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George F. Bearup, J.D. Senior Legal Trust Advisor

May 15, 2023

Federal ‘Exit’ and Inheritance Taxes

Take-Away: Federal stealth taxes should be kept in mind if there is a chance assets might be gifted or inherited from a person who was a non-resident alien or a one-time Green Card holder.

Background: Admittedly, we seldom get asked questions about transfer taxes when it involves non-resident aliens. That said, we need to be somewhat aware of these ‘stealth’ taxes. What is important to remember is that while there are very mechanically applied rules used to determine whether a non-citizen is a resident alien for U.S federal income tax reporting purposes (IRC 7701(b)), the determination of domicile is used for federal transfer tax purposes, which  is fairly subjective with guidance coming from only a handful of federal court decisions.

Federal Exit Tax: The 2008 HEART Act added IRC 877A to the Tax Code. It created an exit tax for those individuals who renounce their US citizenship or who relinquish their long-term residence status after June 16, 2008 and who are deemed to be a covered expatriate. A long-term residence status is a Green Card holder who has been found to be a tax resident for 8 of the last 15 years. IRC 877A uses a ‘mark-to-market’ tax on unrealized appreciation in worldwide assets, as well the exit tax on retirement plan assets, including an immediate tax on IRAs.

Election for Tax Deferral on Retirement Accounts: Under IRC 877A, a long-term resident can make an election to continue to defer U.S. tax on ‘eligible deferred compensation items’, i.e. employer-sponsored retirement plan accounts. However, to make this election, the long-term resident must be aware of the deadline in which to make the election, which is made on Form W-CE filed with the qualified plan sponsor. A timely election on this form defers the tax until retirement as withdrawals are received by the long-term resident. A timely election is made by the expatriate (by filing Form W-8CE with the sponsor) on the earlier of: (i) the day prior to the first distribution on or after the expatriation date; or (ii) 30 days after the covered expatriate’s expatriation (defined in IRC 877A(g)(3).) The first deadline means that an IRC 401(k) distribution occurs within 30 days of the expatriation date. In reality, this never occurs so it is (ii), the second deadline, that is the earlier of the two. Note: If the long-term resident misses this filing deadline, the long-term resident must pay the lump sum tax on the entire retirement account.

Federal Inheritance Tax: The HEART Act also added IRC 2801 to the Tax Code. This is a federal inheritance tax that is applicable to U.S. heirs or gift beneficiaries of a covered expatriate. Thus, an expatriate after June 16,2008 can now expose other U.S. individuals to potential inheritance tax in later years if the long-term resident is a covered expatriate on the day before their expatriation date and who is non-compliant with their federal reporting obligations.

Form 8854: Once such reporting obligation exists, there is the need to file Form 8854 for the year of the long-term resident’s expatriation. The failure to file Form 8854 makes the long-term resident a covered expatriate.

Scope of Inheritance Tax: The IRC 2801 inheritance tax is not limited to the long-term resident’s net worth on his/her expatriation date. Rather, it includes all after-departure net worth that is used to make large gifts or bequests to U.S. heirs or friends. Those U.S. recipients will then be subject to the IRC 2801 inheritance tax on their receipt of the gift or bequest.

Aspects of the Federal Inheritance Tax: Long-term residents who are about to depart the U.S. often overlook three aspects of the IRC 2801 federal inheritance tax.

  1. No Exemption for Recipients: The IRC 2801 inheritance tax is imposed without the recipient-U.S. persons being able to apply their own lifetime federal applicable gift tax exemption amount to the receipt of such gift or bequest from the covered expatriate, i.e. there is no exemption sheltering mechanism to the inheritance tax;
  2. Taxable Amount Not Limited to Net Worth On Expatriation Date: The amount of assets that are subject to the IRC 2801 inheritance tax may be much more than the long-term resident’s personal net worth as of the expatriation date; the tax could include after-acquired inherited assets of the long-term resident; and
  3. Tax Includes Unrealized Appreciation: The IRC 2801 inheritance tax may be imposed even though there was no unrealized appreciation in worldwide assets of the covered expatriate as of their date of expatriation from the U.S..

Example: Assume Juan is a long-term resident, i.e. a Green Card holder, who owns a $2.5 million money market account on the date of his expatriation. Juan expatriates but does not file Form  8854. Juan is classified as a covered expatriate as of his expatriation date even though no exit tax was due in light of the size of his net worth. Later, when he is back in Spain, Juan inherits $50 million, and his new business venture in Europe creates another $50 million of wealth. To the extent any portion of Juan’s $102.5 million of asset value following his expatriation date is gifted or bequeathed to U.S. persons, those recipients will be forced to report their receipt of such property to the IRS on Form 708. Those U.S. persons would then owe 40% tax on the value of such gifts or bequests in excess of the annual exclusion amount ($17,000 in 2023.)

Transferee Liability: If the long-term resident does not timely file Form 8854 it is possible for the IRS to collect the inheritance tax sometime in the future when a gift or bequest is made to family member or friends who are U.S. persons. In this case, transferee liability would be imposed on those U.S. persons in addition to the possible imposition of the IRC 2801 tax. Note that the burden is on the U.S. heirs or friends of the long-term resident to prove the long-term resident was not a covered expatriate when they receive the gifts or bequests from the long-term resident. If the recipients do not meet their burden of proof, they pay the tax.

Conclusion: Due to the potentially large exposure of the inheritance tax liability faced by U.S. heirs and friends, future planning should always include the potential adverse tax effects of IRC 2801 on an individual’s receipt of gifts or bequests if the source was/is an expatriate who has not complied by timely filing Form 8854 for the year of his/her expatriation.