Talking Expatriation (And A Little Latin)

A friend contacted me recently. He was calling to discuss the tax issues of expatriating. As background, there are two types of expatriation. The first is renouncing citizenship, which he is not considering. The second is simply living outside the United States. One remains an American, but one lives elsewhere.

It is not as easy as it used to be. 

I have, for example, been quite critical of Treasury and IRS behavior when it comes to Americans with foreign bank accounts. If you or I moved overseas, one of the first things we would do is open a bank account. As soon as we did, we would immediately be subject to the same regime as the U.S. government applies to the uber-wealthy suspected of stashing money overseas.  

Some aspects of the regime include:

(1) Having to answer questions on your tax return about the existence of foreign accounts. By the way, lying is a criminal offense, although filing taxes is generally a civic matter.

(2) Having to complete a schedule to your tax return listing your foreign financial and other assets. Move here from a society that has communal family ownership of assets and you have a nightmare on your hands. What constitutes wealthy for purposes of this schedule? Let’s start at $50,000, the price of a (very) nice pickup truck.

(3) Having to file a separate report with the Department of Treasury should you have a foreign bank account with funds in excess of $10,000. The reporting also applies if it is not your account but you nonetheless have authority to sign: think about a foreign employer bank account. It should be fun when you explain to your foreign employer that you are required to provide information on their account to the IRS.

(4) Requiring foreign banks to both obtain and forward to the IRS information about your accounts. Technically the foreign banks have a choice, but fail to make the “correct” decision and the IRS will simply keep 30% of monies otherwise going to them.

To add further insult, all this reporting has some of the harshest penalties in the tax Code. Fail to file a given tax form, for example, and take a $10,000 automatic penalty. Fail to file that report with the Treasury Department and forfeit half of your account to the government.

Now, some of this might be palatable if the government limited its application solely to the bigwigs. You know the kind: owners of companies and hedge fund managers and inherited wealth. But they don’t. There cannot be ten thousand people in the country who have enough money overseas to justify this behavior, so one is left wondering why the need for overreach. It would be less intrusive (at least, to the rest of us 320 million Americans) to just audit these ten thousand people every year. There is precedence: the IRS already does this with the largest of the corporations.

Did you know that – if you fail to provide the above information – the IRS will deem your tax return to be “frivolous?” You will be lumped in there with tax protestors who believe that income tax is voluntary and, if not, it only applies to residents of the District of Columbia.

There is yet another penalty for filing a frivolous return: $5,000. That would be on top of all the other penalties, of course. It’s like a party.

Many practitioners, including me, believe this is one of the reasons why record numbers of Americans overseas are turning-in their citizenship. There are millions of American expats. Perhaps they were in the military or foreign service. Perhaps they travelled, studied, married a foreign national and remained overseas. Perhaps they are “accidental” Americans – born to an American parent but have never themselves been to the United States. Can you imagine them having a bank close their account, or perhaps having a bank refuse to open an account, because it would be too burdensome to provide endless reams of information to a never-sated IRS? Why wouldn’t the banks just ban Americans from opening an account? Unfortunately, that is what is happening.

So I am glad to see the IRS lose a case in this area.

The taxpayer timely filed his 2011 tax return. All parties agreed that he correctly reported his interest and dividend income. What he did not do was list every interest and dividend account in detail and answer the questions on Schedule B (that is, Interest and Dividends) Part III. He invoked his Fifth Amendment privilege against self-incrimination, and he wrote that answering those questions might lead to incriminating evidence against him.

Not good enough. The IRS assessed the penalty. The taxpayer in response requested a Collections Due Process Hearing.

Taxpayer said he had an issue: a valid Fifth Amendment claim. The IRS Appeals officer did not care and upheld the penalty.

Off to Tax Court they went.

And the Court reviewed what constitutes “frivolous” for purpose of the Section 6702 penalty:

(1) The document must purport to be a tax return.

(2) The return must either (i) omit enough information to prevent the IRS from judging it as substantially correct or (ii) it must clearly appear to be substantially incorrect.

(3) Taxpayer’s position must demonstrate a desire to impede IRS administration of the tax Code.

The first test is easy: taxpayer filed a return and intended it to be construed as a tax return.

On to the second.

Taxpayer failed to provide the name of only one payer. All parties agreed that the total was correct, however. The IRS argued that it needed this information so that it may defend the homeland, repair roads and bridges and present an entertaining Super Bowl halftime show. The Court asked one question: why? The IRS was unable to give a cogent reply, so the Court considered the return as filed to be substantially correct.

The IRS was feeling froggy on the third test. You see, the IRS had previously issued a Notice declaring that even mentioning the Fifth Amendment on a tax return was de facto evidence of frivolousness. Faciemus quod volumus [*], thundered the IRS. The return was frivolous.

The Court however went back and read that IRS notice. It brought to the IRS’ attention that it had not said that omitting some information for fear of self-incrimination was frivolous. Rather it had said that omitting “all” financial information was frivolous. You cannot file a return with zeros on every line, for example, and be taken seriously. That however is not what happened here.

The IRS could not make a blanket declaration about mentioning the Fifth Amendment because there was judicial precedence it had to observe.  Previous Courts had determined that a return was non-frivolous if the taxpayer had disclosed enough information (while simultaneously not disclosing so much as to incriminate himself/herself) to allow a Court to conclude that there was a reasonable risk of self-incrimination.

The Court pointed out the following:

(1) The taxpayer provided enough information to constitute an accurate return; and

(2) The taxpayer provided enough information (while holding back enough information) that the Court was able to conclude that he was concerned about filing an FBAR. The questions on Schedule B Part III could easily be cross-checked to an FBAR. Given that willful failure to file a complete and accurate FBAR is a crime, the Court concluded that the taxpayer had a reasonable risk of self-incrimination.

The Court dismissed the penalty.

The case is Youssefzadeh v Commissioner, for the at-home players.

I am of course curious why the taxpayer felt that disclosure would be self-incrimination. Why not just file a complete and accurate FBAR and be done with it? Fair enough, but that is not the issue. One would expect that an agency named the Internal “Revenue” Service would task itself with collecting revenue. In this instance, all revenue was correctly reported and collected. With that backdrop, why did the IRS pursue the matter? That is the issue that concerns me. 

[*] Latin for “we do what we want”

Taxation and Renouncing Citizenship: Part I

Why would Eduardo Saverin renounce his U.S. citizenship?  Saverin is one of the Facebook insiders and presently is unbelievably wealthy.

Saverin was not born here. His family is from Brazil, and they were wealthy before Mark Zuckerberg starting working on a networking site from his Harvard dormitory. Saverin became a citizen in 1998 and is now expatriating to Singapore.

A possible reason is U.S. tax policy. The U.S. will tax a citizen or permanent resident (think green card) no matter where you are on planet earth, how long you have lived there or whether you have any intention of ever returning to the U.S. I have family, for example, that has lived outside the U.S. since the 80s, yet the IRS expects to receive a tax return from them annually. If they have over $10,000 in a foreign bank account, Treasury expects an FBAR every June 30^th. If they have accumulated enough assets over the last 30-something years, they are subject to the new IRS “specified foreign financial asset” filings. Their bank may even have to report their banking activity to the U.S. under the new FATCA rules. That is assuming the bank doesn’t close their account to avoid having to deal with these U.S. mandates.

Does this sound even remotely reasonable? Do we wonder why someone would renounce his/her citizenship?

Let’s go over the general rules in this area. The U.S. tax system differentiates between U.S. citizens and permanent residents, on the one hand, and nonresident aliens (NRAs) on the other. We can further differentiate the tax system between income taxes and estate and gift (i.e., transfer) taxes.

INCOME

A  U.S. citizen or permanent resident is taxed on his/her worldwide income. It doesn’t matter where you earned the income (you could be mining ore from the ocean floor) or whether you have or have not been in the U.S. since elementary school. That citizenship will follow you like a bad tattoo.

A nonresident alien (NRA) is a different matter. How an NRA pays income tax is generally based on one key question: is there a business activity involved? The tax term is “effectively connected.”

·         If no, then figure on a flat 30% tax rate

·         If yes, then the NRA gets the same graduated tax rates that you or I use

ESTATE AND GIFT

You can guess the drill at this point. A U.S. citizen or permanent resident is taxed on everything, wherever located, whether in the sky above or the earth below, in days past or yet to come. 

In contrast that NRA is subject to estate tax only on property located in the U.S.

There is an odd rule that stock of domestic corporations is treated as property located in the U.S. I have never quite understood that one. Fortunately, that tax overreach can be stymied by relatively easy tax planning, such as putting the stock in a foreign entity.

The gift tax applies to an NRA to the extent of tangible personal property or real estate located in the U.S. That definition excludes most stock from the reach of the gift tax.

EXPATRIATION

Let’s clarify terms. Any American who lives overseas is an expatriate. It doesn’t mean the one has renounced his/her citizenship. However, renouncing also uses the term “expatriate.” Unfortunate, somewhat like the track record of Bengals linebackers and the court system. We will use the term “expatriate” to refer to renouncing citizenship for the balance of this article.

Pre-2004

Back when, a person renouncing citizenship was subject to tax for the succeeding 10-year period, unless he/she could show that expatriation did not have as one of its principal purposes the avoidance of taxes.

The expatriate was subject to income tax on income from sources within the U.S. or effectively connected with the U.S. There were convoluted rules to slow down the tax planners, such as shutting-down nontaxable exchanges of property and outbound transactions with a controlled foreign corporation.

It didn’t take much to prompt the government to think that one was tax-driven:

(1)     Average income (not tax) for the last 5 years exceeding $100,000, or

(2)    Net worth of $500,000

The estate tax continued to apply, but it was generally limited to assets located in the U.S.

The gift tax however was expanded to include gifts of stock.

One could contest the government’s presumption that one was tax-motivated. One would request and pay for a tax ruling. I presume that everyone did so.

Also, one had to send-in an annual Christmas card to the U.S. government which included one’s address, the foreign country of residence as well as information on one’s assets and liabilities.

After-2004

The IRS found it very difficult to determine tax motivation as previously required under the tax Code. Interestingly, it also found that it could not keep up with the number of people requesting rulings. Congress in response changed the determination standard from a subjective to an objective test.

If one met the new income and asset thresholds, one was now presumed guilty of tax avoidance.

At least they increased the thresholds:

(1)    Average tax of $124,000 for the last 5 years

(2)    Net worth of $2 million

An expatriate under those limits would not be taxed under the expatriate rules even if the motivation was tax-driven. Conversely, one over those limits would be taxed, even if there was no tax motivation. Congress removed the option to request a ruling from the IRS to exempt the expatriate from taxation.

The annual Christmas card was revised to include one’s annual income and the number of days physically present in the U.S. The expatriate could not be present in the U.S. for 30 days in any one year, or one would be treated for tax purposes as a citizen and taxed on all worldwide income.

NOTE: This is pretty harsh stuff, and the U.S. may have been alone among advanced countries with this extraterritorial tax reach. Obviously, you do not spend 30 days in the U.S., for any reason.

2008 and the Heart Act

The current expatriation regime came into the Code in 2008, and it was a revenue-raiser intended to “pay” for other tax provisions of the Heart Act.

INCOME TAX

Let’s add one new threshold:

(1)    Average tax of $124,000 for the last 5 years

(2)    Net worth of $2 million, or

(3)    Fail to certify that one has complied with all tax requirements for the preceding five years

If one falls into one of these categories, one is a “covered” expatriate. Generally speaking, in taxation the adjective “covered” is bad.

There is a brand-new mark-to-market income exit tax.  The tax applies to the unrealized gain in the expatriate’s property as if the property had been sold for its fair market value. One is granted an exemption of $600,000, adjusted for inflation.

NOTE: This “make believe” sale may be surprising, but other countries – for example, Australia and Denmark – do it with their expatriates.

So you now pay tax on the way out.

The covered expatriate can defer tax on property by posting a bond or other security acceptable to the government. This is an election, and the election is irrevocable. One can elect on a property-by-property basis. The deferred tax is due the year the covered expatriate sells the property. 

There are special rules for deferred compensation, trusts and such matters which do not concern us here.

ESTATE AND GIFT

The key here is whether the “covered expatriate” transfers to a U.S. resident or permanent resident. These transfers are called “covered” gifts or bequests and have their very own special transfer tax. The rate will be the maximum estate or gift tax rate at the time.

If the transfer is made to a domestic trust, then the trust has to pay the tax. If made to a foreign trust, the tax is payable when distributions are made to a U.S. citizen or permanent resident.

  

The transfer tax appears to be in addition to existing estate and gift tax. One already had to pay transfer tax on property located in the U.S. This new tax also pulls-in transfers of property located outside the U.S., if the transfers are to a U.S. citizen or permanent resident.

So if my wife and I renounce but our daughter stays in the U.S., we would have a problem transferring assets to her. Those would be “covered” transfers and trigger tax at the maximum rate. I suppose our daughter will have to renounce with us to avoid that “covered” problem.

WHAT ISSUES HAVE BEEN CREATED BY THIS NEW TAX REGIME?

In truth, the new regime is an improvement - in many ways – over the previous system. The potential tax is now calculated once, although its payment may be deferred. The previous system required monitoring for 10 subsequent years and was very difficult to administer. In addition, this regime is not based on one’s ability to live on non-covered assets for 10 years. That of course was a previous way to wait-out the tax and favored the uber-wealthy over the merely wealthy.     

Expect disagreement with the IRS over the valuation of difficult-to-value assets. Here is an example: Eduardo Saverin’s pre-IPO stock in Facebook. The stock was restricted and non-tradable. What do you think it was worth, before its IPO, when Saverin renounced? I’ve got nickels-to-dollars that the IRS will come-in with higher numbers than Saverin does.

Another issue is when to expatriate. If one has assets that are going to appreciate significantly and soon, one wants to leave immediately. Why? Because there is little or no present appreciation in the asset, but the clock is ticking. An example would be land where a new interchange or mall will be built, or Facebook pre-IPO stock. Compare this to prior law where one would still be subject to U.S. tax for 10 years.

What if you have a big inheritance? Same incentive. The inherited asset received a step-up to fair market value at the date of death. If it is appreciating and fast, it is in one’s interest to exit as soon as possible.

NEXT

We will talk more about Eduardo Saverin and his expatriation in another post.