Exit Tax Trust

The Exit Tax Playbook: A Comprehensive Guide to Planning Strategies

The purpose of this guide is to empower the general public with the knowledge needed to successfully expatriate from the United States without any punitive tax consequences. A free and open society should not seek to punish those that wish to leave the society.[1] That is the antithesis of a free and open democratic society.

Section One: Overview

A Page of History is Worth of Volume of Logic

In the first year following the close of the Second World War, the top marginal income tax rate on income over $200,000 (est. $1.6m today when adjusted for inflation) was 91% and remained at that rate until 1963.[2] In response, many high earners and families with high net worths began to relinquish their United States citizenship. In the post-world war environment, this renunciation of citizenship during a time of national unification and common sacrifice was largely viewed as unpatriotic. In 1966, after both the Kennedy and Johnson Administrations successfully lowered the top marginal tax rate from 91% to 70%, Congress also enacted Internal Revenue Code section 877 that was designed to treat the act of expatriation as a taxable event; a deemed sale on worldwide assets to capture the built-in gains of an individual’s worldwide assets before they permanently depart from the United States. From the perspective of the U.S. government, the gains were accrued using the privileges and protections of being a U.S. citizen, so it was only fair the U.S. should tax those gains before the individual permanently departed, which would mean the U.S. would correspondingly permanently lose taxing jurisdiction over the gain.

Over the next 43 years, Section 877 remained largely unchanged. In 1982, Enrico Di Portanova challenged the constitutionality of Section 877 on the basis that it denied fundamental due process rights.[3] Although he lost his case before the U.S. Court of Federal Claims, the court clarified that Section 877 was only “enacted to forestall tax-motivated expatriation.”[4] Nevertheless, in effect, many felt it was simply designed to discourage expatriation in general.

In response to growing discontent with Section 877, the Bush Administration took action. In 2008, Congress enacted Section 877A.[5] For the most part, it overruled Section 877, which now largely only exists as a reference for the definition of terms used in the new Section 877A, such as the criteria for an individual to be deemed a “covered expatriate.”[6]

What is the “Exit” Tax

An “act of expatriation” is whenever an individual departs from a country.[7] However, not all expatriating acts are covered by Sections 877 and 877A. A listed act of expatriation is one that gives rise to a deemed sale of all assets owned worldwide.[8] For example, one listed act of expatriation is a U.S. citizen who renounces citizenship.[9] Another listed act of expatriation is a U.S. lawful permanent resident “green card holder” who has held that status for 8 or more of the last 15 calendar years and decides to formally relinquish the green card by filing USCIS Form i-407.[10]

Now, whether you are an expatriate covered by Section 877A (i.e., a “covered expatriate”) is a separate question. However, before discussing what constitutes being a “covered expatriate,” it is critical to emphasize the notable exemptions.

At-Birth Dual Citizens Not Residing in the U.S.

First, if you were a dual citizen at birth of both the U.S. and another country, and you have not met the Substantial Presence Test for 11 or more of the last 15 calendar years including the current year of intended expatriation, you are exempt from the “covered expatriate” analysis and thus exempt from the Exit Tax.[11] For most at-birth dual nationals that depart and then seek to expatriate, this means you have not met the Substantial Presence Test for the last 5 years including the current year of intended expatriation.

From a planning perspective, this means that if you were a dual citizen at birth, then simply departing from the U.S. and then waiting 5 years before expatriating would exempt you from the Exit Tax. If you already meet this prerequisite, then you’re free to expatriate right now without consequence.

Expatriation as a Minor

Second, if you are under the age of 18½ and have been a resident no more than 10 years since birth, you are exempt from the “covered expatriate” analysis and thus exempt from the Exit Tax.[12] While this generally means you left the U.S. before reaching the age of 9, you must analyze each calendar year separately to determine if you qualified as a resident under the substantial presence test.

What is a “Covered Expatriate”

As discussed above, a U.S. citizen that relinquishes citizenship or a long-term lawful permanent resident that formally abandons a green card by filing USCIS Form i-407 is an “expatriate.”[13] The term “covered expatriate,” however, is a federal tax term that refers to whether that expatriate is covered by the Section 877A “Exit Tax.”

Please note that all of the figures used herein presume the year of expatriation is 2018. Many of the dollar figures are indexed to inflation, so they change each year. Please be certain to check for changes in the dollar figures for years after 2018.

A “covered expatriate” is an expatriate that satisfies one of three tests.[14] In short, the three tests are designed to target three classes of individuals: high earning individuals, high net worth individuals, and noncompliant individuals.

Tax Liability Test: High Earners Not Rich Yet (HENRYs)

If an expatriate’s average income tax liability for the past 5 tax years is more than $165,000, which would generally require a single individual to have wages of $535,000 or more, then that expatriate is now deemed to be a “covered expatriate” subject to the Exit Tax.[15]

The term “annual net income tax” used in Section 877(a)(2)(A) makes a direct reference to Section 38(c)’s definition of the term, which says the “sum of the regular tax liability and the [AMT]… reduced by credits allowable under [Sections 21 to 30d, such as the foreign tax credit, child tax credit, and education credits].”[16] On the Form 1040, this is the figure just above the “other taxes” section.

The Net Worth Test

If an expatriate’s good-faith self-assessed net worth (total assets minus total liabilities) is $2,000,000 or more, then that individual is a “covered expatriate.”[17]

Although IRS Notice 97-19 allows for a reasonable good-faith estimate with regard to the fair market value of assets, it purported to add restrictions and limitations on valuation methods that are otherwise respected for estate tax planning purposes.[18] In a stunningly contradictory section, IRS Notice 97-19 also purports to claim that, although valuation methods for gift and estate tax purposes are not permitted, the determination of whether a person is deemed to own an asset for net worth calculation purposes is based on whether a transfer of the asset would give rise to gift taxation.[19]

This is significant because the IRS is saying they want it both ways: no gift/estate tax valuation methods are permitted, but ownership is determined in accordance with gift/estate tax provisions. This stunning contradiction will not be overlooked by the courts, and it illustrates why the IRS has been reluctant to take Exit Tax cases to court; their interpretation is one-sided and would never be upheld by the courts. For if solely income tax principles applied, a DING Trust would defeat the Exit Tax since it is a separate taxpayer that could reduce net worth down to zero. And if solely gift/estate tax principles applied, a BDIT would defeat the Exit Tax since it is a completed gift. The IRS is trying to have it both ways, and our firm is laying the foundation to have these issues resolved by the courts to provide taxpayers with clarity with regard to their legal obligations. We’ll discuss these two legal strategies later in this article.

Furthermore, why would an income tax provision rely on gift and estate tax principles to begin with? As both the U.S. Court of Federal Claims and the U.S. Tax Court have explained, Section 877 was enacted with the limited purpose of forestalling income tax-motivated expatriations.[20] Section 877 is an income tax provision. It is designed to capture built-in gain for income tax purposes.[21] It is not designed to have any effect for gift and estate tax purposes.[22] It does not result in a deemed death to accelerate estate tax on net worth; it results in a deemed sale to accelerate income tax on gains. Therefore, income tax principles and income tax principles alone should guide its interpretation and enforcement.

Personally, this author believes, from a purely policy standpoint, because Sections 877 and 877A are income tax provisions, the test for whether an individual is the owner of an asset should be determined by analyzing whether that individual would be personally liable for income tax upon the gain arising from the sale of that asset. In that case, a DING Trust would defeat the Exit Tax, but we’ll discuss that more later in this article. Policy beliefs aside, there is nothing that prevents a tax attorney from claiming valuation discounts if beneficial to an ongoing case given the lack of Treasury regulations. IRS Notices are only given respect in court to the extent the legal position is sound, which is the same standard that would be applied to this article that you are now reading; that’s a legally fanciful way of saying that IRS Notices are not given any deference in a court of law. In other words, this article has the same legal weight in a court of law as the IRS Notice.

Let us now examine the third and final test for determining whether an expatriate is a “covered expatriate.”

The Noncompliance Test

This is simple and straightforward. You must certify compliance with all U.S. federal tax obligations for the 5 calendar years preceding the year of expatriation.[23] If you have not been compliant, you will want to consider the “Streamlined Filing Compliance” program as well as the “Delinquent FBAR Filing” program; both of which are tax amnesty programs that allow noncompliant taxpayers to come back into compliance without the risk of penalties.

If any practitioner suggests the need to do a full-scale Offshore Voluntary Disclosure Program (OVDP) submission and you are confident that you were merely innocently negligent in your failure to comply with the law, run far from that attorney. Full-blown OVDP cases are extremely expensive, which is likely the reason why the attorney is pushing it on you. Contact our law firm to speak with one of our attorneys for a second opinion.

Calculating Exit Tax Exposure

Assuming you are a “covered expatriate,” it is not the end of the world, and you do not need to contact a law firm yet. You still have to determine whether you have any actual Exit Tax exposure.

The $713,000 Exemption

The first and most important thing to remember is that the Exit Tax only applies to built-in gains in worldwide assets, and there’s a very generous exclusion of $713,000.[24] That’s right: the first $713,000 of built-in gains is excluded.[25] To calculate your exposure, you can contact our firm to request the Exit Tax Spreadsheet. This is the same spreadsheet we provide every client that engages us for Exit Tax Planning. If your total built-in gains are less than $713,000, then you do not need to engage any law firm. If it is slightly over, you would want to determine whether the cost of engaging a firm would be greater than the potential tax savings that would result from the legal engagement. If engaging a law firm is not necessary, you can have any CPA with experience preparing IRS Form 8854 handle your final tax return preparation and submission for a miniscule fraction of what you would otherwise pay a law firm like ours for Exit Tax Planning. We have CPAs on staff and would be happy to handle it, but it is up to you whom to utilize. A word of caution though, there are those out there who would leverage the average person’s lack of knowledge and sophistication on this subject to extract exorbitant fees to handle a relatively easy process. Our goal is that, through this article, you will educate yourself and be less likely to fall victim to unethical “professionals” in the area of expatriation planning.

Naturalized Citizens and Green Card Holders Calculate Gains Differently

The second most important thing to remember is that, if you are a Naturalized U.S. citizen (i.e., you were not born a U.S. citizen) or a lawful permanent resident “green card holder,” then, upon expatriation, your basis is calculated differently than for U.S. citizens.[26] For U.S. citizens, adjusted basis is determined by adding the purchase cost and any permitted basis adjustments.[27] While this is also true for noncitizens in ordinary circumstances, in the context of the Exit Tax, it is different. The basis in worldwide assets for a naturalized citizen or a long-term lawful permanent resident “green card holder” is the fair market value of the assets on the date the individual first arrived to the U.S. unless the individual elects out of this default rule under 877A(h)(2).

To make this determination of whether to leave your basis as the fair market value the date you first arrived to the U.S. or to elect to apply the regular basis calculation rules (purchase cost plus improvements and other adjustments), you need to calculate your total net gains under both scenarios.

The first step is to determine the original purchase cost of all of the assets. The second step is to add any permitted adjustments to those figures, such as capital improvements. Any relatively competent CPA ought to be able to assist with this exercise. The third step is to subtract that amount from the current fair market values of all assets. This figure is your “opt out calculated gain.”

The next thing you want to determine is the fair market values of the assets on the date you first arrived to the U.S. The IRS allows you to make reasonable, good-faith estimates with regard to the values. Once you have those amounts, subtract it from the current fair market value. This gives you to the “default calculated gain.” If the default calculated gain is less than the opt-out calculated gain, no action is necessary. This generally means a means you have a health portfolio of assets that have appreciated over time. If, however, the default calculated gain is more than the opt-out calculated gain, that means your total portfolio of assets have depreciated, so you are better off filing an election under Section 877A(h)(2).

This is understandably tedious, and our firm is here to assist. If you have already determined that you are a covered expatriate, used our spreadsheet and concluded your gains have exposure being over $713,000, then I would advise you contact our firm. Nevertheless, if you are a true do-it-yourselfer or a fellow international tax professional looking to learn the secrets of the trade, please continue reading.

Treasury Regulations

Most people are surprised to learn that, in the 52 years that Section 877 has existed, Treasury has not promulgated a single regulation interpreting it. In fact, the term “surprised” is an understatement. Ask any tax attorney, and they’ll confirm it is absolutely bizarre. Likewise, in the 10 years that Section 877A has existed, Treasury has not promulgated any regulations interpreting it. The significance of this is that neither the U.S. Treasury nor the IRS are afforded any deference with regard to their interpretation of the provisions. This means that any reasonable interpretation of Section 877 and 877A is permissible, which creates more planning flexibility and substantially reduces the likelihood of examination.

There are those who would argue otherwise and we certainly welcome healthy debate on the issue. However, our goal in publishing this information is to provide information to dispel “expatriation myths” that could potentially be and have been used to prey upon people’s fears due to their lack of understanding of these highly complex international tax provisions. But do not take our word for it; ask your tax professional this one question: since enacted in 2008, has there ever been a court ruling specifically interpreting Section 877A? The last case to substantively address the Exit Tax was in 1984.[28] This is because the IRS is not confident on how to interpret the statute. This is where good lawyering comes into play.

Section Two: Planning Solutions

Plan A (Noncitizens Only): Treaty-Based Nonresidency

If a U.S. lawful permanent resident “green card holder” takes a treaty-based nonresidency position pursuant to an applicable income tax treaty’s “residency tie-breaker provisions,” that is deemed to be an “expatriating act.”[29] However, years in which an individual makes such an election are not counted toward the “8 out of the last 15 years” rule. Now, some tax professionals will emphasize that you cannot amend a tax return beyond three years; however, this is an incorrect interpretation of the law. Section 6511 places a three-year limit on claiming refunds; not amending the information of a prior-year return. The significance of this is that you can retroactively expatriate to avoid the “8 out of the last 15 years” rule. If this sounds too good to be true, you can read a report from the U.S. Joint Committee on Taxation that specifically addressed this legal loophole.[30] This Congressional committee recommended legislation to eliminate this loophole in 2003, but Congress unsurprisingly never took action on their recommendations.

Plan B: Employ Estate Planning Techniques to Reduce Net Worth

U.S. Citizens and long-term green card holders that are U.S. domiciliaries are entitled to an $11.2m lifetime gift and estate tax exemption. With that in mind, it is possible to employ standard estate planning techniques, including valuation discounts (e.g., artificially reducing the value of assets by placing them into restricted form, such as a Family LLC subject to buy-sell agreements), to reduce net worth below the $2,000,000 threshold in order to lawfully avoid the designation of a “covered expatriate.”

To illustrate the power of this option, a married couple that are both expatriating could transfer $22.4m to their children, reduce their net worth down to zero, and expatriate without any Exit Tax exposure. Even if all of the assets are legally owned by only one spouse, an Alaska Community Property Trust also structured to qualify as a Qualified Domestic Trust (QDOT) could be utilized to fully utilize the combined lifetime gift and estate tax exemption. Fully utilizing your lifetime gift and estate tax exemption prior to expatriation is absolutely critical to consider. Utilizing valuation discounts can effectively double the joint exemption amount to $44.8m.

Nevertheless, for individuals that do not have potential beneficiaries or have a net worth far in excess of $11.2m (generally, more than $50m), this may not be feasible.

Plans C and D

As explained above, the IRS needs to make a decision on whether to apply income tax principles or gift/estate tax principles; it cannot apply both. To do raises “void for vagueness” constitutional arguments. In the U.S., even a law passed by Congress can be invalidated by the courts if it is vague. This is because, in a transparent and democratic society, ordinary Americans must be able to understand the law so they can comply with the law. For if a law is vague, the individual is being set up for failure. For this reason, the U.S. Supreme Court will deem a law unconstitutionally vague if it is unclear on its face and no regulations are issued to formally interpret it. This is precisely the case with Sections 877 and 877A. The Department of the Treasury is in dereliction of their duty. They need to do their job and clarify the law by promulgating regulations. Nevertheless, there are two valid interpretations of Sections 877 and 877A with regard to the net worth test. Planning under either will absolutely be respected in a court of law because to not respect it would give rise to a constitutional challenge, which the IRS would not be able to overcome.

The first interpretation is that Sections 877 and 877A are income tax provisions and, therefore, only income tax principles should apply, which means the references to gift tax principles in IRS Notice 97-19 are invalid. In this case, which is admittedly the favored interpretation of our firm, a DING Trust would entirely defeat the Exit Tax, which we’ll discuss below.

The second interpretation is that Sections 877 and 877A are income tax provisions, but the principles of gift and estate ownership should be applied. This, however, would invalidate the attempt by IRS Notice 97-19 to negate the application of valuation discounts. For if you choose to apply gift tax principles for ownership testing for net worth calculation purposes, then you must reasonably permit estate tax asset valuation principles as well. The IRS cannot have it both ways, especially since Congress did not provide the authority for them to interpret the statute in such a one-sided and contradictory way. In this case, a BDIT would entirely defeat the Exit Tax, which we’ll discuss later below.

Plan C: The DING Trust

Applying the first interpretation of Sections 877 and 877A: only income tax principles apply. In this scenario, a Delaware Incomplete Non-Grantor Trust can be employed to lawfully defeat the Exit Tax.

A Delaware Incomplete Non-Grantor (DING) Trust is a trust that is treated as a separate taxpayer for income tax purposes yet not considered a completed transfer for gift and estate tax purposes. The significance of this is that, if you transfer stock to a DING Trust and then sell the stock, it is deemed to be capital gain taxable by a tax resident of Delaware; not your home state.

For example, if you are a resident of California with a maximum state individual income tax rate of 12.3%. If you sell your entire portfolio of stock with $10m of net gain, your California state income tax liability will be an estimated $1,200,000. If, however, you transfer the stock to a DING Trust, that then sells the stock; the tax liability will rest with the trust; not you. As such, the trust pays capital gains tax, and, when it distributes the net after-tax amount to you, it is considered nontaxable principal corpus. Thus, you escaped California state income tax on the capital gain. Sound too good to be true? Well, it was the IRS that blessed this tax strategy by issuing Private Letter Rulings (PLRs) 201310002-201310006. Well, this IRS-backed state tax avoidance strategy is now coming back to haunt them.

By recognizing DING Trusts, the IRS has effectively declared that, if an expatriate contributes all of their net worth to a DING Trust, that individual, under federal income tax principles, is no longer the owner of the resulting capital gains tax liability and, thus, not the owner for purposes of Sections 877 and 877A’s Net Worth Test. Therefore, an individual can contribute their entire net worth into a DING Trust, avoid the designation of being a “covered expatriate,” and complete expatriation without any Exit Tax exposure.

If the DING Trust later distributes the assets back to the grantor, under existing U.S. trust taxation rules, there is no Distributable Net Income (DNI); thus, there is no withholding tax or income tax associated with the distribution.

Furthermore, because it is a distribution to an individual, Section 684 is inapplicable. Moreover, because Section 877A(f)(1)(B) only applies to “covered expatriates,” the distribution is not deemed to be a sale if the DING Trust was properly utilized to reduce net worth below the $2,000,000 threshold.

In fact, even if the trust were to simply convert from a non-grantor trust to a grantor trust, an IRS Chief Counsel Advisory has concluded that would not be a taxable event.[31]

Plan D: The BDIT

Applying the second interpretation of Sections 877 and 877A: only gift and estate tax principles apply. In this scenario, a Beneficiary Defective Inheritor’s Trust (BDIT) can be employed to lawfully defeat the Exit Tax.

It is a grantor trust, so how is it not counted toward Exit Tax Net Worth? Well, it is a completed gift, so, in accordance with IRS Notice 97-19, it is not counted for net worth calculation purposes. Therefore, an individual can potentially utilize a BDIT trust to lawfully avoid the Exit Tax.

The BDIT, much more than other trust structures, requires extremely careful planning to implement. The reason for this is that the BDIT requires a completed gift to occur, followed by assumption of grantor status by the originally named beneficiary, and any other assets acquired by the trust must be through purchase rather than by gift.

Similar to the above DING Trust strategy, an individual could expatriate and avoid the “covered expatriate” status and thus avoid the Exit Tax. Additionally, the BDIT is a “grantor” trust so any taxable items would already be taxed to the beneficiary/grantor. Thus, the trust would not be taxed and there would not be tax concerns on the distribution.

Section Three: Next Steps for You

Conclusion

As stated in the opening, the purpose of this guide is to empower the general public with the knowledge needed to successfully expatriate from the United States. Nevertheless, only a fool would attempt to learn how to sail a boat by reading an article before embarking on a voyage to sail across the Atlantic. If you are still considering the do-it-yourself route, please note that these are incredibly dangerous waters you’re attempting to navigate.

Our firm provides free consultations. We strongly recommend you contact us for one.


[1] From a policy standpoint, unless it is proven that the departure is indisputably an attempt to evade tax on income generated using the privileges and protections of the United States, there should be no deemed sale upon expatriation.

[2] Individual Income Tax Act of 1944, ch. 10, §§ 3, 4(a), 58 Stat. 231, 231-32; Revenue Act of 1964, Pub. L. No. 88-272, § 111(a), 78 Stat. 19, 22-23.

[3] See Di Portanova v. U.S., 690 F.2d 169 (Ct. Cl. 1982).

[4] Id. (citing Kronenberg v. C.I.R., 64 T.C. 428, 434 (1975).

[5] Heroes Earnings Assistance and Relief Tax Act of 2008, Pub. L. No. 110-245, 122 Stat. 1624 (codified in scattered sections of 26 U.S.C.) (West 2008)

[7] Merriam-Webster Online Dictionary. 2018. http://www.merriam-webster.com (20 Nov. 2018).

[8] IRC §877A(a)(1)-(2)

[9] IRC §877A(g)(2)(A)

[10] IRC §§ 877A(g)(2)(B); 7701(b)(6)

[11] IRC §877A(g)(1)(B)(i)(I)-(II).

[12] IRC §877A(g)(1)(B)(ii)(I)-(II).

[13] IRC §§ 877A(g)(2)(A)-(B)

[14] IRC §877(a)(2)

[15] IRC §877(a)(2)(A)

[16] IRC §31(c)

[17] IRC §877(a)(2)(B)

[18] IRS Notice 97-19

[19] IRS Notice 97-19

[20] See Di Portanova v. U.S., 690 F.2d 169 (Ct. Cl. 1982) (citing Kronenberg v. C.I.R., 64 T.C. 428, 434 (1975)).

[21] Kronenberg v. C.I.R., 64 T.C. 428, 436 (1975).

[22] Id.

[23] IRC §877(a)(2)(C)

[24] Rev. Proc. 2017-58.

[25] https://www.irs.gov/irb/2018-10_IRB#RP-2018-18

[26] IRC § 877A(h)(2).

[27] IRC §§ 1012, 1016.

[28] See Furstenberg v. C.I.R., 83 T.C. 755 (1984).

[29] IRC §§ 877A(g)(5), 877(e)(2).

[30] See JCS-2-03 (Feb. 28, 2003).

[31] See IRS CCA 200923024.

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