Expatriation Tax: “Covered Expatriates” under Notice 2009-85

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As an international tax attorney who constantly deals with expatriates, I am often contacted by individuals who are thinking about renouncing their U.S. citizenship. If you are consideration going down this path, you should understand the very serious legal and tax implications of this strategy. On the tax side, you should be especially aware of the current expatriation tax rules under the Internal Revenue Code (IRC) Sections 877A and 2801, IRS Notice 2009-85 and other relevant IRC sections and regulations.

Statutory Background

The new IRC Section 877A (and corresponding changes to other relevant IRC sections) was added pursuant to Section 301 of the Heroes Earnings Assistance and Relief Tax Act (HEART) of 2008. HEART also added important IRC Section 2801, which imposes transfer tax on U.S. persons who receive gifts or bequests on or after June 17, 2008; this article does not address Section 2801 provisions. In response to HEART, on November 9, 2009, the IRS issued Notice 2009-85 which explains the application and implementation of Section 877A provisions.

This article will cover some of the fundamental rules under IRS Notice 2009-85 (note that other expatriation tax rules will apply depending upon when a U.S. citizen relinquished his or her citizenship, or when an individual ceased to be a lawful permanent resident of the U.S.). Notice 2009-85 is a highly complex and broad IRS regulation; therefore this article will focus its attention solely on the definition of a “covered expatriate”.

This article is not intended to constitute tax or legal advice. Expatriation can involve many complex tax and legal issues, so you are advised to seek an experienced expatriate international tax attorney in these matters.

Definition of “Expatriate” Under IRS Notice 2009-85

It is important to understand that the expatriation tax regime imposed by Section 877A applies only to individuals who fall under the definition of “covered expatriates”. Understanding this terms requires definition of each of its part – “expatriate” and “covered”.

IRC Section 877A(g)(2) provides that the term “expatriate” means (1) any U.S. citizen who relinquishes his or her citizenship and (2) any long-term resident of the United States who ceases to be a lawful permanent resident of the United States (within the meaning of section 7701(b)(6), as amended).

Note that “long-term resident” is not equivalent to “permanent resident” and has its own definition. Pursuant to section 877A(g)(5), a long-term resident is an individual who is a lawful permanent resident of the United States in at least 8 taxable years during the period of 15 taxable years ending with the taxable year that includes the expatriation date. Expatriation date is separately defined by Section 877A(g)(3) as the date an individual relinquishes U.S. citizenship or, in the case of a long-term resident of the United States, the date on which the individual ceases to be a lawful permanent resident of the United States within the meaning of section 7701(b)(6).

Let’s deal with each of these events separately. Section 877A(g)(4) foresees four different possibilities of relinquishing U.S. citizenship (whichever is the earliest date will be treated as the date an individual relinquishes his U.S. citizenship):

a) the date the individual renounces his or her U.S. nationality before a diplomatic or consular officer of the United States pursuant to paragraph (5) of section 349(a) of the Immigration and Nationality Act (8 U.S.C. 1481(a)(5)), provided the renunciation is subsequently approved by the issuance to the individual of a certificate of loss of nationality by the United States Department of State;

b) the date the individual furnishes to the United States Department of State a signed statement of voluntary relinquishment of U.S. nationality confirming the performance of an act of expatriation specified in paragraphs (1), (2), (3), or (4) of section 349(a) of the Immigration and Nationality Act (8 U.S.C. 1481(a)(1)-(4)), provided the voluntary relinquishment is subsequently approved by the issuance to the individual of a certificate of loss of nationality by the United States Department of State;

c) the date the United States Department of State issues to the individual a certificate of loss of nationality;

d) the date a court of the United States cancels a naturalized citizen’s certificate of naturalization.

Definition of “cessation of lawful permanent residency” is even more complex (as many expatriate international tax attorneys and immigration attorneys will readily affirm) and primarily driven by immigration law, in particular Section 7701(b)(6). Pursuant to this section, a long-term resident ceases to be a lawful permanent resident if (A) the individual’s status of having been lawfully accorded the privilege of residing permanently in the United States as an immigrant in accordance with immigration laws has been revoked or has been administratively or judicially determined to have been abandoned, or if (B) the individual (1) commences to be treated as a resident of a foreign country under the provisions of a tax treaty between the United States and the foreign country, (2) does not waive the benefits of the treaty applicable to residents of the foreign country, and (3) notifies the Secretary of such treatment on Forms 8833 and 8854. Again, it is a strong recommendation to contact an expatriate international tax attorney to determine whether your situation fits under the legal definitions provided above.

“Covered Expatriates” Under IRC Section 877A

We have finally come to the final destination of this article – understanding who is considered to be a “covered expatriate”. Generally, expatriate international tax attorneys would turn to IRC Section 877A(g)(1)(A), which defines three categories of “covered expatriate”. Under this section, the term “covered expatriate” means an expatriate who:

(1) has an average annual net income tax liability for the five preceding taxable years ending before the expatriation date that exceeds a specified amount that is adjusted for inflation ($145,000 in 2009) (the “tax liability test”);

(2) has a net worth of $2 million or more as of the expatriation date (the “net worth test”); or

(3) fails to certify, under penalties of perjury, compliance with all U.S. Federal tax obligations for the five taxable years preceding the taxable year that includes the expatriation date, including, but not limited to, obligations to file income tax, employment tax, gift tax, and information returns, if applicable, and obligations to pay all relevant tax liabilities, interest, and penalties (the “certification test”).

For the purposes of the certification test, this certification must be made on Form 8854 and must be filed by the due date of the taxpayer’s Federal income tax return for the taxable year that includes the day before the expatriation date. See a separate article on www.sherayzenlaw.com for information concerning Form 8854.

Note that the determination as to whether an individual is a covered expatriate is made as of the expatriation date (see above for the definition).

Definition of “Covered Expatriate” is Complex; Two Major Exceptions Listed

As expected, there are serious complications with respect to determining eligibility under the “tax liability” and “net worth” tests (generally, Section III of IRS Notice 97-19 should be consulted) – you will need to discuss your particular situation with an expatriate international tax attorney to determine whether you fall under any of the three categories.

I will solely  point out the most glaring exceptions to the tax liability test and net worth test. IRC Section 877A(g)(1)(B) provides that an expatriate will not be treated as meeting the tax liability test or the net worth test of section 877(a)(2)(A) or (B) if:

(1) the expatriate became at birth a U.S. citizen and a citizen of another country and, as of the expatriation date, continues to be a citizen of, and is taxed as a resident of, such other country, and has been a U.S. resident for not more than 10 taxable years during the 15 taxable year period ending with the taxable year during which the expatriation date occurs; or

(2) the expatriate relinquishes U.S. citizenship before the age of 18.5 (eighteen and a half) and has been a U.S. resident for not more than 10 taxable years before the date of relinquishment.

Contact Sherayzen Law Office for Legal Help with Expatriation Issues

If you are considering expatriation as a tax strategy, you need to be aware of the very complex legal and tax issues related to expatriation. This why you need to contact Eugene Sherayzen, an experienced international tax attorney at Sherayzen Law Office; our international tax firm will thoroughly analyze the expatriation option for you, explain to you the consequences of taking such a step, and (if you still wish to proceed with the strategy) guide you through the entire process of expatriation, including completing all necessary tax and legal forms.

Tax Withholding and Payments to Foreign Persons: Form W-8BEN

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Form W-8BEN, (“Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding”) may be used by foreign persons who receive certain types of income to establish that they are non-U.S. persons, or to claim a reduced rate of (or exemption from) withholding as a resident of a foreign country with which the U.S. has a tax treaty.

This article will cover the basics of Form W-8BEN. It is not intended to convey tax or legal advice. US tax rules regarding international taxation can involve many complex tax and legal issues, so you are advised to seek an experienced attorney in these matters.

General Rule: Income Subject to Tax Withholding Under IRC Sections 1441, 1442 and 1446

In general, pursuant to IRC Sections 1441 and 1442, foreign persons are subject to a 30% U.S. tax rate on income received from U.S.-source income consisting of dividends, rents, annuities, royalties, compensation received (or expected) for services performed, premiums, substitute payments in a securities lending transaction, or any other fixed or determinable annual or periodical gains, profits, or income. A payment is considered to have been made to foreign persons whether such payment is made directly to the beneficial owner or indirectly through an intermediary, agent or partnership, for the benefit of the beneficial owner.

It is also important to note that, pursuant to IRC Section 1446 (Withholding Tax on Foreign Partners’ Share of Effectively Connected Income), a partnership that conducts trade or business in the United States is required to withhold tax on a foreign partner’s distributive share of the partnership’s “effectively connected income” (ECI). Note that ECI is a term of art in the area of tax withholding law with its own complex definition and important tax consequences to the partnership and its partners.

Form W-8BEN

If certain types of income (such as described above) are received by an individual required to file Form W-8BEN, the form must be filed in order to demonstrate any of the following: (1) for foreign persons to establish that they are not U.S. persons, (2) to claim a reduced rate of, or exemption from, a tax withholding by reason of being a resident of a foreign country with which the United States has an income tax treaty, if applicable, (3) or in order for persons to claim that they are beneficial owners of the income for which Form W-8BEN is being provided or a partner in a partnership subject to IRC section 1446.

With respect to Section 1446, note that submitting Form W-8BEN by a foreign person that is a partner in a partnership may satisfy the requirements for all three Section 1441, 1442 and 1446; but this is not always the case. Sometimes, the documentation requirements for Section 1446 may differ from those of 1441 and 1442 (See Regulations sections 1.1446-1 through 1.1446-6). Furthermore, the owner of a disregarded entity will need to submit the appropriate Form W-8 for the purposes of Section 1446.

Form W-8BEN may also be required to be filed in order for persons to claim an exception from domestic information reporting and backup withholding for certain categories of income not subject to foreign-person withholding, including bank deposit interest, foreign source interest, dividends, rents, or royalties, broker proceeds, short-term (183 days or less) original issue discount (OID), and proceeds from a wager placed by a nonresident alien individual in various types of gambling games. Additionally, Form W-8BEN may be used to establish that income from a notional principal contract is not effectively connected income with a U.S. trade or business.

Who Must File Form W-8BEN

Foreign persons who are the beneficial owners of an amount subject to withholding must submit W-8BEN to the withholding agent or payer (and it must be given when requested by the withholding agent or payer regardless of whether a reduced rate of, or exemption from, withholding is claimed). However, Form W-8BEN should not be submitted by U.S. citizens (even if such citizens reside outside the U.S.), or by nonresident alien individuals claiming exemption from withholding on compensation for independent or dependent personal services performed in the U.S.

Contact Sherayzen Law Office for Help With US Tax Withholding Rules Regarding Payments to Foreign Persons

U.S. tax withholding rules are complex and may lead to various complications in tax compliance and tax planning for businesses and individuals. In order to avoid costly mistakes, contact the experienced Form W-8BEN tax firm of Sherayzen Law Office for help with U.S. tax withholding rules.

Home Office Expense and Unrecaptured Section 1250 gain

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Do you take the home office expense on Schedule C for your small business? While taking the home office expense can help reduce your tax liability, you should be aware of a potential significant downside: unrecaptured Section 1250 gain on depreciation.

This article will explain the basics of unrecaptured Section 1250 gain; it is not intended to convey tax or legal advice. Running a small business can involve many complex tax and legal issues, so you are advised to seek an experienced attorney in these matters. Sherayzen Law Office, PLLC can assist you in all of your tax and legal needs, and help you avoid making costly mistakes.

Section 1250 Property Defined

The IRS defines Section 1250 property to include, “[A]ll real property that is subject to an allowance for depreciation and that is not and never has been section 1245 property. It includes a leasehold of land or section 1250 property subject to an allowance for depreciation.” (Section 1245 property includes a variety of specified types of property, including tangible and intangible personal property).

Treatment of Unrecaptured Section 1250 Gain

Most taxpayers are aware that when single individuals or married couples sell their primary residence, some or all of the gain may be excluded from taxation (the exclusion is $250,000 for single taxpayers and $500,000 for married couples). Gain that exceeds the exclusion amount is then taxed at the favorable capital gains rates.

However, when taxpayers take the home office expense and depreciate their homes, the typical tax rules no longer apply. This is partly because by taking a depreciation expense on a home, a benefit is received in the form of a lower tax liability; thus it only makes sense that the IRS would want a portion of that amount back when a taxpayer finally sells a home (this is referred to as “recapturing” depreciation).

Unlike the general rule for sales or exchanges of property, if depreciable or amortizable property is disposed of at a gain, taxpayers may have to treat all, or part of, the gain (even if otherwise nontaxable) as ordinary income. Whereas the sale or exchange will allow taxpayers to pay at capital gains rates, dispositions involving unrecaptured Section 1250 gain will be taxed at a maximum of 25%, regardless of a taxpayer’s ordinary income bracket. Note that like typical capital gains transactions, dispositions involving unrecaptured Section 1250 gain will still be reported on Schedule D of Form 1040.

Does it Matter if Depreciation Expense Was Not Taken?

A frequent question arises when taxpayers take the home office expense on their Form 1040 Schedule C. Because of the disadvantage of paying tax on unrecaptured Section 1250 gain, taxpayers wonder whether they can simply take the home office expense but not take depreciation expense on their home, thereby avoiding this tax.

Unfortunately, this is not allowed under the Internal Revenue Code. As with rental real estate, taxpayers are imputed to have depreciated their business assets, regardless of whether depreciation was actually taken. As the IRS notes in Publication 946, “You must reduce the basis of property by the depreciation allowed or allowable, whichever is greater. Depreciation allowed is depreciation you actually deducted (from which you received a tax benefit). Depreciation allowable is depreciation you are entitled to deduct. If you do not claim depreciation you are entitled to deduct, you must still reduce the basis of the property by the full amount of depreciation allowable.”

IRS Issues a Proposed Regulation Regarding Employer-Sponsored Healthcare Plans

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The IRS recently issued a proposed rule entitled, “Minimum Value of Eligible Employer-Sponsored Plans and Other Rules Regarding the Health Insurance Premium Tax Credit” (see, 26 CFR Part 1) regarding the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act of 2010, and related rules and laws (generally, “PPACA”). In the proposed regulation, the IRS has ruled that employer-sponsored healthcare plans will be unable to include various wellness programs in order to meet minimum value (MV) coverage requirements under the PPACA and related rules. In general, large employers (typically 50 full-time employees or more) who do not meet certain minimum coverage standards under the PPACA must pay an excise tax.

Many employers sought to include wellness programs in their plans in order to reduce health care coverage costs. In general, wellness programs are often designed to reduce potential health problems for employees through various means. Certain wellness programs may even require employees to meet an established health standard.

The article will give a basic summary of a proposed rule and the MV calculation. It is not intended to constitute tax or legal advice. The new rules under the PPACA will involve many complex tax and legal issues, so you are advised to seek an experienced attorney if you have questions in these areas. Sherayzen Law Office, PLLC can assist you in all of your tax, business-planning and legal needs, and help you avoid making costly mistakes.

MV Determinations under the Proposed Regulation

In making its proposed rule, the IRS noted:

“Commentators offered differing opinions about how nondiscriminatory wellness program incentives that may affect an employee’s cost sharing should be taken into account for purposes of the MV calculation. Some commentators noted that the rules governing wellness incentives require that they be available to all similarly situated individuals. These commentators suggested that because eligible individuals have the opportunity to reduce their cost-sharing if they choose, a plan’s share of costs should be based on the costs paid by individuals who satisfy the terms of the wellness program. Other commentators expressed concern that, despite the safeguards of the regulations governing wellness incentives, certain individuals inevitably will face barriers to participation and fail to qualify for rewards. These commentators suggested that a plan’s share of costs should be determined without assuming that individuals would qualify for the reduced cost-sharing available under a wellness program.”

The IRS stated that there are several methods for determining MV (under Notice 2012-31 and 45 CFR 156.145(a)): “the MV Calculator, a safe harbor, actuarial certification, and, for small group market plans, a metal level.” According to the proposed rule, employers may determine whether a certain plan provides MV by utilizing an HHS and IRS MV calculator, unless a safe harbor exists. Certain safe harbor plans will be specified in future guidance.

Under 45 CFR 156.145(a) and the proposed rule, “[P]lans with nonstandard features that cannot determine MV using the MV Calculator or a safe harbor” must use the actuarial certification method. Further, it is required that the actuary performing the MV calculation must be a member of the American Academy of Actuaries and perform the analysis in accordance with generally accepted actuarial principles and methodologies, and its related standards.

Exception to the Wellness Program Rule

The IRS proposed rule does provide one exception to the wellness program MV calculations for certain anti-tobacco related programs. Under the proposed regulation, “…[F]or nondiscriminatory wellness programs designed to prevent or reduce tobacco use, MV may be calculated assuming that every eligible individual satisfies the terms of the program relating to prevention or reduction of tobacco use.”

Forms 3520 and 3520-A and Increased Use of Foreign Trusts

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The Internal Revenue Service recently released its Statistics of Income Studies (SOI) reports concerning data for 2010 foreign trusts that have U.S. persons as grantors, transferors, or beneficiaries. The data shows that, despite the various compliance costs associated with reporting requirements, use of foreign trusts by U.S. taxpayers continues to increase.

This article will briefly explain Form 3520 and Form 3520-A, and highlight some of the newly released SOI data relating to such forms. The article is not intended to constitute tax or legal advice. US-International taxation and foreign trusts can involve many complex tax and legal issues, so you are advised to seek an experienced attorney in these matters.

Form 3520

The purpose of Form 3520 (“Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts”) is for U.S. persons (and executors of estates of U.S. decedents) to report certain transactions with foreign trusts, ownership of foreign trusts (see IRC Sections 671-679), and receipt of certain large gifts or bequests from certain foreign individuals.

The SOI data for Forms 3520 with Gratuitous Transfers for 2010 shows U.S. taxpayers filed 950 returns with transfers for a total value of 1.49 billion dollars. This was an increase in the number of returns from 2006 (752 returns with transfers) and 2002 (429 returns with transfers). The total transferred value for the year of the study, however, decreased from 2002 (2.18 billion) and 2006 (1.64 billion).

Certain countries figure prominently in the SOI data. For Forms 3520 with Gratuitous Transfers for 2010, Mexico led the way with 178 transfers (approximately $236 million in value), followed by Puerto Rico (approximately $57 million in value). Other leading countries include St. Christopher/Nevis, with 58 ($21.68 million), Canada, with 49 ($63.69 million), Isle of Man with 47 ($82.44 million), and United Kingdom and Northern Ireland with 45 (12.78 million).

For Forms 3520 with Non-Grantor Trust Distributions, there were 1,698 total returns with total distributions of 3.165 billion dollars for the 2010 SOI data. This was also an increase from the 2006 data of 1,200 returns with distributions of 2.87 billion, and the 2002 data of 607 returns with distributions of 311 million dollars.

Form 3520-A

Form 3520-A (“Annual Information Return of Foreign Trust With a U.S. Owner”) must be filed by foreign trusts with a U.S. owner in order to satisfy its annual information reporting requirements under section 6048(b). Form 3520-A provides information about the foreign trust, its U.S. beneficiaries, and any U.S. person who is treated as an owner of any portion of the foreign trust.

For the 2010 SOI data, 7,051 foreign grantor trusts reported total distributions of $3.96 billion, net income of 1.13 billion, and foreign taxes paid of 13.75 million. This is a huge increase from the 2006 data of 740 total returns with distributions of 57.88 million, net income of 6 million, and foreign taxes paid of $149 thousand; and 2002 with 2,550 returns with distributions of $884 million, net income of $358 million, and foreign taxes paid of $4 million. A distribution is defined by Form 3520-A instructions to be, “[A]ny gratuitous transfer of money or other property from a trust, whether or not the trust is treated as owned by another person under the grantor trust rules, and without regard to whether the recipient is designated as a beneficiary by the terms of the trust.”

Contact Sherayzen Law Office for Help With Forms 3520, 3520-A and Foreign Trust Tax Planning Issues

International tax issues, like foreign trust compliance, are highly complex and result in very costly mistakes and even criminal liability. This is why it is important to consult an experienced Form 3520 foreign trust tax attorney who would be able to analyze the issues involved, identify compliance requirements, complete all of the necessary legal and tax documents, and create a tax plan for moving forward.

Contact Sherayzen Law Office if you are a beneficiary of a foreign trust, an owner of a foreign trust, or you are thinking about a comprehensive asset protection plan involving foreign trusts. Our experienced international tax firm can assist you with U.S. tax compliance with respect to foreign trusts (including Forms 3520, 3520-A, FinCEN Form 114, (formerly form TD F 90-22.1), Form 8938 and other relevant forms) as well as creation of a comprehensive asset protection plan that will strive to balance tax optimization with asset protection strategies according to your needs.