On October 16, 2009 the IRS released an advance copy of Notice 2009-85 (the “Notice”), which provides guidance under the expatriation tax rules for citizens who relinquish their US citizenship or long-term residency on or after June 17, 2008.
The 2008 legislation (HEART Act)
The HEART Act was enacted on June 17, 2008. It imposes a mark-to-market tax regime on “covered expatriates” whose expatriation date occurs on or after June 17, 2008. The mark-to-market tax regime applies only to “high net worth” US citizens or long-term green card holders who fall within the definition of a “covered expatriate.” An individual is a “covered expatriate” if the individual:
- has an average US income tax liability for the five-year period prior to expatriation of greater than US$145,000 (in 2009 and 2010, adjusted for inflation) (the “income test”);
- has a net worth of US$2,000,000 or more (the “asset test”); or
- fails to certify under penalty of perjury that he has complied with his US tax requirements for the five preceding tax years.
Covered expatriates are deemed to have sold for fair market value all of their property on the day before their expatriation date. For 2009, there is a $626,000 exclusion amount (for 2010 the amount is $627,000, adjusted for inflation) applied to the gain resulting from the deemed sale; the resulting tax is due with the taxpayer’s timely filed return for the year of expatriation.
The mark-to-market tax regime does not apply to deferred compensation items, specified tax deferred accounts, and interests in a “nongrantor trust” of which the covered expatriate was a beneficiary on the day before the expatriation date. These items are subject to alternative tax regimes with a 30% withholding tax. This withholding tax applies to taxable payments to a covered expatriate that are “eligible deferred compensation items” or a direct or indirect distribution of property from a nongrantor trust of which the covered expatriate was a beneficiary on the day before the expatriation date, provided that the covered expatriate elects to waive tax treaty benefits. “Ineligible deferred compensation items” are treated as having been received in an amount equal to the present value of the covered expatriate’s accrued benefit on the day before the expatriation date, and specified tax deferred accounts are treated as being distributed to the covered expatriate on the day before the expatriation date. Similarly, covered expatriates who do not elect to waive treaty benefits are treated as recognizing gain with respect to qualified deferred compensation items and nongrantor trust interests.
Key points of the notice
Gain from the deemed sale of a covered expatriate’s worldwide property is recognized in the taxable year of the deemed sale notwithstanding any deferral provision in the Code. Losses may only be taken into account in computing gain in the manner otherwise provided in the Code – there is no special regime except that the wash sale rules of section 1091 do not apply. Thus, for example, capital losses, cannot be used to offset business assets gain.
For purposes of computing the mark-to-market tax, the covered expatriate generally includes any property that would be taxable as part of his gross estate for federal estate tax purposes. The covered expatriate determines his tax liability as though he had died as a US citizen or resident on the day before his expatriation date. The property will be deemed sold at its fair market value; the alternative valuation rules are not available.
The exclusion amount is allocated pro-rata to each asset with built-in gain and each asset retains its character of gain or loss. The allocation is determined by multiplying the total exclusion amount by the ratio of the built-in gain in an asset over the total built-in gain in all assets with built-in gain. This calculation ignores losses except to the extent they reduce built-in gain in a particular asset.
There is a basis adjustment to the property subject to the mark-to-market tax regime whereby the basis of the asset is increased by the built-in gain recognized without regard to the exclusion allocated to that asset.
For purposes of the mark-to-market tax regime, non-resident aliens receive a step-up in basis to the fair market value of the property they owned on the date they first became a resident of the United States. But US real property interests and property used or held for use in connection with the conduct of a trade or business are not allowed this step-up.
Deferral of payment of the mark-to-market tax is made by an irrevocable election on the deemed sale of an asset if adequate security is provided, treaty benefits are waived, and a tax deferral agreement is executed. Interest accrues on the deferred tax at the underpayment rate under section 6621. This election is made on an asset-by-asset basis and a US agent must be appointed.
A covered expatriate will recognize gain to the extent he has deferred gain under a section 367 gain recognition agreement, section 684 trust (i.e., a U.S. Trust which has migrated to be a non-U.S. trust) or a like-kind exchange. In addition, gain recognition under the mark-to-market regime tax applies to USRPIs despite the withholding tax regime under section 1445.
A covered expatriate must submit a Form W-8CE to the payor of an eligible deferred compensation item to notify the payor of his covered expatriate status. The payor of an ineligible deferred compensation item must advise the covered expatriation of the present value of the covered expatriate’s accrued benefit after receiving the Form W-8CE. However, an adjustment is made to exclude any amount of deferred compensation attributable to services performed outside of the United States.
A 30% withholding tax is applied to any direct or indirect distribution of property to a covered expatriate from a nongrantor trust which would have been includible in the covered expatriate’s gross income if the covered expatriate had continued to be subject to tax as a citizen or resident of the United States.
If the fair market value of the property distributed to a covered expatriate from a nongrantor trust exceeds its adjusted basis in the hands of the trust, gain must be recognized to the trust as if the property had been sold by the trust and the proceeds distributed to the covered expatriate.
In order to elect deferral of tax on nongrantor trust interests, the covered expatriate must get a letter ruling from the IRS as to the value of the interest.
Tax due by US recipients of gifts and bequests from covered expatriates will be payable after further guidance.
The Treasury Department and IRS expect to issue regulations incorporating the guidance set forth in the Notice, which will apply to individuals whose expatriation date is on or after October 15, 2009. Until such regulations are issued, and for individuals whose expatriation date is on or after June 17, 2008 and before October 15, 2009, taxpayers may rely on the guidance in the Notice.