Exit Tax: Covered and Non-Covered Expatriates
Many US citizens and Green Card holders give up their citizenship or Green Card for various reasons, taxes being the main one. If you are considering giving up your US citizenship/Green Card, or you have recently done it, you must know the difference between covered and non-covered expatriates.
Covered Expatriates are the ones that IRS tells them, “not so fast cowboy!” This group of expats have a “deemed sale” of their worldwide assets: they must pretend that they sold their worldwide assets the day before their expatriation date and pay a hefty tax on their gain, a go away gift from the IRS!
Non-covered Expatriates do not have to do the deemed sale of their assets. They are, however, required to report to the IRS about their expatriation.
How do I become a covered expatriate?
There are three tests that will tell you whether you are a covered expat or not:
If you are a high achiever and successful in your life, try not to ace these test! As a matter of fact it is to your benefit to meet all three test! If you pass any of these tests, you are a covered expat and will be subject to exit tax. There are, of course, few exceptions as is the case with every tax code. Now let’s see what each test is about.
1. Certification Test
Under this test you are a covered expatriate if you meet any of the following:
You must 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”). 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.”
Prior Five Years
The purpose of this is that the IRS wants to know that you have filed and paid your taxes in the past five years prior your exit, so that people with large amount of tax due do not flee the country without paying their taxes.
If you have not filed your tax returns for the prior five years, we recommend to it before you expatriate. If you did not file your tax return because you did not have any filing requirement, it is still a good move to file your tax returns because it proves to the IRS that you are up to date regarding your taxes and there won’t be any review and delay in your expatriation process. Moreover, since you did not have any filing requirement, there won’t be penalty and interest imposed you for filing late.
Filing Form 8854 On Time
This form must be filed as an attachment to your tax return for the year you are expatriating. Normally the tax return filing deadline is April 15. If you live abroad and do not have any wages in the US, generally your deadline is June 15. In either case, you are entitled to get a six months extension that extends your filing deadline to October 15 and December 15 respectively.
Many expatriates forget to file this form with their tax return, and as a result they become a covered expatriate. There is a $10,000 penalty for filing Form 8854 late also might apply to you. So watch out!
2. Net Worth Test
Most people become a covered expatriate because they pass (or fail, depending on your life philosophy) this test. If your personal net worth is more than $2,000,000 (this figure does not get adjusted for inflation) on the date you are expatriating, you become a covered expatriate.
You must include your personal assets and liabilities for this test. If you are married, each spouse does this separately.
Assets
The assets that you report for this test include “any interest in property”. “Interest in property” is a term of art, and generally it means any property that you own or have the right to use (pretty much everything you own A-Z)!
Liabilities
You get to reduce your assets by your liabilities to calculate your net worth. For example, if you own a Rolls Royce with fair market value of $500,000 with a loan of $400,000, your net worth is $100,000. Other liabilities include credit card debts, student loan, …
If you are beneficiary of a trust, you must calculate the value of your beneficial interest and include it in your net worth.
3. Net Tax Liability Test
You know the IRS is after you if you are reach enough! If your average tax liability for the 5 years prior to your expatriation is $165,000 (for 2018, indexed for inflation) or more, the IRS will award you as being a covered expatriate, and thus subject to even more taxes.
Married Filing Jointly
As you know, many of the IRS rules are not marriage friendly. This case is one of them. Let’s say a married couple have an average tax liability of $200,000 before their expatriation. In a fair world, they would divide that by two, and each of their average tax liability would be $100,000, well under the threshold, and therefore would not pass this test. But the reality is that this poor couple each must take the entire $200,000 as their tax liability and are doomed to be a covered expatriate.
Exceptions
The good fellows at the IRS have created some exceptions so that if you meet any of these tests and become a covered expatriate, you can use the exceptions and be treated as a noncovered expatriate.
If you passed the certification test, there is no way around it and there is no exception for it. But if passed any or both of the other two tests (net worth test and net liability test), you may be able to use the one of the exception to covered expatriate status. If you qualify for any of the exceptions, congratulations: you are a non-covered expatriate. Now what are the exceptions to covered expatriate status?
Dual Citizen At Birth
You qualify for the “dual citizenship at birth” exception if you satisfy all of the following:
Relinquish Citizenship Before Age 18 1/2
You qualify for this exception if you satisfy both of the following:
If you have expatriated or if you are planning to expatriate soon, please consult with us as soon as possible to make sure that you are not missing any deadline and that you are up to date with all of your filing requirements.
Covered Expatriates are the ones that IRS tells them, “not so fast cowboy!” This group of expats have a “deemed sale” of their worldwide assets: they must pretend that they sold their worldwide assets the day before their expatriation date and pay a hefty tax on their gain, a go away gift from the IRS!
Non-covered Expatriates do not have to do the deemed sale of their assets. They are, however, required to report to the IRS about their expatriation.
How do I become a covered expatriate?
There are three tests that will tell you whether you are a covered expat or not:
- Certification Test
- Net Worth Test
- Net Liability Test
If you are a high achiever and successful in your life, try not to ace these test! As a matter of fact it is to your benefit to meet all three test! If you pass any of these tests, you are a covered expat and will be subject to exit tax. There are, of course, few exceptions as is the case with every tax code. Now let’s see what each test is about.
1. Certification Test
Under this test you are a covered expatriate if you meet any of the following:
- You are not up to date with all if your Federal tax obligations; or
- Your Form 8854 was filed late after your expatriation event; or
- There is untrue information on your ta return or Form 8854
You must 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”). 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.”
Prior Five Years
The purpose of this is that the IRS wants to know that you have filed and paid your taxes in the past five years prior your exit, so that people with large amount of tax due do not flee the country without paying their taxes.
If you have not filed your tax returns for the prior five years, we recommend to it before you expatriate. If you did not file your tax return because you did not have any filing requirement, it is still a good move to file your tax returns because it proves to the IRS that you are up to date regarding your taxes and there won’t be any review and delay in your expatriation process. Moreover, since you did not have any filing requirement, there won’t be penalty and interest imposed you for filing late.
Filing Form 8854 On Time
This form must be filed as an attachment to your tax return for the year you are expatriating. Normally the tax return filing deadline is April 15. If you live abroad and do not have any wages in the US, generally your deadline is June 15. In either case, you are entitled to get a six months extension that extends your filing deadline to October 15 and December 15 respectively.
Many expatriates forget to file this form with their tax return, and as a result they become a covered expatriate. There is a $10,000 penalty for filing Form 8854 late also might apply to you. So watch out!
2. Net Worth Test
Most people become a covered expatriate because they pass (or fail, depending on your life philosophy) this test. If your personal net worth is more than $2,000,000 (this figure does not get adjusted for inflation) on the date you are expatriating, you become a covered expatriate.
You must include your personal assets and liabilities for this test. If you are married, each spouse does this separately.
Assets
The assets that you report for this test include “any interest in property”. “Interest in property” is a term of art, and generally it means any property that you own or have the right to use (pretty much everything you own A-Z)!
Liabilities
You get to reduce your assets by your liabilities to calculate your net worth. For example, if you own a Rolls Royce with fair market value of $500,000 with a loan of $400,000, your net worth is $100,000. Other liabilities include credit card debts, student loan, …
If you are beneficiary of a trust, you must calculate the value of your beneficial interest and include it in your net worth.
3. Net Tax Liability Test
You know the IRS is after you if you are reach enough! If your average tax liability for the 5 years prior to your expatriation is $165,000 (for 2018, indexed for inflation) or more, the IRS will award you as being a covered expatriate, and thus subject to even more taxes.
Married Filing Jointly
As you know, many of the IRS rules are not marriage friendly. This case is one of them. Let’s say a married couple have an average tax liability of $200,000 before their expatriation. In a fair world, they would divide that by two, and each of their average tax liability would be $100,000, well under the threshold, and therefore would not pass this test. But the reality is that this poor couple each must take the entire $200,000 as their tax liability and are doomed to be a covered expatriate.
Exceptions
The good fellows at the IRS have created some exceptions so that if you meet any of these tests and become a covered expatriate, you can use the exceptions and be treated as a noncovered expatriate.
If you passed the certification test, there is no way around it and there is no exception for it. But if passed any or both of the other two tests (net worth test and net liability test), you may be able to use the one of the exception to covered expatriate status. If you qualify for any of the exceptions, congratulations: you are a non-covered expatriate. Now what are the exceptions to covered expatriate status?
Dual Citizen At Birth
You qualify for the “dual citizenship at birth” exception if you satisfy all of the following:
- You became a US citizen at birth; and
- You also became a citizen of another country at birth; and
- On your expatriation date you “continue” to be a citizen of that country; and
- On your expatriation date you “continue” to be taxed as a resident of that country; and
- On your expatriation date you were not a US resident for 10 of the 15 tax years that end with the year that you expatriated.
Relinquish Citizenship Before Age 18 1/2
You qualify for this exception if you satisfy both of the following:
- You relinquish your US citizenship before age 18 1/2; and
- You were not a US resident for more than 10 taxable years before the date of relinquishment.
If you have expatriated or if you are planning to expatriate soon, please consult with us as soon as possible to make sure that you are not missing any deadline and that you are up to date with all of your filing requirements.