Press Room: Tax Release

December 21, 2012

Estate Planning for Expatriates Under Chapter 15

Due to the impending increase in tax rates and other expected changes regarding the U.S. transfer tax system, more individuals are considering – sometimes seriously – the tax consequences of expatriation. Two WTAS advisors with extensive experience in estate planning for expatriates have published an article on this topic in Estate Planning Journal Volume 40, Number 01, January 2013.  Below is a synopsis of that article. 

To view the entire article, please click here.

Section 2801 imposes special transfer tax rules on covered expatriates, but planning strategies may be implemented to reduce the provision's impact.

In order to address concerns about individuals relinquishing U.S. citizenship or terminating long-term residency to avoid U.S. income, estate, and gift taxes, Congress has enacted various waves of expatriation tax regimes with the latest included in the Heroes Earnings Assistance and Relief Act of 2008 (“the HEART Act”).  This article discusses Subtitle B, Chapter 15 of Title 26 of the U.S. Code, which was created under the HEART Act to supplement the U.S. estate and gift tax regimes for certain gifts and bequests received from covered expatriates.  The analysis below assists practitioners in understanding the changes imposed by Chapter 15, as well as identify tax traps and planning opportunities.

Key tax distinctions

Under Chapter 12, U.S. citizens and residents are generally subject to U.S. gift tax on lifetime transfers of any property, wherever situated.  Similarly, under Chapter 11, the estates of U.S. citizens and residents are generally subject to U.S. estate tax on all property located worldwide.  On the other hand, nonresident aliens are generally subject to U.S. gift tax on transfers of only real property or tangible property located in the U.S. and U.S. estate tax on the transfer of U.S. situs property, including stock in a U.S. corporation.  As such, with proper structuring, a nonresident who is not a U.S. citizen could greatly minimize or avoid U.S. gift and estate tax on gratuitous transfers to either U.S. persons or non-U.S. persons.

For gift and estate tax purposes, a resident is an individual who has his or her domicile in the U.S., and a nonresident is an individual who is not a resident. Absent a separate expatriation tax regime, an individual could relinquish his or her U.S. citizenship or terminate his or her long-term residency and become a nonresident alien in order to save substantial U.S. gift and estate taxes on future property transfers. Congress intended the expatriation regime imposed by Chapter 15 to make an individual's decision to relinquish U.S. citizenship or terminate his or her long-term residency more tax-neutral; however, as discussed below, various tax planning opportunities remain.

Chapter 15 consists of only one section, Section 2801, which imposes a tax on U.S. citizens or residents who receive certain gifts and bequests on or after 6/17/2008, from certain expatriates.  Although the IRS announced on 7/20/2009 that it plans to issue guidance under Section 2801, at the time of this writing little guidance has been issued, leaving practitioners to rely largely on the language of the statute. The Section 2801 tax is imposed on a calendar-year basis, and a new Form 708 will be issued by the IRS for purposes of reporting the receipt of such gifts and bequests. The IRS announced that the reporting and tax obligations for covered gifts or bequests received will be deferred, pending the issuance of guidance. As of the writing of this article, Form 708 has not been released.

Factors in the expatriation decision

This article explores selected estate and gift planning techniques for expatriates who are covered by Section 2801. Traditionally, expatriation has been inherently tax driven—a person currently taxed as a U.S. citizen or resident evaluates the tax advantages/disadvantages of exiting the U.S. tax regime. Absent tax advantages, there is seldom a reason to relinquish citizenship; however, privacy is becoming much more of a reason in light of a major enforcement by the IRS of foreign reporting requirements and the potential penalties that could be levied as a result of failure to file tax information forms. Nevertheless, the decision as to whether to expatriate is usually focused on the income, estate, and gift tax implications following expatriation.

In recent years, the U.S. income tax rates have been very favorable to U.S. citizens and residents who have substantial portfolio income with a 15% federal income tax rate on qualified dividends and long-term gains, as well as no federal income tax on municipal bond income. This is particularly the case where the individual lives in or migrates to a state where there is no income tax (e.g., Florida and Nevada) and as such pays only federal tax on portfolio income.

Avoiding these taxes, however, is generally not a sufficient impetus to leave the U.S. U.S. citizens and residents with large amounts of ordinary income such as wages, self-employment earnings, rent, etc. generally are not attracted to the concept of expatriation because, if the income is derived from the U.S., even as a nonresident, they would likely have to pay U.S. income tax on the earnings. Because individuals with significant portfolio income generally also have a substantial asset base, income tax planning as well as estate and gift tax planning must be viewed together when evaluating whether to expatriate.

The prospect of almost certainly higher tax rates on all types of income, as well as the 3.8% Medicare contribution tax imposed after 2012 on the net investment income and the continued high tax rates on gifts and estates, is causing many individuals to take a fresh look at the consequences of the new tax rules on expatriation. Another factor to consider is the depressed nature of most assets. One of the more dramatic changes to the income tax rules that affect expatriation is the “mark-to-market” regime whereby the expatriate is deemed to have sold all of his or her worldwide assets the day before expatriation. With asset values low, the mark-to-market gain will likely be smaller (or a loss). Also, to the extent gains exist, the exit tax under Section 877A will be calculated using current-law tax rates (especially the lower rate on long-term gains).

This article covers selected estate and gift tax observations and planning techniques under Chapter 15. As various other works have compared the new expatriation regime with the former regimes and outlined the technical qualifications under the statute, this article does not delve in any depth into the technicalities of who is a “covered expatriate” under new Section 877A and Section 2801, but assumes that an individual would be a covered expatriate should he or she relinquish U.S. citizenship or no longer be a long-time permanent resident (green card holder).

To view the entire article, please click here.