On Sept 6, 2019, the IRS announced commencement of a new program, Relief Procedures for Certain Former Citizens.
For many U.S. citizens living outside of the U.S. who either gave up their citizenship or would like to do so, this new Internal Revenue Service program will provide welcome and extremely taxpayer-friendly relief from the tax obligations that normally accompany renouncing U.S. citizenship. For those who do not meet the program’s strict criteria, they may be hearing from the IRS sooner rather than later.
TAX FRAMEWORK FOR U.S. CITIZENS LIVING ABROAD
U.S. citizenship comes with a lot of benefits. U.S. citizens may travel with a U.S. passport, are eligible for government benefit programs such as financial aid for college and can vote in national elections. When a U.S. citizen has a child, the child is automatically a U.S. citizen, even if the child is born outside of the U.S., if the birth is reported to a U.S. embassy or consulate. One natural consequence of this citizenship “benefit” is that many U.S. citizens live abroad and have never lived or worked in the U.S., but have maintained their citizenship for a variety of reasons.
U.S. citizens have certain responsibilities, regardless of whether they live or work in the U.S. One of the most unique—and onerous—responsibilities of U.S. citizenship is the duty to report and pay tax on worldwide income, regardless of whether the income was earned in the U.S. or whether the citizen lives in the U.S. The U.S. is one of only a handful of countries and is the only major nation that taxes its citizens on worldwide income.
Many U.S. citizens living abroad either don’t know that they are required to file tax returns in the U.S. or just don’t file them, for a variety of reasons. Some people mistakenly believe that there is no such thing as double-taxation, and if they are living in a country with a higher tax rate than the highest effective tax rate in the U.S., that they won’t owe tax and therefore don’t need to file. It is true that the U.S. has entered into treaties with many foreign countries that often result in eliminating double-taxation, but it is not a hard and fast rule. Foreign taxes paid may result in foreign tax credits that offset tax due in the U.S., but it doesn’t automatically result in a dollar for dollar credit. More importantly, just because a U.S. citizen has paid enough foreign tax to offset tax in the U.S. doesn’t mean that individual does not need to file taxes in the U.S. On the contrary, the only way that the IRS can know that an individual paid enough foreign taxes to offset the U.S. tax that would be due is by filing a tax return with the IRS that includes Form 1116, Foreign Tax Credit.
The benefits of U.S. citizenship often lose their appeal and value when individuals living abroad have to go through the time and expense of preparing and filing a U.S. Income Tax Return, and other required forms such as the Report of Foreign Bank and Financial Accounts (FBAR), year after year. Even if no tax is due, the time and administrative cost of compliance with U.S. tax laws is onerous if one does not intend to come and live in the U.S. As a result, the number of Americans who have decided to give up their U.S. citizenship is steadily rising as the IRS has gotten more aggressive about enforcing tax compliance laws abroad.
Who can expatriate?
Any U.S. citizen who is living outside the U.S. can expatriate. U.S. citizens who renounce or relinquish their citizenship must make an appointment at the U.S. embassy or consulate in the country where they are living and complete various State Department Forms, take an oath renouncing citizenship, pay a fee of $2,350, and, most importantly, address the U.S. tax consequences of expatriation.
What are the tax requirements and consequences of expatriation?
In general, U.S. citizens who expatriate after June 17, 2008, must file IRS Form 8854 and follow the rules in tax code Section 877A. An expatriate will be a “covered expatriate” who may be required to pay an exit tax if certain criteria are met. In general, the exit tax is computed by calculating what the gain on the sale of all worldwide assets would be if the individual sold all assets on the day before expatriation. For example, if John Doe owned a home in Illinois worth $1.5 million and a home in France worth $5 million, and had a basis in the Illinois home of $500,000 and a basis in the French home of $250,000, then the starting point for determining John’s exit tax would be calculated as follows:
Illinois Home: $1,500,000 - $500,000 = $1,000,000 mark to market gain
French Home: $5,000,000 - $250,000 = $4,750,000 mark to market gain
Total mark to market gain: $5,750,000
To first determine whether an individual who is expatriating is a “covered expatriate” and must pay an exit tax, Section 877A sets forth the following criteria:
- The individual has an average annual net income tax liability of the five years preceding the year of expatriation that exceeds a specified amount adjusted for inflation (for example, $161,000 for 2016, $162,000 for 2017, $165,000 for 2018, and $168,000 for 2019) (Average Income Test);
- The individual has a net worth of $2 million or more as of the expatriation date (Net Worth Test); or
- The individual cannot certify, under penalties of perjury, on Form 8854, Initial and Annual Expatriation Statement, that the individual is compliant with all federal tax obligations for the five tax years preceding the tax year that includes the expatriation date.
Returning to our John Doe example, John is a covered expatriate and must calculate his exit tax, because John has a net worth in excess of $2 million.
Now consider a different example of Jane Doe. Jane owns one home in Illinois worth $250,000 and she earns $110,000 per year. She has filed her tax returns and paid her tax in full each year. She decides to move to France, where she does not own property. Her total worldwide assets, including her retirement accounts, amount to $850,000. Jane is not a covered expatriate, and she is not subject to an exit tax.
How do U.S. citizens living abroad typically handle tax filing and expatriation?
When a U.S. citizen decides to expatriate, it is usually because the cost of being a citizen outweighs the benefits. The IRS is aware that there are many U.S. citizens living abroad who have not formally expatriated and would not meet the criteria to expatriate under Section 877A because they cannot certify that they are in compliance with their tax requirements for the last five years. The reality is, many U.S. citizens living abroad simply do not file tax returns in the U.S. Getting five years of past due tax returns filed is necessary to expatriating without paying the exit tax that would otherwise be due. But preparing and filing five years of back tax returns is no easy task. Therefore, U.S. citizens living abroad who have not filed all tax returns due have historically had three choices:
1. Do nothing and hope the IRS never finds them.
2. File Form 8854 and state that they are not in compliance with the past five years of tax returns, pay exit tax (if any is due), and hope the IRS does not further examine them.
3. Prepare and file past due tax returns for five years, pay any past due tax, interest and penalties, and then complete Form 8854 certifying compliance with tax obligations. Often this could be and was accomplished through the IRS’s streamlined program available to Americans living offshore in conjunction with expatriation.
Options 1 and 2 are not ideal options because they are based on a hope and a prayer that the IRS won’t examine the taxpayer. The statute of limitations for the IRS to assess tax never expires unless a tax return is filed, so for those who choose option 2 and pay exit tax but do not file five years of past due returns, the IRS can always come back and ask for the missing returns or assess the tax that the IRS thinks is due. Option 3 can be very expensive, both from a tax perspective and in professional fees.
How do we know that there are many Americans living abroad who have chosen either option 1 or option 2? Because the IRS is putting significant resources into getting Americans living abroad into tax compliance. The IRS publishes the names of individuals who have expatriated, or given up citizenship, on a quarterly basis. On July 19, 2019, The IRS Large Business and International Division (LB&I) announced six new compliance campaigns, including a campaign directed at expatriation. LB&I announced:
“U.S. citizens and long-term residents (lawful permanent residents in eight out of the last 15 taxable years) who expatriated on or after June 17, 2008, may not have met their filing requirements or tax obligations. The Internal Revenue Service will address noncompliance through a variety of treatment streams, including outreach, soft letters, and examination.”
In light of this new compliance campaign, U.S. citizens living abroad, including those who have expatriated and those who have not, need to carefully consider whether they need to address outstanding tax issues with the IRS.
IRS RELIEF PROCEDURE ANNOUNCED SEPT. 6, 2019
Recognizing that many Americans living abroad need to resolve outstanding tax issues but that there are real financial and logistical hurdles to accomplishing this goal, the IRS announced a new program to assist U.S. citizens living abroad who have expatriated or would like to expatriate. The program provides quite generous relief, but is only available to a select group of individuals.
Who qualifies for the program?
To qualify for the program, and individual must meet the following criteria:
1. Relinquished or will relinquish U.S. citizenship after March 18, 2010;
2. No filing history with the IRS as a citizen or resident. This requirement will eliminate anyone who has ever filed a tax return with the IRS from qualification for the relief program unless they only ever filed as a Non-Resident;
3. Income does not exceed the Net Income Test;
4. Worldwide net worth does not exceed $2 million at the time of expatriation and at the time of the submission to the IRS, if different;
5. Total aggregate tax liability does not exceed $25,000 for each of the five years preceding expatriation and the year of expatriation;
6. Submit past due tax returns for five years preceding submission and for the year of expatriation, plus a completed Form 8854, all signed under penalty of perjury, submitted pursuant to the procedures in the program; and
7. The failure to file tax returns on time must be due not non-willful conduct.
Given the generous terms of the program and the IRS’s announcement that expatriation is a focus of a compliance campaign that will include soft letters and examinations, those who have expatriated or are considering it should consult an attorney to determine if they qualify. An attorney can provide advice regarding whether the individual meets the test and, more importantly, whether the individual’s stated reasons for not previously filing returns will qualify as non-willful conduct. The procedures do not call for a statement stating why the returns were filed late, but attorneys assisting clients in these procedures will be able to carefully consider whether such a statement should be included with a cover letter enclosing the submission.
How does the program work?
For those who meet these criteria, the terms of the program are exceedingly generous. No payment is due as long as the criteria are met, even if a taxpayer owes $24,999 in past due tax! Normally, someone seeking to come into compliance with the IRS would have to pay, at a minimum, past due tax and interest, and most likely a 20% negligence or accuracy penalty. Those who are considering participating should take the following steps:
A. Hire an attorney to advise them of their options, risks and benefits of expatriating and participating in the program.
B. Hire an accountant to prepare past due tax returns and Form 8854.
C. Attorney and accountant must analyze whether the individual qualifies both before and after returns are prepared to determine whether the total tax due exceeds the $25,000 threshold and whether the net worth test is met.
D. Make a final decision on whether to expatriate in light of final analysis of tax returns and net worth test.
E. Follow State Department guidelines on renouncing citizenship.
F. Prepare and send complete package to IRS following the instructions in the program.
The IRS will notify taxpayers who participate in the program that their submission was complete and processed. The IRS anticipates participants will receive notification of processing within two months of submission. However, participants should keep in mind that the IRS always has three years from the date a return is filed to examine that return, even if the return is processed pursuant to this program.
The program does not have a set expiration date, so those who qualify and have expatriated in the past can use it as well as those who would like to expatriate but have not done so yet. The program should include those individuals who expatriated previously under “Option 2” outlined above, filing Form 8854 and stating that the tax requirements for the past five years have not been met, so long as they meet all of the criteria.
The program does not provide guidance regarding whether individuals who previously expatriated and would have qualified under this program, but paid the past due tax, can receive a refund. Given that the tax paid was due, and there is no mechanism for claiming a refund of tax that was due even if it would not be required to be paid under a special program, it is hard to imagine that the IRS would provide a refund to anyone who previously expatriated but paid the full amount due.
What about those expatriates who don’t qualify for the relief program?
The criteria for this program are quite strict and there will certainly be many people who would like to participate but do not meet the criteria. For example, long-term residents who lived and worked in the U.S., filed taxes here, and moved abroad will still have a U.S. filing obligation unless they formally expatriate. They will not qualify for relief under this program because they have filed tax returns in the U.S. U.S. citizens living abroad who have a net worth of greater than $2 million, have too high of a yearly income, or owe more than $25,000 in tax will also not qualify, even if they never filed a tax return in the U.S.
U.S. tax laws are quite different than many other countries, for example, on gains from passive foreign investment companies. An investment may result in no tax due in one country and a large tax due in the U.S. Many U.S. citizens living abroad find themselves owing the IRS what they consider to be an obscene amount of tax for something that isn’t taxed at all in their home country. For this reason and others, it is very likely that there are many people who expatriated since March of 2010 and chose Option 2, which meant that they filed Form 8854 but certified that they were not in compliance IRS requirements for the past five years, who will not qualify for this program because they owe more than $25,000 in U.S. tax. Individuals who expatriated and filed Form 8854 stating that they are not in compliance with tax requirements for the past five years should consult an attorney and carefully consider what their options are.
Just over a month before the IRS announced this new relief program, LB&I launched a compliance campaign for expatriates, clearly and unequivocally stating that expatriation enforcement is a priority that will require outreach, soft letters, and examinations. This program is clearly part of the outreach effort, and enforcement—including soft letters and examinations—will not be far behind. Americans living abroad who can take advantage of this program would be wise to do so, and those who are not eligible should consult an attorney to determine what their best options are in light of this new enforcement priority.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Guinevere Moore is a partner Johnson Moore LLP and represents taxpayers in civil and criminal tax controversies.