Tax Expatriations May Result From Denaturalization Initiative

The Department of Justice Civil Division in June directed its employees to prioritize revocation of US citizenship that was “procured by concealment of a material fact, by willful misrepresentation,” or otherwise illegally procured, as authorized by 8 USC Section 1451(a).

Some commentators have questioned the practicality and constitutionality of such denaturalization proceedings. But given the potential breadth of the initiative, and the existence of 25 million naturalized US citizens, the initiative could have broad application.

Indeed, some have raised the possibility of Elon Musk, the world’s wealthiest individual, being denaturalized, if the grounds mentioned in the DOJ directive were hypothetically found to exist in his situation. Due to the related anti-expatriation income tax provisions discussed below, Musk’s hypothetical denaturalization could trigger the largest individual income tax liability in US history.

Because of the DOJ memo, naturalized US citizens who now find themselves facing a government investigation—in addition to dealing with the issues involved in that current investigation—may need to review any potential concerns related to their earlier naturalization, and consider any future US tax issues that could arise from denaturalization.

Denaturalization can extend beyond the culpable individual. Under Section 1451(d), if an individual is denaturalized under Section 1451(a), any spouse or child whose naturalization was obtained through that denaturalized individual can also be subject to denaturalization.

Tax Expatriation

Section 877A imposes a special mark-to-market gain recognition on covered expatriates, although deferral of payment may be available if adequate security is posted. Section 2801 imposes a special transfer tax regime on donees and legatees from covered expatriates. A covered expatriate is generally an expatriate who meets certain criteria concerning average income tax liability, minimum net worth, or past tax noncompliance.

An expatriate is defined to include a US citizen who relinquishes that citizenship. Section 877A(g)(4)(D) generally provides that a US citizen is deemed to relinquish US citizenship on the date a US court cancels a “naturalized citizen’s certificate of naturalization.”

According to the Joint Committee on Taxation, a US citizen, apparently including a naturalized US citizen, “continues to be treated as a US citizen” for purposes of Section 877A until denaturalization or other expatriating event occurs.

Although the Joint Committee on Taxation’s interpretation is eminently logical, the existence of arguably conflicting language in Section 1451(a) has presented interpretative issues. Section 1451(a) provides that in the case of a denaturalization, “such revocation and setting aside of the order admitting such person to citizenship and such canceling of certificate of naturalization shall be effective as of the original date of the order and certificate, respectively.”

This relation-back of non-citizenship could enable denaturalized US citizens to argue that they were retroactively never a US citizen within the meaning of 877A(g)(4) and thus can’t be viewed as relinquishing US citizenship for purposes of Sections 877A and 2801. Such an illogical interpretation would practically eliminate expatriation under Section 877A(g)(4)(D).

The DOJ argued Castillo v. Bondi on the same day it issued the denaturalization memo. Paradoxically, when viewed in connection with Section 877A(g)(4), the DOJ in Castillo posited an expansive interpretation of the relation-back clause, though that interpretation was made in a non-tax context and rejected by the US Court of Appeals for the Sixth Circuit.

A tax court following the Sixth Circuit’s Castillo approach wouldn’t apply the relation-back doctrine to find a denaturalized citizen was never a citizen for purposes of applying Section 877A(g)(4)(D). Rather, such a denaturalized citizen would be viewed as expatriating under Section 877A(g)(4)(D) at the time of denaturalization.

Tax Planning

As a practical matter, possible pre-expatriation tax planning for an individual opposing a DOJ denaturalization proceeding is more nuanced than such planning for US citizens who have decided to eventually voluntarily renounce their citizenship to minimize their post-expatriation US tax.

Those seeking voluntary expatriation know they can achieve non-resident, non-domiciled, alien tax status after renunciation. Many make a one-time decision that certain traditional expatriation-related tax planning steps—such as making gifts to children before the planned expatriation—are acceptable, despite loss of ownership, to reduce or eliminate their projected income tax costs of such expatriation.

By contrast, optimistic individuals who oppose a denaturalization proceeding will discount the expected tax benefits of such steps in hopes that the denaturalization proceeding will fail, and there eventually will be no expatriation.

A tax adviser may need to continually coordinate with the individual’s denaturalization counsel and the individual as the denaturalization proceedings continue.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law, Bloomberg Tax, and Bloomberg Government, or its owners.

Author Information

Alan S. Lederman is a shareholder at Gunster, with a focus on income tax planning and controversies.

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