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Trusts and Expatriation

Exit Tax Overview

The exit tax consists of primarily three distinct taxes. 

  • Pension or Retirement Schemes: The value of one’s pension or retirement scheme is taxed either immediately upon expatriation or on a deferred basis. 
  • Non-grantor Trusts: Distributions to an expatriate beneficiary from a non-grantor trust are subject to withholding tax on the portion of the distribution representing ordinary trust income. 
  • mark-to-market tax All other assets, wherever located, are subject to a mark-to-market tax on unrealized gains as if sold at the time of expatriation. The first $767,000 (adjusted for inflation) of deemed gain is exempt from this tax.

The tax rates for these categories range from about 20% to 40%. Additionally, if an expatriate later transfers assets to U.S. citizens or residents during life or at death, the recipient may be subject to the estate tax, which is currently 40% for estates exceeding a certain threshold.”

Covered Expatriates & Non-grantor Trusts 

A non-grantor trust is one where the original asset owner no longer controls the assets, unlike a grantor trust, where the grantor retains some control. 

Specific tax issues arise during and after expatriation involving non-grantor trusts and covered expatriates: 

  • Sale of trust property owned by the Covered Expatriate
  • Distributions of property or money to the Covered Expatriate
  • Filing of IRS Form 8854 to preserve potential rights and avoid annual reporting

Non-Grantor Trust Expatriation Basic Exit Tax Rule 

Ownership: If a covered expatriate is considered the owner of any part of a trust under the grantor trust rules (sections 671 through 679) on the day before their expatriation date, the assets held by that portion of the trust become subject to the mark-to-market regime.

Distributions: Distributions to covered expatriates from a non-grantor trust are taxed at 30%, with the trustee responsible for withholding this amount. Property distributions may also result in tax. (Section 877A(f))

There are two main rules to consider involving Non-grantor Trusts and Covered Expatriates:

Section 7 (Notice 2009-85): Interests in Non-grantor Trusts

General Information:

  • The mark-to-market regime does not apply to any interest in a non-grantor trust.
  • A “non-grantor trust” refers to the portion of any trust (whether domestic or foreign) where the covered expatriate is not considered the owner under subpart E of Part I of subchapter J, as determined on the day before the expatriation date.
  • If a covered expatriate receives a direct or indirect distribution of property (including money) from a non-grantor trust where they were a beneficiary on the day before the expatriation date, the trustee must withhold 30% of the taxable portion of the distribution. The “taxable portion” refers to what would have been included in the covered expatriate’s gross income if they had continued to be subject to U.S. tax as a citizen or resident.
  • To determine whether a covered expatriate is a beneficiary of a non-grantor trust on the day before expatriation, consider whether the person is entitled to receive trust income or corpus, has the power to apply trust assets for their benefit, or could receive income or corpus if the trust were terminated.
  • If a non-grantor trust becomes a grantor trust (where the covered expatriate is treated as the owner), it’s treated as a taxable distribution to the extent of the portion of the trust where the covered expatriate is the owner.

Recognition of gain by trust

If property distributed from a trust described in section 7A exceeds its adjusted basis in the hands of the trust, gain is recognized by the trust as if the property had been sold to the covered expatriate at its fair market value. 

Example 1 On Date 1, the Trustee of a complex non-grantor trust distributes a painting to A, a covered expatriate who was a beneficiary of the trust on the day before A’s expatriation date.   Here are the details:

  • The painting is a capital asset with a basis of $100,000 and a fair market value of $400,000.
  • The trust is a domestic trust that excludes gains from the sale or exchange of capital assets from its distributable net income (DNI) under section 643(a)(3).
  • On Date 1, the trust recognizes a capital gain of $300,000 under section 877A(f)(1)(B).
  • The trust must include the $300,000 capital gain in its gross income and cannot deduct that amount under section 661 when computing its taxable income under section 641.
  • The trust is taxable on the $300,000 capital gain (reduced by the applicable exemption amount under section 642(b) and any applicable deductions).
  • Importantly, the trust is not required to deduct and withhold any amount pursuant to section 877A(f)(1)(A).

Thus, A, the covered expatriate, is not directly taxable on the $300,000 capital gain.

Example 2. The facts are the same as in Example 1 except that the trust is a foreign trust that includes capital gain in DNI pursuant to section 643(a)(6)(C). 

Although the trust must include the $300,000 of capital gain in its gross income, it may deduct that amount under section 661 in computing its taxable income under section 641. 

If A, now a nonresident alien, had continued to be subject to tax as a citizen or resident of the United States, the capital gain of $300,000 would have been includible in A’s gross income pursuant to section 662. Accordingly, the trust is required to deduct and withhold $90,000 (30 percent of $300,000) pursuant to section 877A(f)(1)(A).

Withholding

  • Section 877A(f)(4)(A) applies rules similar to section 877A(d)(6). The tax imposed by section 877A(f) falls under section 871, but payment is subject to withholding under section 877A(f)(1)(A), not section 1441.
  • Any amount due under section 871 that isn’t paid via withholding must be reported on the covered expatriate’s income tax return for the relevant taxable year.
  • Rules similar to sections 1461 through 1464 apply, making the trustee liable for withholding tax.
  • Covered expatriates must notify the trustee of their status by submitting Form W-8CE either before the first distribution after the expatriation date or within 30 days after the expatriation date.
  • Section 877A(g)(1) states that: if a covered expatriate is subject to U.S. tax as a citizen or resident after the expatriation date, they won’t be treated as a covered expatriate during that period for the 30 percent withholding tax on the taxable portion of a distribution from a non-grantor trust. Instead, the taxable portion of the distribution would be subject to the tax imposed on distributions to U.S. citizens or residents.

Interaction with Treaties:

  • Section 877A(f)(4)(B) states that a covered expatriate shall be treated as having waived any right to claim any reduction under any treaty with the United States in withholding on any distribution to which section 877A(f)(1)(A) applies unless the covered expatriate agrees to such other treatment as the Secretary determines appropriate.
  • To preserve treaty benefits, a covered expatriate can elect on Form 8854 to be treated as having received the value of their interest in the trust as determined for purposes of section 877A, on the day before the expatriation date.
  • To make this election, the covered expatriate must obtain an IRS letter ruling on the interest’s value (if ascertainable) as of the day before the expatriation date, following the procedures in Revenue Procedure 2009-4, 2009-1 I.R.B. 118 (or any subsequent publication that replaces Revenue Procedure 2009-4).
  • Until the trustee receives a copy of the letter ruling from the covered expatriate and a certification signed under penalties of perjury that the tax due on the value of the interest in the trust has been paid to the IRS, the trustee must withhold as provided in section 877A(f)(1).
  • The amount of tax due on the value of the interest in the non-grantor trust as of the day before the expatriation date will be adjusted by the amount of any tax withheld on or after the expatriation date and prior to receipt of the letter ruling. The covered expatriate may not make the election if the IRS determines that their interest in the trust does not have an ascertainable value as of the day before the expatriation date.
  • If the covered expatriate provides the trustee with a copy of the letter ruling and a certification written under penalties of perjury that the tax due on the value of the interest in the trust has been paid to the IRS, then the tax imposed under section 877A(f) with respect to the trust will be deemed to have been fully satisfied.
  • Accordingly, No subsequent distribution from the trust to the covered expatriate will be subject to 30 percent withholding under section 877A(f)(1)(A).
  • The covered expatriate will not be precluded by section 877A(f)(4)(B) from claiming treaty benefits with respect to any distribution from the trust under the appropriate article of an applicable treaty.

Interest in a non-grantor trust. 

  • Covered expatriates with an interest in a non-grantor trust must file Form 8854 annually.
  • This form confirms whether they received any distributions.
  • If a covered expatriate elects to be treated as having received the value of their entire trust interest (for section 877A purposes) on the day before expatriation, they can still claim treaty benefits.
  • To make this election, they must follow the procedure in section 7.D to obtain an IRS letter ruling on the interest’s value.
  • Once made, this election cannot be revoked without the Commissioner’s consent.

EXCEPTIONS – Fitting into an exception 

There are two exceptions that may benefit US citizens who otherwise may be deemed to be covered expatriates. 

  • Dual Nationals: Dual nationals who have not been U.S. residents for more than 10 out of the last 15 years can avoid covered expatriate status.
  • Minors: U.S. citizens expatriating before age 18.5 who have not met the residence test for more than 10 years are exempt.

Notes:

  • The residence test calculates the days an individual spent physically present in the United States during the current tax year and the two preceding tax years. These days are then used in a formula to determine residency status.
  • While exceptions exist for dual nationals and minors, exceptions provide relief only for net worth and tax liability prongs; compliance is still required.

Pre-Expatriation Strategies:

Pre-expatriation planning can help avoid covered expatriate classification.

Strategies include:

  1.  waiting for tax liability averages to fall below the threshold or using gift tax exclusions to reduce net worth.
  2. Trusts, like the “Ohio power-of-appointment trust,” can exclude assets from net worth calculations.
  3. Consider gift tax laws in the person’s country of residence or other citizenship.
  4. Using gifts or asset transfers to reduce net worth below $2,000,000.

If covered expatriate status is unavoidable, consider:

  • Retaining assets with unrealized gains near the mark-to-market tax exemption
  • Using the gift tax exclusion to remove assets from mark-to-market tax reach
  • Employing grantor trusts for tax advantages

Beneficial Interest in Trusts:

  • A beneficial interest in a trust, which would otherwise count toward net worth, can be disclaimed.
  • However, this disclaimer itself may be considered a gift and could use up the exclusion.
  • When contemplating gifts, consider the gift tax laws of the person’s country of residence or other citizenship.
  • While some European countries impose gift taxes, many others do not.
  • If a person’s net worth remains substantial even after making gifts, there are legitimate options under US tax law:
  • Package assets into company structures.
  • Make fractionalized interest gifts.
  • These interests are valued less than the underlying asset value (discounts of 30–40% are not  uncommon).

This type of structuring takes careful planning and implementation and requires in-depth valuation reports by high-caliber experts. 

There are other advanced US estate planning techniques that may serve the would-be covered expatriate well. 

Trust Structures to Avoid Covered Expatriate Status:

  • Some US states offer trust structures that remove assets from net worth calculations.
  • For instance, under Ohio law, you can:
  • Create a trust (settlement) without retaining powers or beneficial interests.
  • Grant a third party the power to appoint trust assets back to the settlor.
  • Creditors cannot reach these assets.
  • The IRS ignores this trust in net worth calculations.
  • The settlor’s lack of beneficial interest further avoids inclusion.
  • Preferably, use domestic trusts under US law to avoid unintended consequences.
  • Foreign trusts may trigger additional taxes beyond the exit tax.

Covered Expatriate Status:

  • In some cases, covered expatriate status is unavoidable.
  • For example, if pension and retirement scheme values exceed $2,000,000.
  • Retirement schemes are usually not assignable or giftable.
  • Successful planning can eliminate exit tax and inheritance tax for expatriates.

Minimizing the tax as a covered expatriate

 If covered expatriate status is unavoidable, pre-expatriation planning can help minimize or defer the tax. Here are some strategies:

 1. Retaining Assets with Unrealized Gain:

  • The expatriate can keep assets that have unrealized gains close to the exemption threshold for the mark-to-market tax.
  • For instance, if the retained assets include a US vacation property or a prior homestead, a tax basis adjustment can be effective.
  • After renouncing citizenship, the expatriate remains liable for capital gains tax on US-situs immovable property.
  • However, the tax basis in the US property will be adjusted proportionately based on the gain exemption allocated to each asset.

 As a result, what would otherwise have been a taxable gain on sale will be tax free, wholly or in part. 

 2. Leveraging Gift Tax Exclusion:

  • The expatriate can still use the gift tax exclusion amount to transfer assets beyond the reach of the mark-to-market tax.
  • Gifts to non-US citizen or resident recipients generally avoid US capital gains tax upon later asset sales.
  • If outright gifting is uncomfortable, consider using:
  • The “Ohio power-of-appointment trust” or a self-settled spendthrift trust (recognized in Ohio).
  • Unrealized gain in transferred trust assets remains untaxed until sale by the trustee.
  • Distributions of appreciated assets back to the expatriate do not trigger US capital gains tax.
  • Expatriate’s status as a ‘non-resident alien’ further shields from capital gains charges.

To the extent that trusts are used, it is important that the planner structure the trust to be ‘grantor’ for US income tax purposes. There are various reserved powers that can be used to accomplish this purpose without causing the transfer to run afoul of the separate US gift and estate tax rules that apply to the transfer.

 3. Structuring Trusts for Tax Efficiency:

  • When using trusts, structure them as ‘grantor’ trusts for US income tax purposes.
  • Reserved powers can achieve this without conflicting with gift and estate tax rules.
  • Although the trust becomes ‘non-grantor’ upon expatriation, the exit tax component only applies to ‘non-grantor’ trusts.
  • Distributions from the trust to the expatriate remain free from the 30% withholding tax.
  • Note: The exit tax still applies to the renouncing citizen, affecting the heirs.

Estate and Gift Tax Considerations:

If a covered expatriate chooses not to sell US immovable property during their lifetime and instead holds it or makes a gift of it, certain tax implications arise.

 1. Estate Tax:

  • Upon the expatriate’s death, the US estate tax may apply to the property.
  • Relevant sections include IRC §2101 and subsequent sections (§2501 and beyond).
  • However, an applicable inheritance tax treaty may provide relief.

 2. Inheritance Tax Relief:

  • If the recipient of a bequest or gift from the covered expatriate is a US citizen or resident, the inheritance tax under IRC §2801 will not be chargeable (avoiding double taxation).
  • IRC §2801(e)(2) addresses this exemption.

 3. Sale of Assets Connected with US Business:

  • The tax would also be due on the sale of assets effectively connected with the operations of a US business.
  • Relevant sections include IRC §§871 and 897.
  • IRS Notice 2009-85 provides additional guidance (2009-45 IRB 598, issued on October 15, 2009).

Trust Structuring for Transfer Tax Purposes:

  • When structuring trusts, consider making them a ‘completed gift’ for US transfer tax purposes.
  • A domestic ‘non-grantor’ trust is treated as a resident US taxpayer (IRC §643(e)).
  • However, distributions from the trust may carry a portion of the trust’s US-derived dividend income, taxable to nonresident alien distributees.
  • Treaty relief may be available to reduce the 30% tax rate on dividend income.

Substitution of Trust Assets:

  • One commonly used power is the settlor’s ability (acting in a non-fiduciary capacity) to substitute personal assets for trust assets of equivalent value (IRC §675(4)).
  • This power triggers grantor trust status but does not render the gift to the trust ‘incomplete’ for US transfer tax purposes.
  • An incomplete gift would subject the trust assets to the mark-to-market tax.

Remember that tax planning should be tailored to individual circumstances, and professional advice is crucial.

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