Covered Expatriate: Annual U.S. Income Tax Compliance
A “covered expatriate” subject to annual U.S. income tax compliance must file IRS Form 8854 for:
1. Each year subject to mark-to-market tax;
2. Each year with deferred compensation items to certify either: no distributions received, or to report distributions received;
3. Each year elects to defer payment of mark-to-market tax, through the year that the deferred tax and all interest is paid.
A covered expatriate must file Form 1040 NR to report taxable income (i.e. eligible deferred compensation, distribution from non-grantor trust) for which income taxes are not fully withheld at the U.S. source of payment)
Covered Expatriate – “Covered Gifts”
IRC Sec. 2801 imposes an inheritance tax on the receipt by a U.S. citizen or resident of a gift from a covered expatriate. This inheritance tax contrasts with traditional U.S. estate and gift tax, which tax is imposed on the gift donor (not the gift recipient).
This tax is imposed on a “covered gift”, i.e.:
1. Property acquired by gift from a covered expatriate (whether directly or indirectly);
2. Property acquired by reason of the death of a covered expatriate (IRC Sec. 2801(e)(1).
A “covered gift” does not include:
1. Taxable gifts disclosed on a timely filed gift tax return by the covered expatriate (Form 709);
2. Property included in the gross estate of the covered expatriate disclosed on a timely filed estate tax return (Form 706);
3. Property to which a gift or estate tax charitable or marital deduction would be allowed (IRC Sec. 2801(e)(2), 2801(e)(3)).
The IRC Sec. 2801 inheritance tax applies to indirect gifts to U.S. persons, unless they are “taxable gifts”. The inheritance tax applies when a covered expatriate pays for the education or medical expenses of a U.S. person. Under IRC Sec. 2803(e)(1), such payments are not transfers of property by gift, so they do not qualify for the IRC Sec. 2801(e)(2)(A) gift tax exclusion.
A marital deduction is allowed for property transfers (by a covered expatriate) that would qualify under the IRC Sec. 2056 but not under IRC Sec. 2056A, which allows an estate tax deduction for bequests to a non-citizen spouse if made to a Qualified Domestic Trust (“QDT”). If a covered expatriate has a spouse who is a green card holder, the inheritance tax will apply to any bequest to the spouse. If the spouse also expatriates, the inheritance tax will not apply because the surviving spouse will not be a U.S. person.
The inheritance tax on gifts by a covered expatriate contrasts with the more favorable estate and gift tax treatment of those who are non-resident, non-citizen (“NRNCs”). A NRNC pays no gift or estate tax for transferring property to a U.S. citizen or resident unless the transferred property is situated in the U.S. (IRC Sec. 2101, et seq. and Sec. 2501(a)(2)).
A NRNC has a $60,000 estate tax exemption for bequests of U.S. situs property. In contrast, a covered expatriate has tax imposed on the gift or bequest of property to a U.S. person, regardless of where the property is located, with only a $13,000 per beneficiary exception.
A NRNC can obtain U.S. estate tax deferral, until the death of the surviving spouse, through the use of a QDOT, which may not be possible for the covered expatriate subject to the inheritance tax.
The tax impact of the IRC Sec. 2801 inheritance tax may be reduced, since a credit is provided for gift or estate taxes paid to a foreign country with respect to a covered gift (IRC Sec. 2801(d).
For long-term residents (i.e. green card holders), if they return their green cards, as NRNCs, they will be able to leave their entire net assets to their descendants free of any U.S. estate or gift tax (as long as they are not classified as having a U.S. domicile, which would subject them to U.S. estate and gift tax). If they expatriate, any gift to their children or grandchildren’s share, above $13,000 per beneficiary, will trigger a 35% tax under IRC Sec. 2801.
For clients who are domiciled in the U.S. before expatriation, they should consider making gifts that exhaust their $5.12 Million Exemption (2012), since once they expatriate they will lose their U.S. domicile and this exemption.
If they retain their domicile, covered expatriates may use IRC Sec. 2801(e)(2) which excludes U.S. situs property that is subject to tax under the U.S. gift or estate tax regime from the inheritance tax.
The covered expatriate should make gifts of U.S. property subject to U.S. estate and gift tax (not the inheritance tax), since it is tax exclusive vs. the tax inclusive inheritance tax.
For example, a $650,000 gift: if a covered expatriate wishes to make a net gift of $650,000, under the IRC Sec. 2801 succession tax, the gift of $1m of non-U.S. property would leave a U.S. person with only $650,000 after paying the inheritance tax ($350,000 inheritance tax paid by the gift recipient).
A gift of $650,000 of U.S. property would have a maximum gift tax of $227,500, a tax savings of $122,500 (the donor pays the gift tax, not the recipient).
In addition, it may be advisable to maintain sufficient U.S. property in the donor’s estate, to receive the advantage of lower estate tax brackets compared to the flat inheritance tax (on gifts received from covered expatriates).
Gifts to foreign trusts do not cause an immediate inheritance tax, creating an opportunity for tax deferral (IRC Sec. 2801(e)(4)(B). Distributing money to U.S. persons from foreign trusts may involve IRC Sec. 665 “Throwback” rules (income tax issues).
U.S. estate planning techniques, including: sales to grantor trusts, use of life insurance (held by irrevocable trusts) can diminish the IRC Sec. 2801 “inheritance tax” consequences to the United States taxpayer/”Covered Expatriate” gift recipients.