By: Jerald David August
Chair, International Taxation and Wealth Planning Group
This is the fourth and last segment to the set of posts that summarizes the expatriation rules contained in the Internal Revenue Code. This last segment addresses exceptions to the mark-to-market rules under Section 877A and moves onto to address the somewhat overlooked succession tax under Section 2801.
Exceptions to the Mark-to-Market Tax Under Section 877A
The mark-to-market tax applies to most types of property interests held by the individual on the date of relinquishment of citizenship or termination of residency, with certain exceptions. Deferred compensation items, interests in non-grantor trusts, and specified tax-deferred accounts are excepted from the mark-to-market tax but are subject to the special rules described below.
Deferred Compensation in General
Special rules are contained in Section 877A(d) for interests in non-grantor trusts, specified tax-deferral accounts, and deferred compensation items. For purposes of the provision, a “deferred compensation item” means any interest in a qualified plan or arrangement described in Section 219(g)(5), any interest in a foreign pension plan or similar retirement arrangement or program, any interest in a foreign pension plan or similar retirement arrangement or program, any item of deferred compensation, and any property, or right to property, which the individual is entitled to receive in connection with the performance of services to the extent not previously taken into account under Section 83 or in accordance with Section 83 (a Code section that requires the inclusion of the fair market value of property received for the performance of services, less any amount paid for such property, to be included in gross income of the service provider in the first taxable year in which such property is transferable or not subject to substantial risk of forfeiture).
A special deferral rule, an “inclusion deferral election,” is provided in the TCJA for postponing income tax on the spread associated with exercising non-qualified stock options for example for a period of up to five years. Under Section 83(i), a qualified employee may elect to defer the inclusion in income of the amount of income attributable to qualified stock received by the employee. While presently uncertain, presumably Section 83(i) may result in the applicable period of deferral of income to a covered expatriate. Under Section 877A(d), alternative tax regimes apply with respect to “eligible deferred compensation items” and to other or “ineligible deferred compensation items.” For eligible deferred compensation items, Section 877A(d)(1)(A) provides, in general, that the payor must deduct and withhold from any taxable payments to a covered expatriate as to such items a tax equal to 30% of the amount of such taxable payments. For “ineligible deferred compensation items,”
Section 877(d)(2)(A) provides that a covered expatriate generally is treated as having received an amount equal to the present value of the covered expatriate’s accrued benefit on the day prior to the expatriation date. Section 877A(e)(1)(A) provides that if a covered expatriate holds any interest in a specified tax-deferred account on the day before the expatriation date, such covered expatriate is treated as having received a distribution of the covered expatriate’s entire interest in such account on the day before the expatriation date.
The special covered plans and arrangements described in Section 219(g)(5) are (i) a plan described in Section 401(a), which includes a trust exempt from tax under Section 501(a); (ii) an annuity plan described in Section 403(a); (iii) a plan established for its employees by the United States, by a State or political subdivision thereof, or by an agency or instrumentality of any of the foregoing, but excluding an eligible deferred compensation plan (within the meaning of Section 457(b)); (iv) an annuity contract described in Section 403(b); (v) a simplified employee pension (within the meaning of Section 408(k)); (vi) a simplified retirement account (within the meaning of Section 408(p)); and (vii) a trust described in Section 501(c)(18).
Where a deferred compensation item is an eligible deferred compensation item, the payor must deduct and withhold from a “taxable payment” to the covered expatriate a tax equal to 30% of such.payment. This.is in addition to any withholding rule imposed under current law. An identified taxable payment is subject to withholding to the extent it would be included in gross income of the covered expatriate, if such person were subject to tax as a citizen or resident of the United States. A deferred compensation item is taken into account as a payment when such item would be so includible. An “eligible deferred compensation item” means any deferred compensation item with respect to which (i) the payor is either a U.S. person or a non-U.S. person who elects to be treated as a U.S. person for purposes of withholding and who meet the requirements prescribed by the Secretary to ensure compliance with the withholding requirements, and (ii) the covered expatriate notifies the payor of his status as a covered expatriate and irrevocably waives any claim of withholding reduction under any treaty with the United States.
The foregoing rules regarding eligible deferred compensation items and items that are not eligible deferred compensation items do not apply to deferred compensation items to the extent attributable to services performed outside the United States while the covered expatriate was not a citizen or resident of the United States.
“Secified taxdeferred accounts.” If a covered expatriate holds any interest in a specified tax-deferred account on the day before the expatriation date, such covered expatriate is treated as receiving a distribution of his entire interest in such account on the day before the expatriation date. Appropriate adjustments are made for subsequent distributions to take into account this treatment. As with deferred compensation items, these deemed distributions are not subject to early distribution tax. “specified tax-deferred account” means an individual retirement plan (as defined in Section 7701(a)(37)), a qualified tuition plan (as defined in Section 529), a Coverdell education savings account (as defined in Section 530), a health savings account (as defined in Section 223), and an Archer MSA (as defined in Section 220). However, simplified employee pensions (within the meaning of Section 408(k)) and simplified retirement accounts (within the meaning of Section 408(p)) of a covered expatriate are treated as deferred compensation items and not as specified tax-deferred accounts. Where an item of deferred compensation is not an “eligible deferred compensation” item (and is not subject to Section 83), an amount equal to the present value of the covered expatriate’s deferred compensation item is treated as having been received on the day before the expatriation date. In the case of a deferred compensation item that is subject to Section 83, the item is treated as becoming transferable and no longer subject to a substantial risk of forfeiture on the day before the expatriation date. Appropriate adjustments are made to subsequent distributions to take into account the foregoing treatment. In addition, these deemed distributions are not subject to early distribution tax. nterests in Trusts Grantor trusts. In the case of the portion of any trust for which the covered expatriate is treated as the owner under the grantor trust provisions of the Code, as determined immediately before the expatriation date, the assets held by that portion of the trust are subject to the mark-to-market tax. If a trust that is a grantor trust immediately before the expatriation date subsequently becomes a non-grantor trust, such trust remains a grantor trust for purposes of the provision.
Succession Tax: New Section 2801— Pertains to Gifts or Bequests from Covered Expatriate Donors to U.S. Donees
The new “succession tax” covers any “direct or indirect gift or bequest,” and imposes a tax rate that is equivalent to “the highest applicable gift or estate tax rates.” The expatriation succession tax under Section 2801 is imposed at the rate of 40% on the value of the gift, bequest, or distribution from a foreign or domestic trust to a U.S. person from the expatriate donor. The expatriate donor may, however, be subject to federal gift or estate tax with respect to transfers of U.S. situs property, in which event the application of the succession tax under Section 2801 is “turned-off” should the recipient of the gift or bequest be a U.S. donee.
Under the Section 2801 succession tax, the tax is imposed in any calendar year during which a U.S. citizen or resident receives a “covered gift or bequest” (Code Secs. 2801(a), 2801(b)). Congress, in 2008, adopted an entirely new approach to this concept. Under this approach, which applies to gifts by and the estates of persons who expatriate after June 16, 2008, the expatriate is taxed under the normal rules for nonresident alien decedents and donors, but a special tax, in the nature of an inheritance tax, applies to a U.S. citizen or resident who receives a gift or bequest from a “covered expatriate” (Section 2801). This tax applies regardless of the length of time between the act of expatriation and the date that the gift is receive.
Thus, where a U.S. citizen or resident emigrates together with all objects of his or her bounty, the U.S. estate and gift taxes have no application to subsequent transfers of his or her property, except as they are caught by the rules for nonresident alien donors and decedents, but if an emigrating citizen or resident later transfers property to who remain the United States, the donees and heirs are subject to this special tax, which may exceed the gift or estate tax that the expatriate or his or her estate would have paid, absent expatriation. According to the House Ways and Means Committee, in recommending enactment of these rules, “where U.S. estate or gift taxes are avoided with respect to a transfer of property to a U.S. person by reason of the expatriation of the donor, it is appropriate for the recipient to be subject to a transfer tax similar to the avoided transfer taxes.”
Covered Gift or Bequest
A covered gift or bequest is any property acquired (i) by gift directly or indirectly from an individual who is a covered expatriate at the time of such acquisition, or (ii) directly or indirectly by reason of the death of an individual who was a covered expatriate immediately before death (Section 2801(e)(1)). A covered gift or bequest, however, does not include (i) any property shown as a taxable gift on a timely filed gift tax return by the covered expatriate, (ii) any property included in the gross estate of the covered expatriate for estate tax purposes and shown on a timely filed estate tax return of the estate of the covered expatriate, and (iii) any property with respect to which a deduction would be allowed under Sections 2055, 2056, 2522 or 2523, whichever is appropriate (these sections allow deductions for transfers for charitable purposes or to spouses, for purposes of determining estate and gift taxes) (Code Secs. 2801(e)(2) and 2801(e)(3)). Rate of Tax Under Section 2801 The amount of the Section 2801 tax is determined by multiplying the value of the covered gift or bequest by the greater of (i) the highest estate tax rate listed in the Section 2001(c) rate table in effect on the date the transferee receives the covered gift or bequest, or (ii) the highest gift tax rate listed in the Section 2502(a) rate table in effect on that date (Section 2801(a)):
Net Gift. For gift tax purposes, the donor is the person primarily liable for paying the tax. The donor may make the gift conditional on the donee paying the tax out of the transferred property, i.e., a “net gift.” The value of a net gift is the fair market value of the property passing from the donor, minus the amount of gift tax to be paid by the donee.
Covered Gift. A covered gift is similar to a net gift in that the recipient of a covered gift is liable for the Section 2801 tax on the gift. However, neither Section 2801 nor the legislative history contains any statement that the value of a covered gift is computed in the same way as the value of a net gift. In the absence of such a statement, it would appear that Congress intended that the full value of a covered gift, without reduction for the Section 2801 tax payable by the donee, is subject to the Section 2801 tax. Exception for Certain Gifts The tax applies to a recipient of a covered gift or bequest only to the extent that the total value of covered gifts and bequests received by such recipient during a calendar year exceeds the amount in effect under Section 2503(b) for that calendar year (Rev. Proc. 2007-66100). The tax on covered gifts and bequests is reduced by the amount of any gift or estate tax paid to a foreign country with respect to such covered gift or bequest (Section 2801(d)). Transfers in Trust Special rules apply to the tax on covered gifts or bequests made to domestic or foreign trusts. Domestic Trust In the case of a covered gift or bequest made to a domestic trust, the tax applies as if the trust is a U.S. citizen, and the trust is required to pay the tax. In the case of a covered gift or bequest made to a foreign trust, the tax applies to any distribution from such trust (whether from income or corpus) attributable to such covered gift or bequest to a recipient that is a U.S. citizen or resident, in the same manner as if such distribution were a covered gift or bequest. Such a recipient is entitled to deduct the amount of such tax for income tax purposes to the extent such tax is imposed on the portion of such distribution that is included in the gross income of the recipient (Section 2801(e)(4)(A)).
Foreign Trust. For purposes of these rules, a foreign trust may elect to be treated as a domestic trust. The election may not be revoked without the Secretary’s consent (Section 2801(e)(4)(B)).
As this and the preceding posts reveal, the idea of expatriation from the U.S. may sound highly desirable at times to high net worth individuals who already are resident in another country or are otherwise motivated by personal or tax reasons to “leave”, the reality is that the Internal Revenue Code and regulations requires that such individuals receive “high level” legal advice from immigration and tax counsel, including estate planning advises.
This post is issued for information purposes only and may not be relied upon as legal advice from Fox Rothschild LLP or Jerald David August. If you have questions about expatriation please contact your lawyer, attorney contact at Fox Rothschild LLP or Mr. August.