There are some specific issues that Americans should be aware of prior to giving up their US citizenship. One of those is to avoid being a Covered Expatriate.
What is a Covered Expatriate?
A covered expatriate is an individual who relinquishes his or her US citizenship or long-term US residency and who either: 1) has a five-year average annual income tax liability of more than $162,000 (all amounts are based on 2017 limits); 2) a net worth of $2,000,000 or greater on the date of expatriation; or 3) cannot certify compliance with US tax obligations for the five years prior to expatriation (via form 8854). An individual who meets any one of these criteria is referred to as a “covered expatriate.”
Why avoid being a covered expatriate?
A covered expatriate is required to determine if an exit tax is due at expatriation under the exit tax rules. This tax is based on a deemed sale of the individual’s assets. While there is an exit tax exclusion available to offset the first $699,000 of deemed gain calculated under the rules, please note that not all assets are eligible for this exclusion.
If the covered expatriate has any ‘ineligible deferred compensation’ (a foreign pension plan, for example), the full value of the account will be taxed as income on final return of the covered expatriate. If a covered expatriate has an ‘eligible deferred compensation plan’ (e.g. U.S. 401(k) plan) this too will be included on the final return as income unless certain steps are taken in a timely fashion. Timely is relative, under the current rules, form W-8CE must be filed within 30 days of expatriation with the plan administrator to defer tax (flat 30% withholding) until distribution.
In addition, gifts or bequests left to a US person by a covered expatriate may incur a tax payable by the US person at the prevailing gift tax rate (currently 40%).
What can I do?
If you are lucky enough to be a dual citizen by birth and living in your non-U.S. birth country at expatriation, you are exempt from both the net worth test and average liability test discussed above. However, you still need to be compliant with your US tax affairs for the five years prior to expatriation.
If you are not lucky enough to be a dual citizen, there are other methods to avoid the covered expatriate status or to lessen the blow of the exit tax. You can gift some of your assets prior to expatriation to get below the $2 million net asset threshold (or at least lower the amount of assets that will be taxed under the exit tax rules). The current gift rules allow you to gift up $5.49 million (2017 amount) in a lifetime, tax free. It should be noted that the gift should be made at least a year prior to expatriation. (Current Congressional tax proposals may substantially increase this amount in future years.)
Selling your principal residence is another possibility. There is an exclusion of up to $250,000 per spouse available to offset the gain on the sale of a principal residence. It is currently unclear if this exclusion is available under the exit tax rules when the home is deemed sold. Until this issue is clarified by the IRS, thought should be given to selling your principal residence prior to expatriation to properly claim the exclusion. The potential tax savings is roughly $100,000 (20% long term capital gains rate on $500,000 gain assuming both spouses qualify for the exclusion).
These are just some of the issues to be aware of when contemplating renunciation of US citizenship. The exit tax rules and tax filings are complex and require professional tax help. Seek advice from a qualified tax advisor well in advance of your expatriation. Mistakes in this area can be very costly.
US Tax & Financial Services is a specialist team of cross border US/UK tax professionals providing US and UK tax return preparation, planning, compliance, and expatriation as well as all US business tax services, wherever you are in the world.