Expatriation Tax

The expatriation tax is the tax the United States imposes on certain individuals who end their US tax status by giving it up. "Expatriation Tax" is the Internal Revenue Service's own heading for the rules of section 877A, and the same thing is widely called the exit tax. It applies to a US citizen who formally renounces citizenship and to a long-term lawful permanent resident (a green card holder for at least 8 of the prior 15 years) who abandons that status. Critically, it does not fall on everyone who leaves. It falls only on a covered expatriate, a defined category of higher-income or higher-net-worth individuals, or those who cannot certify tax compliance.

For a covered expatriate, the core rule is a mark-to-market deemed sale: most types of property are treated as if sold at fair market value on the day before the expatriation date, so unrealized gains that had never been taxed are brought into a final US return. The net gain from that deemed sale is then reduced by an exclusion amount before tax applies. The idea is that the United States collects the tax on appreciation accrued during the years of US status, before the person moves outside its taxing reach.

Whether the tax applies at all turns on being a covered expatriate, so that test comes first. An individual is a covered expatriate if they meet any of three tests as of the expatriation date. The first is the average income tax test: an average annual net US income tax for the five years ending before expatriation greater than $211,000, a figure adjusted each year for inflation. The second is the net worth test: a net worth of $2 million or more, an amount set by statute that is not indexed and so does not change with inflation. The third is the certification test: a failure to certify, on Form 8854, that all federal tax obligations for the five preceding years have been met. Failing that third test makes someone a covered expatriate regardless of income or wealth, which is how a person of modest means with a lapse in filing can be swept in. Narrow exceptions exist for certain dual citizens from birth and for some who expatriate as minors, provided they too can certify compliance.

The mark-to-market tax reaches the gain above an indexed exclusion. For a covered expatriate, the deemed sale of most property produces a net gain, and that net gain is reduced by an exclusion of $910,000, also indexed annually, before any tax is due. Only the net gain in excess of that exclusion is taxed, at the capital-gains or ordinary rates that would apply to each asset in an actual sale. A covered expatriate can elect to defer the tax on particular assets until they are actually sold, but the election requires adequate security and an agreement to pay interest, so it is not costless.

Three categories of property step outside the deemed sale and get their own rules. Deferred compensation items, such as pensions and nonqualified deferred compensation, are generally not marked to market; instead, "eligible" deferred compensation is subject to a flat 30 percent withholding on future payments, while "ineligible" deferred compensation is treated as received in a lump sum the day before expatriation. Specified tax-deferred accounts, such as individual retirement arrangements, are treated as fully distributed the day before expatriation, a deemed distribution taxed as income but not subject to the early-withdrawal additional tax. And interests in non-grantor trusts are handled through a 30 percent withholding on future distributions. These carve-outs exist because a mark-to-market sale does not fit assets that are taxed on payment rather than on disposition.

A second tax can follow the money long after the person has gone. Under section 2801, a US citizen or resident who receives a "covered gift or bequest" from a covered expatriate can owe a transfer tax on it, at the highest gift or estate tax rate, paid by the recipient rather than the giver. This is a deliberate backstop: without it, a covered expatriate could later pass wealth to US family members free of the US transfer tax system they had left. It means the consequences of covered-expatriate status can reach US recipients for years afterward.

The steps are: determine whether the person is a covered expatriate under the three tests; if so, compute the mark-to-market deemed sale of most property; reduce the resulting net gain by the exclusion; apply the special rules to deferred compensation, tax-deferred accounts, and trust interests; and file Form 8854 with the final return.

A hypothetical example. Ingrid, a US citizen, renounces her citizenship. Her net worth is about $3 million, so she meets the $2 million net-worth test and is a covered expatriate. On the day before her expatriation date, her marketable assets are treated as sold at fair market value. Say the deemed sale produces a net built-in gain of $1,500,000. That net gain is reduced by the exclusion of $910,000, so the expatriation tax applies only to the portion of the gain that exceeds the exclusion, taxed at the capital-gains rates that would have applied to those assets in a real sale. Her individual retirement arrangement is handled separately: it is treated as fully distributed the day before expatriation and taxed as ordinary income, though without the 10 percent early-withdrawal additional tax. Years later, if Ingrid gives a substantial gift to her US-citizen nephew, section 2801 can require him to pay a transfer tax on it as the recipient.

The expatriation tax is a consequence of a decision to leave the US tax system, so the useful framing is what triggers it and how its pieces fall.

What softens it

• It applies only to covered expatriates, so most people who give up citizenship or a green card are not subject to the mark-to-market tax at all.
• The net gain is reduced by a sizable indexed exclusion before any tax applies, which shelters a substantial amount of appreciation.
• Tax on specific assets can be deferred by election until they are actually sold, if adequate security is posted.

Where it bites

• The certification test makes someone a covered expatriate for a compliance failure alone, regardless of income or wealth, so a filing lapse can be costly.
• The deemed sale accelerates tax on gains that were never realized, producing a bill with no cash from an actual sale to pay it, unless deferral is elected.
• Tax-deferred accounts are treated as fully distributed, which can create a large one-year income spike.
• The section 2801 transfer tax can reach US recipients of later gifts or bequests, extending the consequences well beyond the year of expatriation.