New “EXPAT” Tax Laws

June 2008Alerts Tax & Estates Department Alert

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On June 17, President Bush signed into law the Heroes Earnings Assistance and Relief Tax Act (HEART), containing legislation that significantly changes the way the U.S. taxes citizens who renounce their U.S. citizenship and permanent non-citizen residents who choose to relinquish their green cards (expatriates). The legislation is aimed primarily at those high net-worth individuals who give up their citizenship or permanent residence rights to avoid paying U.S. income, gift, or estate tax. It is effective on the date of enactment.

The former law required an expatriate to continue to pay income taxes for a 10-year period after leaving the country, but only on U.S.-sourced income. Estate and gift taxes also continued to apply during that 10-year period to certain transfers of U.S. assets. This alternate tax regime, although complicated, had the advantage of releasing the expatriate from the U.S. tax net at the end of the 10-year period. Thereafter, the expatriate would continue to be taxed in the U.S. in the same manner as other foreign non-residents. With proper planning, the alternate tax regime could be relatively tax-neutral to the expatriate.

The HEART legislation replaces the 10-year tax transition rule with a "mark to market" regime. It is essentially the “exit tax” that the government has sought to pass for many years. The expatriate to whom this law applies would be deemed to have sold all of his or her worldwide appreciated assets at fair market value on the day before expatriation. He or she would have to recognize and pay a tax on the unrealized gain (in excess of $600,000, to be adjusted for inflation) in the year of expatriation. The taxpayer could elect to defer the income taxes otherwise due until the property is actually sold and the taxpayer has the money to cover the tax. However, the expatriate would have to post a bond and pay interest on the deferred taxes at the rate set for the underpayment of taxes. This rate fluctuates quarterly. It is currently 6%; it was 7% for the first quarter of 2008, and 8% for the last quarter of 2007.

Although an exit tax has a one-time application, the legislation has an ongoing effect on various non-grantor trusts, the income of which would be payable to beneficiaries who are expatriates. To make sure that the government gets its due, the trustee would be required to withhold 30% of any distribution of ordinary income, and the expatriate would be subject to tax on such income as if he or she were still a citizen or resident of the U.S. If appreciated property were distributed to the expatriate, the trustee would be deemed to have "sold" the property to the beneficiary and the trust would recognize any gain.

In addition, the legislation applies the mark-to-market regime to grantor trusts. Grantor trusts are generally those established for the benefit of others, but the grantor or settlor remains liable for the tax on any income or capital gain generated by the trust. Expatriated grantors of such trusts would be deemed to have sold all of the assets in the trust at fair market value at the time of expatriation, requiring the recognition of taxable gain in the year of expatriation.

Finally, any gifts or testamentary transfers by an expatriate to a U.S. citizen or resident which would otherwise not be subject to U.S. gift or estate tax would be subject to such tax under HEART. The U.S. recipient, instead of the donor, would be liable for such taxes.