Inside/Out Report: A Guide to Expatriation
The pernicious nature of taxation is no secret, although many seem to forget it. Take this quote from John Marshall, the longest serving chief justice in the history of the Supreme Court:
“An unlimited power to tax involves, necessarily, a power to destroy; because there is a limit beyond which no institution and no property can bear taxation.“
Let me first make one thing clear. To the extent that this message or any attachment concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law.
The decision to expatriate is a momentous one. We do not recommend it as a silver bullet to solve all your problems. It is a radical step that may uproot the life of comfort you have come to know.
The emotional and social impact of expatriating is beyond the scope of this report; only you and your family can properly assess such consequences. You may decide it’s not right for you. But comfort can be an illusion of the present – an illusion that breeds complacency. (Of course, we know, given your choice to join us at Bonner & Partners Family Office, that you have not been lulled by the present.)
The decision to expatriate is only part of a long-term plan. Therefore, extensive planning is necessary beforehand.
The law that now governs US expatriates is relatively new and has changed how one approaches the decision. As I explain in more depth below, expatriates are now subjected to a “mark to market” exit tax that will take a substantial bite out of their estate on the day of expatriation.
This exit tax may delay the decision of wealthier individuals to expatriate so that they can take advantage of current estate planning devices to lessen the bite.
But the exit tax may speed up the decision process for younger, less wealthy Americans who plan to build a lasting estate in the coming years.
The IRS is determined to lay claim to a substantial portion of your future growth. By “rendering unto Caesar what is Caesar’s now” you can make sure he has no claim over the rest of your life.
The exit tax may also speed up expatriation for those who just received a large inheritance. The exit tax, while potentially vicious for some, hardly threatens unappreciated assets at all. And the beauty of an inherited, estate is that your basis is its fair market value at the time of inheritance. If such is your situation, ask yourself whether it is wiser to move your estate elsewhere so that you have something to pass along to your heirs.
Of course, the longer you wait, the more you risk.
You know higher taxes are coming. And you know they will be aimed at you. Expatriating may have a high upfront cost, but it will free your wealth to grow well into the future.
At Bonner & Partners we are not afraid of radical moves, provided they are founded in sound reasoning and planning.
Given the coming tax hikes, we believe bold moves may be necessary for you to protect your wealth.
This report will give you the tools to decide whether this under- appreciated strategy is right for you.
Expatriation is not a political statement. The shape and character of your estate is guided not just by your decisions and successes but also by the laws that govern how assets grow and are taxed.
Renouncing your US citizenship and freeing yourself from the dictates of Uncle Sam can lead to substantial tax savings and give you more power to determine the ultimate form of your estate.
It is a near certainty that US taxes will become more restrictive on individual growth.
Nevertheless, expatriation is still a tool that is appropriate only for a select group. And even within that group, I wouldn’t be surprised if many discarded the idea.
Expatriation is a strategy for the future. It focuses on what will happen to your assets as they grow… and on keeping the benefit of that growth in your estate.
A person who knows nothing about farming would likely be shocked to see the annual burning of the fields. But the farmer knows that the seeming destruction is only cosmetic and impermanent; it disguises the fact that needed nutrients are being returned to the soil to ensure that next year’s crop will be robust.
So what is the future benefit? Simply put, the US tax system distinguishes between US citizens (or permanent residents) and non- resident aliens. A citizen is taxed on worldwide income. It doesn’t matter where that income comes from. And it doesn’t matter where you were when you made it. The magic words from the tax code are “all income from whatever source derived.”
Non-resident aliens are subject to different rates. First, they are generally subject to rate of 30% on US-sourced income that is not effectively connected with a US trade or business, unless the rate is reduced by a tax treaty. The maximum tax rate will likely reach 39.6% (and even higher) for US citizens in the near future (and this does not take into account state income taxes and Medicare taxes.) So 30% isn’t bad.
A non-resident alien is also subject to graduated tax rates on income that is effectively connected to a US trade or business. These graduated rates also apply to certain property sales in the US. But a non-resident alien is not subject to taxes on net capital gains, unless they are effectively connected to a US trade or business (or fall within another narrow exception, discussed further below).
We will get into the specifics of “non-resident aliens” and the different forms of property later on. For now, keep in mind that these individuals, if they are wealthy, will qualify for beneficial tax rates on US-sourced income. They’ll also be free of the US income tax for non-US sourced income, as well as much of the capital gains tax.
The Estate Tax
The estate tax is a significant threat to the wealth you have spent a lifetime earning. Like income tax, the estate tax hits a citizen’s worldwide estate.
In 2010, the estate tax as abolished. That’s right: no taxes, on an estate passed along in 2010, regardless of its size. But for 2011 and 2010, the exemption was reinstated at $5 million, and the highest tax rate skyrockets to 35%. That means more than a third of your entire estate over $5 million will help fuel Washington’s spending habits for the next two years. Further, after 2012, the estate tax exemption and estate tax rates will be anyone’s guess.
The good news is non-resident aliens will be able to slip out from under much of this looming tax burden.
Although US residents are taxed on the transfer of any property— regardless of where it’s located – when it is passed along at death, non- resident aliens are only taxed on property located within the US.
Granted, this will still include a lot of property, such as stock in domestic corporations, etc.
But there is a huge opportunity here. The US does not tax stocks held by non-resident aliens in foreign corporations. That means you can escape the noose of the estate tax by buying and holding US assets through a foreign corporation.
The Gift Tax
The gift tax applies to tangible personal or real property held within the US. Intangible assets, such as stocks and other securities, will generally be shielded from the tax for the non-resident alien.
If you are not a US citizen… and if you don’t reside in the US… the estate and gift tax will only fall on property physically located within the US after expatriation. You can pass on worldwide property, and properly managed US securities, without manhandling by the IRS.
What Is a Non-Resident Alien?
A non-US citizen will be evaluated for tax purposes under the “substantial presence test.” This person will be considered a resident alien (and therefore subject to taxation) if he or she is physically present in the US for at least 31 days during the calendar year and a total of 183 days during that same year and the previous two added together after certain adjustments are made for days of the previous two years.
The requirement is not as restrictive as it sounds. First, the 31 days in the current year is a threshold – if it is not reached, it doesn’t matter if the person has been there for more than 183 days in the preceding years. Second, the days in previous years are weighted (that is one-third for days in the previous year and one-sixth for days in the year before that.)
You will be restricted on the amount of time you spend in the US to keep your non-resident alien status, especially in the years immediately after expatriation. But within three years of your expatriation (since days are discounted for previous years) you will be able to spend substantial periods in the US without giving up your newly-acquired beneficial tax status.
There are exceptions for individuals who meet something called the “substantial presence test”; complexity, after all, is the hallmark of the tax code. Non-citizens who meet the requirements of the test can still avoid taxation if able to establish that:
1. They were present in the US for fewer than 183 days in the current year; and
2. Have a tax home in a country to which they have a close connection than to the US; or
3. They are considered a tax resident of another country that has a tax treaty with the US (in which case the tax home will be determined by the individual’s “permanent residence.”)
So, under certain circumstances, you can claim non-resident alien status, and avoid taxation, while still spending just under half the year in the US.
Let me give you a few numbers to put the benefits of expatriation into perspective.
Let’s say you hold a portfolio of US securities valued at $6 million, with a basis of $1 million dollars and dividends of $200,000. As a US citizen you pay a 15% tax on your dividends. (Remember: this rate will likely increase in 2013.)
If you sold your securities you would be looking at a gain all of which will be taxed at the top capital gains rate (currently 15%). If you had passed away in 2009 and left the securities to your children, they would have had to pay the 45% rate on $2.5 million – and 35% on $1 million in 2011.
Now let’s say you are a non-resident alien. You’ve still got the house in the US where you can stay nearly six months out of the year. You also have your permanent home outside the US. And let’s say you hold those same securities through a foreign corporation.
You’d still likely have to pay taxes on the dividends. But if you wanted to sell the securities there would likely be no tax. And there would be no tax if you left them to your children in your will – because they are held by a foreign corporation and therefore aren’t located in the US.
I’m sure you can start to see how the prospect of avoiding the capital gains and estate taxes can be enticing for many people.
A Hardening of Heart
Keeping money away from the Department of the Treasury will always be a battle. And that battle is getting tougher all the time.
On June 12, 2008, President Bush signed the Heroes Earnings Assistance and Relief Tax (Heart) Act. This built on earlier amendments to the law passed in 2004. And it completed changes that radically affect not only who is taxed but also how they are taxed. Most importantly, the law imposes a hefty exit tax on wealthier expatriates.
See, the Heart Act applies to “covered expatriates.” And if you terminate your US citizenship, you will feel its sting if you meet any of the following conditions:
1. Your average annual net income tax liability for the five years before expatriation is more than $124,000 (as indexed each year.
2. Your net worth is more than $2 million.
3. You fail to certify under penalty of perjury that you have complied with all of your US federal tax obligations for the past five years.
These rules are fixed – except for dual citizens and minors. If you or your spouse has dual-citizenship, you may be able to legally shift assets and take advantage of the exception. To qualify, a dual-citizen must show they are taxed as a resident in the other country and have not been a US resident for more than 10 of the last 15 years.
A minor can avoid the Heart Act if he or she was a resident for no more than ten years before expatriating.
It is especially important for you to discuss this strategy with a professional estate tax attorney who can advise you on your particular circumstances. You would not want your transfers to be disallowed after the fact, or deemed as fraudulent, should you employ this strategy.
The Exit Tax
The exit tax is the most punitive change to the law that governs expatriates. It guarantees the US government will get its taxes, and will get them now. And it presents planning problems because for its heftiness and its apparent disregard for liquidity issues.
Traditionally, expatriates were subject to a ten-year reporting period. If they sold assets within the window after expatriating, they were required to pay taxes to the US government on the sale. That is to say expatriation was a waiting game: if you could hold your assets long-term, you could wait out the tax. The imposition of the exit tax doesn’t kill the benefits of expatriation. But it does threaten it. It doesn’t force you to sell your property. But for tax purposes the feds will send you a bill as if you had. And the unfortunate thing is that this applies under normal US tax rules. Your worldwide assets will be considered sold, and you will be taxed as if you had made that entire income in one year.
Obviously, this can lead to a large tax bill – and to being taxed as though you had sold property that you most likely haven’t. This can lead to liquidity problems; after all, paying taxes is premised on the idea that you actually made money.
The IRS allows you to defer the payment of the exit tax. But there is a steep price: your unpaid taxes will accrue interest at the normal rate for unpaid taxes.
You can defer the tax on a property-by-property basis. But you must put up a bond. And the tax (plus interest) will be due the year the property is sold.
The exit tax is a big change from earlier policy. Previously, property of expatriates was tracked for ten years. If you could hold onto it beyond that period, then you were free from the tax. This favored wealthy individuals who could support themselves while holding property long term. But as the government has cracked down on expatriation, Congress has gotten smarter. Now, the moment you try and walk out the door, the IRS will be standing there with hand politely extended.
If you are thinking about expatriating, it is important to know the following categories receive special treatment:
1) Tax deferred accounts and deferred compensation
2) Trust interests
3) Transfer tax on gifts and bequests
The details are complex. If you hold any of the above interests, talk to an accountant or qualified tax lawyer to get the specific details of your potential tax obligations.
Forward Planning: Treatment of Gifts and Bequests
You may be considering expatriation for yourself. But if the decision is motivated by a desire to plan for your family, then there are certain provisions you should be aware of because they create a huge disincentive for some individuals. I am speaking here of the transfer tax on gifts and bequests, mentioned above.
The transfer tax applies to “covered gifts or bequests” received by a US citizen or resident. Covered property is any gift directly or indirectly from a covered expatriate or property received directly or indirectly from a deceased covered expatriate. This means if your children or family remain US citizens, they will have to pay a tax on any gifts or inheritance from you as a covered expatriate.
This tax will be assessed at the greater of the highest marginal rate of the gift or estate tax. Luckily, you can avoid it up to an extent. It applies only to gifts above the annual exemption – currently $13,000 a year. This tax is also reduced by any estate or gift tax paid to another country. The covered expatriate is therefore liable for estate and gift transfers for property located inside the US and for taxes on property outside the US that is given to a US citizen.
Obviously, the transfer tax can be a substantial burden on those who are planning to leave much of their estate to people who remain US citizens. Because of this wall many have become much more hesitant to expatriate.
The transfer tax is a real obstacle for some. It gives rise to constitutional concerns regarding double taxation that, as far as I know, have yet to be resolved under the new law.
For instance, would property that you had been taxed on at the time of expatriation be again subject to the transfer tax?
Although I do not encourage you to become a test case for IRS enforcement, the transfer tax highlights the importance of planning. And underlines once again that expatriation would be just a part – albeit a very important one – of your overall strategy. By taking advantage of pre-expatriation transfers you can lessen any potential exit tax and pre- plan the distribution of your estate.
Of course, smart tax strategists will exploit foreign entities as holding companies for assets. Beneficiaries who remain US citizens may still have to pay some tax on property received from foreign entities. But they may be able to avoid the highest rates imposed by the transfer tax.
Your tax planning will not end with expatriation. But you may find yourself more flexible in your options under a different tax regime.
Forward Planning: Shrinking Your Estate Before Expatriation
I want to leave you with several positive planning possibilities and strategies. Whether or not you are considering expatriation, the efficient management of your estate, and the thoughtful disposition of it, can save it from substantial trimming by the IRS.
As mentioned above, IRC §2503(b) allows for yearly gifts, exempt from any gift tax, to any particular individual each year. This applies to both a husband and wife, so together they can gift $26,000 to each child, grandchild, etc. And the gifts can be repeated year after year.
Gifts to any individual totaling more than $13,000 in a year will be subject to the gift tax, paid by the giver of the gift. But the unified credit allows for a tax credit against lifetime credit. The unified credit for 2011 and 2012 allows for a tax credit against lifetime gifts up to a total of $5 million in value (over any applicable annual exclusion). But using the credit will reduce your overall estate tax exemption on any inheritance.
As I’ve already mentioned, the estate tax is in flux, though it is $5 million currently and is likely to stay at or above $3.5 million.
Taking advantage of the annual exclusions can allow you to trim down your estate while preserving its ownership by your family and loved ones.
Whether you are trying to mitigate the severity of the exit tax when expatriating or planning to stay domestically and deal with the estate tax, a comprehensive plan may lower any potential taxes due.
Remember also that the exit tax applies to realized gains. If you have low value assets that you expect considerable appreciation from, getting out quicker will only do you good. Or if you just received an inheritance, the gain will be calculated from a stepped-up basis. In fact, there may not be any tax due on a substantial estate.
You can also take advantage of the annual gift exclusion for a few years and dispense low-basis assets that have already appreciated substantially while retaining the high basis ones for yourself.
As you can see, once you know the basics of the exit tax, you can start to plan for it and place yourself in a position to avoid its worst bite. Given the favorable tax treatment you could enjoy for many years to come, you may even decide that you need to take the plunge through the exit tax.
Although it will likely be bracing at first, you may find that you warm considerably quickly in a sunnier tax climate.
Who Should Be Considering Expatriation?
The exit tax can be a substantial burden on the expatriate. But remember: This exit tax is a one-time deal. Once the IRS has put you through the ringer, the benefits of expatriation remain.
Like cauterizing a wound, the immediate pain may be worth the long- term gain.
Expatriation is a big step for anyone. Beyond dealing with the exit tax, it is an emotional and life-changing event. Yet many forward- thinking families are seriously considering it.
Storm clouds are gathering over the wealthy in the US, as unchecked spending and unfunded entitlements drive the public debt to stratospheric levels. Your tax burden already hits hard… in the near future, this weight may become suffocating.
Believe it or not, the current economic climate presents you with a window of opportunity. People of all wealth levels have seen their estates shrink. The upside of this drop in value is that it will result in a much lower exit tax than expatriating in rosier times. If your holdings are low in value now, but you expect substantial growth when things turn around, then now may be the time to walk away. Especially since US tax increases are certain in the near future.
Expatriation may also make a lot of sense for those who recently received an inheritance. Under estate tax rules, inherited property receives a “stepped-up basis.” This means that the person who inherited the property is considered to have bought it at the fair market value price at the time of inheritance. And it is this number from which any unrealized gain is calculated from. Therefore, as the recent beneficiary of an inheritance, your “selling price” under the exit tax would be very close to your “buying price” – meaning there is very little gain to tax.
Expatriation may also make sense for young entrepreneurs. As mentioned above, the Heart Act applies to those with substantial holdings. This country is doing its best to break the backs of the coming generations. And some of you out there may decide to throw off the yoke before submitting to years of labor for the government.
Expatriation is for the wealthy and those who expect to see substantial growth in their assets. It is for the mobile – those who are both able and willing to uproot and search for more fertile ground. It is a forward- looking decision, based on assessing the potential for future growth and weighing your needs and desires against future tax burdens.
It is a radical decision. But that doesn’t mean you need to be a radical to expatriate.
Take a sober look at your current position, at your own and your family’s character and wishes, and at the potential for future taxes. We can never know the future with certainty, but we can see where it’s trending.
You may decide that the future is brighter somewhere else… or you may not. At Bonner & Partners we are simply interested in making sure you are aware of the choices available to you.