Exit Tax Planning & IRS (2018) – Green Card & U.S. Citizen Tax Rules
Exit Tax Planning & IRS (2018) – Green Card & U.S. Citizen Tax Rules
Exit Tax and Expatriation involve certain key issues. These typically include:
- Renouncing U.S. Citizenship
- Relinquishing a Green Card
- Exit Tax
- Form 8854
- Covered Expatriates
With the repeal of FATCA being eliminated from tax reform, coupled by the fact that residence-based taxation was also not included in the recent tax reform (RBT), many individuals are coming to the sobering realization that expatriating/renouncing citizenship is a very real option.
Otherwise, they will continue to be taxed by the United States on their worldwide income (aka Citizen-Based Taxation or CBT), and have to report under FATCA.
What is U.S. Exit Tax?
U.S. Exit Tax is the IRS and U.S. Government’s way of making individuals who are considered U.S. Citizens or Long-Term Residents to pay a tax (depending on certain factors) to the U.S. Government upon “Exiting” or “Expatriating” from the U.S.
The following are the typical categories of individuals we work with for exit tax planning.
Legal Permanent Residents/Green Card holders
For some people, they may have citizenship in a foreign country but are considered Legal Permanent Residents (aka Green Card Holders) in the United States and were never made aware of the true tax consequences of being considered a US person (especially worldwide taxation).
Many clients we work with were under the misimpression (understandably so) that citizen-based taxation involves U.S. citizens. And, since Legal Permanent Residents/Green Card Holders are not citizens of the United States, they would not be subject to worldwide income and offshore reporting.
Another group of individuals who are being unfairly burdened by FATCA and other offshore reporting rules are Accidental Americans. There has been a surge in the number of Accidental Americans that we have been working due to the fact that many of them had no idea that they were considered Americans.
The typical example is an individual whose parents were US citizens and they may have been born in the United States or outside of the United States to U.S. Citizen parents — and literally never thought of themselves as US citizens. Why would they? They reside outside of the United States and in many situations have literally never stepped foot in the US.
As a result, it is dumbfounding if not mind-numbing to believe that the US requires these individuals to still report and pay tax to the United States.
U.S. Citizens or Green Card Holder Turned “Expat”
A final category of individuals we work with, are US citizens who have simply moved outside of the United States and have literally no intention of ever returning. As a result, the idea of paying continual US tax in a situation in which they may live in a low tax jurisdiction and the receiving income which is considered tax-free under the laws of their current country just makes no sense.
As a result, these individuals want to renounce their US citizenship.
Why Does the IRS Care?
Because the IRS believes (incorrectly), that proper tax avoidance is the same as illegal tax avoidance (e.g. attempting to avoid long-term status in the United States in order to avoid paying tax)
Here’s a typical example: David a Permanent Resident who came to the United States in 2010. While in the United States David earned millions upon millions of dollars and uses that money to purchase stocks and investments offshore. David is smarter than the rest of us and was able to successfully grow his investments into the solid eight figures.
David wants to expatriate from the U.S. for multiple reason, including paying any “exit tax.” It should be noted that David is otherwise in tax compliance in the United States.
When David leaves the United States, if he was considered to be a long-term resident, he would be subject to certain taxes (aka exit taxes) that he would otherwise not be subject to if he was not considered a long-term resident.
As a result, David leaves the United States after 7 years, and gives up his green card prior to having to pay any exit tax.
Key Exit Tax Planning Tips
The following are a few key tips to keep in mind:
Citizen vs. Resident
If you are a U.S. citizen, then chances are under any circumstance (excluding dual-citizenship exceptions) you would be required to file form 8854, which is the IRS form used for expatriation (aka renouncing your citizenship).
Alternatively, if you are resident of the United States, then it is important to determine whether you are a long-term resident. Typically (there are always exceptions) you are considered a long-term resident if you reside in the United States (tax treaty residence rules notwithstanding) for at least eight of the last 15 years. If you are considered a long-term resident then you will usually have to follow the same expatriation rules as a citizen would- typically requiring the filing of form 8854.
**Exceptions: There are certain exceptions for both citizens and residents when determining whether they have to file a form 8854. While typically is better to err on the side of caution, that does not mean proactively filing forms with the IRS in which you otherwise do not have to file if an exception applies. You should speak with an experienced attorney to assess your specific situation.
5 Years of Tax Compliance
It is important to understand that there are different categories of what is considered a “covered expatriate,” and the third category is the most encompassing. The third category is having to show that you properly filed all of your returns and other tax compliance for the last five years.
Thus, even if you do not need the income tax/asset value tests in determining whether you are considered a covered expatriate, the mere fact that you may not have properly filed your returns, FBARs may result in you being out of compliance.
With the recent enforcement of FATCA and more than 300,000 foreign financial institutions reporting taxpayer information to the IRS, the IRS may already have your foreign account information without you even knowing it.
This is not intended to scare you, but rather to make sure you are informed that if you try to confirm or sign under penalty of perjury that you are in tax compliance for the last five years, but have not reported foreign income or disclosed foreign accounts (and the IRS already has your information), you may be leading to a much bigger headache in the future.
When it comes to determining the $2 million asset test it is important to understand that certain assets may be excluded or exempted from that value. Oftentimes, assets involving retirement and other employment plans may not be included as part of the total amount used to determine whether you need the asset test.
Getting Into Tax Compliance
If you are considering expatriation but are pretty sure you have not properly complied with all the necessary IRS tax and offshore reporting rules, you may consider getting into compliance first before filing the necessary documentation through IRS Offshore Voluntary Disclosure.
Just because you are expatriate does not mean the IRS is estopped (prevented) from auditing you for the prior years. Moreover, while the IRS is not necessarily go country to country to enforce tax debts against prior citizens or residents, they have the power to do so and often times the foreign country will actually cooperate with the IRS. Moreover, any assets you keep in the U.S. are still fair-game.
Most recently, the IRS worked with the Canadian tax authority to enforce a $120,000 tax liability against individuals who did not properly file form 5471.
Want to learn more about IRS Offshore Disclosure?
There are five main methods people/businesses use to get into compliance. Four of these methods are perfectly legitimate as long as you meet the requirements for the particular mechanism of disclosure. The fifth alternative, which is called a Quiet Disclosure a.k.a. Silent Disclosure a.k.a. Soft Disclosure, is ill-advised as it is illegal and very well may result in criminal prosecution.
5 IRS Methods for Offshore Compliance
- Streamlined Domestic Offshore Procedures
- Streamlined Foreign Offshore Procedures
- Reasonable Cause
- Quiet Disclosure (Illegal)
We are going to provide a brief summary of each program below. We have also included links to the specific programs. If you are interested, we have also prepared very popular “FAQs from the Trenches” for FBAR, OVDP and Streamlined Disclosure reporting. Unlike the technical jargon of the IRS FAQs, our FAQs are based on the hundreds of different types of issues we have handled over the many years that we have been practicing international tax law and offshore disclosure in particular.
After reading this webpage, we hope you develop a basic understanding of each offshore disclosure alternative and how it may benefit you to get into compliance. We do not recommend attempting to disclose the information yourself as you may become subject to an IRS investigation insofar as you will have to answer questions directly to the IRS, which you can avoid with an attorney representative.
If you retain an attorney, then you will get the benefit of the attorney-client privilege which provides confidentiality between you and your representative. With a CPA, there is a relatively small privilege which does provide some comfort, but the privilege is nowhere near as strong as the confidentiality privilege you enjoy with an attorney.
Since you will be dealing with the Internal Revenue Service and they are not known to play nice or fair – it is in your best interest to obtain an experienced Offshore Disclosure Attorney.
OVDP is the Offshore Voluntary Disclosure Program — a program designed to facilitate taxpayer compliance with IRS, DOT, and DOJ International Tax Reporting and Compliance. It is generally reserved for individuals and businesses who were “Willful” (aka intentional) in their failure to comply with U.S. Government Laws and Regulations.
The Offshore Voluntary Disclosure Program is open to any US taxpayer who has offshore and foreign accounts and has not reported the financial information to the Internal Revenue Service (restrictions apply). There are some basic program requirements, with the main one being that the person/business who is applying under this amnesty program is not currently under IRS examination.
The reason is simple: OVDP is a voluntary program and if you are only entering because you are already under IRS examination, then technically, you are not voluntarily entering the program – rather, you are doing so under duress.
Any account that would have to be included on either the FBAR or 8938 form as well as additional income generating assets such as rental properties are accounts that qualify under OVDP. It should be noted that the requirements are different for the modified streamlined program, in which the taxpayer penalties are limited to only assets that are actually listed on either an FBAR or 8938 form; thus the value of a rental property would not be calculated into the penalty amount in a streamlined application, but it would be applicable in an OVDP submission.
An OVDP submission involves the failure of a taxpayer(s) to report foreign and overseas accounts such as: Foreign Bank Accounts, Foreign Financial Accounts, Foreign Retirement Accounts, Foreign Trading Accounts, Foreign Insurance, and Foreign Income, including 8938s, FBAR, Schedule B, 5741, 3520, and more.
What is Included in the Full OVDP Submission?
The full OVDP application includes:
- Eight (8) years of Amended Tax Return filings;
- Eight (8) Years of FBAR (Foreign Bank and Account Reporting Statements);
- Penalty Computation Worksheet; and
- Various OVDP specific documents in support of the application.
Under this program, the Internal Revenue Service wants to know all of the income that was generated under these accounts that were not properly reported previously. The way the taxpayer accomplishes this is by amending tax returns for eight years.
Generally, if the taxpayer has not previously reported his accounts, then there are common forms which were probably excluded from the prior year’s tax returns and include 8938 Forms, Schedule B forms, 3520 Forms, 5471 Forms, 8621 Forms, as well as proof of filing of FBARs (Foreign Bank and Financial Account Reports).
The taxpayer is required to pay the outstanding tax liability for the eight years within the disclosure period – as well as payment of interest along with another 20% penalty on that amount (for nonpayment of tax). To give you an example, let’s pick one tax year during the compliance period. If the taxpayer owed $20,000 in taxes for year 2014, then they would also have to include in the check the amount of $4,000 to cover the 20% penalty, as well as estimated interest (which is generally averaged at about 3% per year). This must be done for each year during the compliance period.
Then there is the “FBAR/8938” Penalty. The Penalty is 27.5% (or 50% if any of the foreign accounts are held at an IRS “Bad Bank”) on the highest year’s “annual aggregate total” of unreported accounts (accounts which were previously reported are not calculated into the penalty amount).
For OVDP, the annual aggregate total is determined by adding the “maximum value” of each unreported account for each year, in each of the last 8 years. To determine what the maximum value is, the taxpayer will add up the highest balances of all of their accounts for each year. In other words, for each tax year within the compliance period, the application will locate the highest balance for each account for each year, and total up the values to determine the maximum value for each year.
Thereafter, the OVDP applicant selects the highest year’s value, and multiplies it by either 27.5%, or possibly 50% if any of the money was being held in what the IRS considers to be one of the “bad banks.” When a person is completing the penalty portion of the application, the two most important things are to breathe and remember that by entering the program, the applicant is seeking to avoid criminal prosecution!
2. Streamlined Domestic Offshore Disclosure
The Streamlined Domestic Offshore Disclosure Program is a highly cost-effective method of quickly getting you into IRS (Internal Revenue Service) or DOT (Department of Treasury) compliance.
What am I supposed to Report?
There are three main reporting aspects: (1) foreign account(s), (2) certain specified assets, and (3) foreign money. While the IRS or DOJ will most likely not be kicking in your door and arresting you on the spot for failing to report, there are significantly high penalties associated with failing to comply.
In fact, the US government has the right to penalize you upwards of $10,000 per unreported account, per year for a six-year period if you are non-willful. If you are determined to be willful, the penalties can reach 100% value of the foreign accounts, including many other fines and penalties… not the least being a criminal investigation.
Reporting Specified Foreign Assets – FATCA Form 8938
Not all foreign assets must be reported. With that said, a majority of assets do have to be reported on a form 8938. For example, if you have ownership of a foreign business interest or investment such as a limited liability share of a foreign corporation, it may not need to be reported on the FBAR but may need to be disclosed on an 8938.
The reason why you may get caught in the middle of whether it must be filed or not is due largely to the reporting thresholds of the 8938. For example, while the threshold requirements for the FBAR is when the foreign accounts exceed $10,000 in annual aggregate total – and is not impacted by marital status and country of residence – the same is not true of the 8938.
The threshold requirements for filing the 8938 will depend on whether you are married filing jointly or married filing separate/single, or whether you are considered a US resident or foreign resident.
Other Forms – Foreign Business
While the FBAR and Form 8938 are the two most common forms, please keep in mind that there are many other forms that may need to be filed based on your specific facts and circumstances. For example:
- If you are the Beneficiary of a foreign trust or receive a foreign gift, you may have to file Form 3520.
- If you are the Owner of a foreign trust, you will also have to file Form 3520-A.
- If you have certain Ownerships of a foreign corporation, you have to file Form 5471.
- And (regrettably) if you fall into the unfortunate category of owning foreign mutual funds or any other Passive Foreign Investment Companies then you will have to file Form 8621 and possibly be subject to significant tax liabilities in accordance with excess distributions.
Reporting Foreign Income
If you are considered a US tax resident (which normally means you are a US citizen, Legal Permanent Resident/Green-Card Holder or Foreign National subject to US tax under the substantial presence test), then you will be taxed on your worldwide Income.
It does not matter if you earned the money in a foreign country or if it is the type of income that is not taxed in the country of origin such as interest income in Asian countries. The fact of the matter is you are required to report this information on your US tax return and pay any differential in tax that might be due.
In other words, if you earn $100,000 USD in Japan and paid 25% tax ($25,000) in Japan, you would receive a $25,000 tax credit against your foreign earnings. Thus, if your US tax liability is less than $25,000, then you will receive a carryover to use in future years against foreign income (you do not get a refund and it cannot be used against US income). If you have to pay the exact same in the United States as you did in Japan, it would equal itself out. If you would owe more money in the United States than you paid in Japan on the earnings (a.k.a. you are in a higher tax bracket), then you have to pay the difference to the U.S. Government.
3. Streamlined Foreign Offshore Disclosure
What do you do if you reside outside of the United States and recently learned that you’re out of US tax compliance, have no idea what FATCA or FBAR means, and are under the misimpression that you are going to be arrested and hauled off to jail due to irresponsible blogging by inexperienced attorneys and accountants?
If you live overseas and qualify as a foreign resident (reside outside of the United States for at least 330 days in any one of the last three tax years or do not meet the Substantial Presence Test), you may be in for a pleasant surprise.
Even though you may be completely out of US tax and reporting compliance, you may qualify for a penalty waiver and ALL of your disclosure penalties would be waived. Thus, all you will have to do besides reporting and disclosing the information is pay any outstanding tax liability and interest, if any is due. (Your foreign tax credit may offset any US taxes and you may end up with zero penalty and zero tax liability.)
*Under the Streamlined Foreign, you also have to amend or file 3 years of tax returns (and 8938s if applicable) as well as 6 years of FBAR statements just as in the Streamlined Domestic program.
4. Reasonable Cause
Reasonable Cause is different than the above referenced programs. Reasonable Cause is not a “program.” Rather, it is an alternative to traditional Offshore Voluntary Disclosure, which should be considered on a case by case basis, taking the specific facts and circumstances into consideration.
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