(From the June 30, 2008 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)
Expatriate Rules in HEART
Expatriation on or after June 17, 2008, may cause an expatriate to be subject to IRC § 877A, which was enacted as part of the Heroes Earnings Assistance and Relief Tax Act (HEART) Act of 2008. Generally, IRC § 877A imposes income tax on the net unrealized gain on property held by certain U.S. citizens or green card holders who terminate their US residency as if their worldwide property had been sold for its fair market value on the day before the expatriation or residency termination (mark-to-market tax). The Treasury Department and IRS have authority to issue regulations under IRC § 877A so further guidance is expected.
Individuals Covered and Expatriation
The provisions of IRC § 877A apply to all U.S. citizens and former long-term permanent residents who expatriate on or after June 17, 2008, (a covered expatriate) if they meet any of the following three tests:
A long-term permanent resident is any individual who was a lawful permanent resident (green card holder) for any part of at least 8 of the last 15 taxable years.
Exceptions may be applicable for certain individuals with dual citizenship and individuals who relinquish citizenship prior to age 18½.
Generally, the actual act of expatriation for a U.S. citizen for tax purposes occurs when an individual formally renounces U.S. citizenship. A U.S. citizen is treated as relinquishing citizenship on the earliest of the following dates:
Note that a renunciation or relinquishment must be subsequently approved by the issuance to the individual of a certificate of loss of nationality by the U.S. Department of State. A green card holder is deemed to have expatriated on the date that lawful permanent resident status ceases. This generally occurs either on the date a green card is determined to have been revoked or judicially or administratively abandoned, or on the first day of a tax year for which a long-term permanent resident invokes a tax treaty to be treated as a resident of a foreign country and does not waive the benefits offered by the treaty to residents of such foreign country.
Imposition of Mark-to-Market Tax
As previously indicated, IRC § 877A subjects a covered expatriate to an income tax on the net unrealized gain on their worldwide property as if the property had been sold for fair market value on the day before expatriation. Losses may be taken into account, but only to the extent of gains. Thus, application of the expatriation rules may not result in a loss for tax purposes. The first $600,000 (indexed annually) of net gain is excluded for each expatriating individual.
A basis adjustment is applied to all property subject to the deemed sale provisions to ensure that a future sale does not result in double taxation as a result of the application of the deemed sale rules. For purposes of determining the basis of property subject to the deemed sale rules, property that was held by an individual on the date the individual first became a resident of the U.S. may be treated as having a basis equal to the fair market value of such property on the residency start date. An individual may elect not to have this step-up in basis apply. Basis of property acquired after the residency start date would be computed under the standard basis rules.
Special rules apply to certain deferred compensation assets, certain interests in foreign trusts, and specified tax-deferred accounts.
Deferral of Tax
An election may be made to defer payment of the mark-to-market tax imposed on the deemed sale of property. Interest is charged, the election is irrevocable, and bond (or other security) must be furnished. Generally, the deferred tax is due when the return is due for the taxable year in which the property is disposed, but may not be extended beyond the due date of the return for the taxable year which includes the individual's death.
Treatment of Nonqualified Deferred Compensation
Special rules are applicable for an eligible deferred compensation item. Generally, an eligible deferred compensation item is any deferred compensation item with respect to which
With respect to the payment of an eligible deferred compensation item (including certain qualified retirement plans, foreign pension plans, deferred compensation, or property transferred in connection with the performance of services to the extent not previously included in income under IRC § 83), the payor must deduct and withhold 30 percent of the payment. A payment is subject to withholding to the extent it would be included in the individual's gross income if the individual was subject to tax as a U.S. citizen or resident. The payment is also subject to tax under IRC § 871.
If a deferred compensation item is not an eligible deferred compensation item (and not subject to IRC § 83), an amount equal to the present value of the deferred compensation item is treated as having been received on the day before the expatriation date. For a deferred compensation item subject to IRC § 83, the item is treated as becoming transferable and no longer subject to a substantial risk of forfeiture on the date before the expatriation date. Adjustments are made to subsequent distributions to take into account this treatment. Additionally, the deemed distributions are not subject to early distribution tax.
These rules do not apply to the extent the deferred compensation is attributable to services performed outside the US while the covered expatriate was not a citizen or resident of the US.
Specified Tax Deferred Accounts
For specified tax-deferred accounts (such as individual retirement plan, qualified tuition plans, a Coverdell education savings account, a health savings account, and an Archer MSA), the account is treated as having been distributed on the day before the expatriation date. The deemed distribution is subject to income tax at ordinary income rates, however, the penalties normally applicable to early withdrawals do not apply to a deemed distribution under the expatriation rules. A basis adjustment is made to reflect the taxation incurred as a result of the deemed distribution under the expatriation rules.
With respect to the portion of a trust for which the covered expatriate is treated as the owner under the grantor trust rules, the assets are subject to the mark-to-market rules. However, the mark-to-market rules do not apply to any trust or portion of a trust not treated as owned by the covered expatriate immediately before the expatriation date. Instead, in the case of a distribution from a non-grantor trust, the trustee must withhold 30 percent of the portion of the distribution which would be includible in the gross income of the covered expatriate if he or she had been subject to tax as a U.S. citizen or resident. The covered expatriate is treated as waiving any right to claim a reduction in withholding under any U.S. tax treaty.
Gifts and Bequests from a Covered Expatriate
A U.S. person who receives a gift or bequest from a covered expatriate is subject to U.S. tax on the receipt of such gift or bequest. For this purpose, a gift or bequest includes property acquired by gift directly (or indirectly) from a covered expatriate or directly (or indirectly) by reason of the death of a covered expatriate. The total value of the gift is first reduced by the available annual exclusion ($12,000 in 2008; indexed annually), and tax is then assessed at the highest applicable gift tax rate at the time of the gift (in 2008, the top gift tax rate is 45 percent). Special rules apply to gifts or bequests made to domestic or foreign trusts by a covered expatriate.