $161,000, for 2016 expatriates. (This amount is adjusted annually for inflation).
Briefly, the exit tax has two elements. Firstly, the taxpayer is treated as if he or she had sold all of their assets the day before renunciation. Any deemed gain, in excess of $693,000 (adjusted for inflation) is included on the individual’s income tax return and subject to tax just as if the gain had actually been realized.
The second element requires the taxpayer to accelerate all deferred compensation, (pensions, IRA, deferred compensation plans, foreign pensions etc.) and treat all such amounts as if they were received on the day before renunciation.
The combination of the two elements can clearly have a major cash flow impact on the taxpayer. Further, it is likely that at some point in the future she or he will owe foreign tax on the item. As neither the US nor the foreign country is likely to give credit for the taxes paid to the other country, true double tax will occur.
The above rules also apply to green card holders who have held the green card during any part of eight or the last fifteen tax years. These individuals are classified as “long-term residents” and the exit tax can have a devastating impact on them as well.
What many green card holders are not aware of, is that the US tax and immigration rules work differently. For immigration purposes the green card may lose its validity if the individual leaves the US for an extended period of time. However, for tax purposes, the individual remains subject to worldwide US tax until the green card is formally given up. As a result, many green card holders who have just thrown the green card in the drawer thinking it was nothing for them to worry about, suddenly find out not only are they subject to US tax, but, because of the exit tax, they cannot afford to give it up.
There is one other aspect of the Exit tax provisions that should be considered. If the individual is a covered expat, any gifts they make during their life, or any assets they leave at death to a US citizen or resident will be subject to a substitute gift/estate tax, currently subject to a 40% tax rate.
For these taxpayers, it may be possible to restructure their estate to reduce their net worth below the $2 million trigger amount. For those who have not been compliant with their obligation to file/pay US income tax, there are also programs available to bring them into compliance. These individuals should consult a qualified US tax advisor.