Take-Away: We are well aware of the federal gift, estate and generation skipping transfer taxes that we have to deal with on a daily basis. Far fewer of us are aware of the federal inheritance tax, the federal expatriate or exit tax, or the federal transition tax imposed on foreign income. This summary should only be viewed as a very basic primer on these federal inheritance, expatriate, and transition taxes regarding expatriates that fortunately are seldom encountered.

Background: To initially understand how these taxes can arise, an understanding of the reach of U.S. taxation is required. The U.S. estate tax is imposed on all the assets owned or controlled by a decedent at the time of his/her death- worldwide. The same can be said for all income earned by a U.S. citizen. The status of the individual who is exposed to federal income or estate taxation is where these taxes get very complicated.

  • Expatriate: An expatriate is either (i) a former U.S. citizen or (ii) a permanent legal resident, e.g. Green-Card holder. Expatriates usually no longer live full time in the United States. Consequently, an expatriate is either a former U.S. citizen who lives abroad, or a long-term resident, such as a Green-Card holder, who has resided within the U.S. eight (8) of the last fifteen (15) years. The federal estate tax is imposed on worldwide assets of a U.S. citizen or on the non-citizen who lives in the U.S. and is considered domiciled in the U.S. With few exceptions, a Green-Card holder will be considered an income tax citizen for U.S. taxation purposes.
  • Covered Expatriate Status: If an individual falls within the technical definition of a covered expatriate status, they will be subject to the federal exit tax upon their departure from the U.S… This covered expatriate status can arise if any one of three criteria are satisfied by the individual: if he/she: (i) has a prior U.S. tax filing compliance failure; (ii) exceeds an average income tax liability (i.e. 5 year average annual income of $168,000); or (iii) exceeds a net worth threshold ($2.0 million.) A tax compliance failure is the failure to file an income tax return, the failure to report income, or the failure to even file any tax report or informational return, such as one of the many FBAR reports required from those who live abroad. Accordingly, for a Green-Card holder, maybe one who is not fluent in English, who has lived both abroad and in the U.S. over an extended period of time, the failure to file any one of the many federal reporting and disclosure forms, e.g. foreign bank accounts or other assets, will cause that Green-Card holder to fall within the covered expatriate status. In sum, a covered expatriate is either a former long-term Green-Card holder who abandons his/her Green-Card status, or a former U.S. citizen who has turned in his/her passport and renounced his/her U.S. citizenship.
  • Dual Citizenship: These folks are sometimes called accidental citizens as they may have been born in the U.S. but they have spent their entire life living in a foreign country. Some dual citizens and children, despite meeting either the net worth or the average annual income tax test just described can be exempt from qualifying as a covered expatriate if they have obtained U.S. citizenship solely by reason of birth as well as retain citizenship of another country, they pay taxes in that other country, and they have not lived in the U.S. for 8 of the past 15 years.

Expatriation: An individual must voluntarily and with requisite intent relinquish their U.S. citizenship by: (i) appearing in person before a U.S. consular or diplomatic officer; (ii) in a foreign country or at a U.S. Embassy or Consulate; and (iii) sign an oath of renunciation of U.S. citizenship. [8 U.S.C. 1481(a) (5).]

Federal Exit Tax: Congress added taxation of expatriates in the Heroes and Earnings Assistance and Relief Tax Act of 2008, aka the HEART Act. It added IRC 877A and IRC 2801 to the Tax Code, which included tougher penalties for former citizens and long-term permanent residents who relinquish their U.S. status, i.e. who become covered expatriates.

  • Federal Exit Tax– A Deemed Sale of All Assets: Once an individual is considered to be a covered expatriate, he or she is deemed to have sold all of his or her worldwide assets at their fair market value on the date of their expatriation from the U.S. [IRC 877A.] Any gain that results from this ‘mark-to-market’ deemed sale in excess of an allowable exemption of $725,000 (this is the adjusted inflation amount for 2019) is taxed at the top federal capital gains rate of 23.8%. An option exists to defer the payment of this capital gains and NIIT exit tax on some hard-to-value assets (the phrase used in the statute is that taxes are not realizable). However, if the expatriate’s payment of the deemed capital gain tax is delayed, interest will accrue on the unpaid capital gain tax.
    • Example: A wealthy individual decides to renounce his U.S. citizenship and move to Belize “to escape pernicious U.S. taxes.” That decision to abandon citizenship will trigger a capital gain and the net investment income tax of 23.8% on his worldwide wealth, and it is immediately due to be paid by the departing former citizen unless a bond is posted, but the unpaid amount will accrue annual interest payments until the tax is ultimately paid.

Federal Inheritance Tax:  The possible scope of the federal inheritance tax can be draconian. It applies to wealth that is accumulated outside the U.S., including long after an expatriate’s Green-Card status has ended. This inheritance tax can even apply to U.S. beneficiaries who were not even born when the U.S. citizen surrendered citizenship or the Green-Card holder permanently left the U.S. decades earlier.

  • Inheritance Tax Rate: The federal inheritance tax rate is the highest gift tax rate in existence at the time of the inheritance, currently 40%. [IRC 2801.]
  • Tax Inclusive: The imposition of the federal gift tax is tax Thus, the federal gift tax is imposed on the amount that the recipient of a gift actually receives- the donor pays the gift tax, but the amount paid in gift taxes is not calculated for gift, hence the gift tax is exclusive in nature. In contrast, the federal inheritance tax is tax inclusive in nature, which means that the inheritance tax is imposed on the assets that will be used to pay the federal inheritance tax. Therefore, the federal inheritance tax is tax inclusive as it is imposed on the gross value of the assets received/inherited by the decedent’s U.S. heirs.
  • Covered Gift: A covered gift is any property that is acquired by gift directly or indirectly from an individual who is a covered expatriate at the time the gift is received. [IRC 2801(e) (1) (A).]
  • Covered Bequest: A covered bequest is any property that is acquired directly or indirectly by reason of death from an individual who was a covered expatriate immediately before their death. [IRC 2801(e) (1) (B).]
  • Recipient Pays the Tax: An individual who receives the gift or who inherits assets, or receives a distribution from a foreign trust or directly from a covered expatriate (dead or alive), must pay the federal inheritance This obligation is in contrast to the federal estate (or gift) tax, which taxes the transferor of that wealth; if the transferred wealth comes from the technically defined covered expatriate, the recipient is on the hook to pay the 40% inheritance tax.
  • Tax Rate: The U.S. recipient of either a covered gift or bequest from a covered expatriate is subject to a federal transfer tax on the product of (i) the highest estate tax rate in effect under IRC 2001(c) on the date of receipt or, if greater, the highest gift tax rate in effect under IRC 2502(a) on that date, and (the value of the covered gift or covered bequest.) [IRC2801 (b).]
  • Distributions to Trusts: Even if a distribution is made from the deceased covered expatriate’s estate to a domestic trust, the trust will be subject to the same federal inheritance tax upon the trustee’s receipt of the asset. The transfer of the decedent covered expatriate’s assets to a foreign trust will delay the imposition of the inheritance tax until that trust actually makes a distribution to a U.S. beneficiary. However, a special election can be made that enables the foreign trust to elect to be treated as a domestic trust for federal inheritance tax purposes. This election has the effect of accelerating that taxable event (to protect future acquired assets and appreciation in those trust-held assets) from subsequent federal inheritance
  • ‘Open’ Exposure to the Inheritance Tax: The scope of the federal inheritance tax is exceptionally broad. The federal inheritance tax takes effect on the date of expatriation, i.e. when the covered expatriate status It continues in perpetuity until all assets of the covered expatriate have been distributed, i.e. gifted or passed as bequests. Consequently, the ‘tail-period’ of a donee or heir’s exposure to the federal inheritance tax is seemingly open-ended.
    • Example: At one time Lars lived in the U.S. on a valid Green-Card. Lars permanently returned to Sweden in 1999, having amassed worldwide assets of $2.0 million at the time that he surrendered his Green-Card, which made Lars a covered expatriate. In 2019, twenty years later, Lars died. During the 20 years, that Lars lived in Sweden his estate grew from $2 million to $20 million. All of Lars’ wealth, meaning the full $20 million, is exposed to the U.S. inheritance tax to the extent that Lars’ property is distributed to family or friends who happen to be U.S. citizens at the time of Lars’ death. The federal inheritance tax will be imposed on all of Lars’ after-acquired property because Lars was a covered expatriate when he permanently left the U.S. In short, the federal inheritance tax will be assessed not only on the assets that Lars earned while living in Sweden, it also will apply to any assets that Lars might have inherited from others after Lars left the U.S. in 1999. The federal inheritance tax is imposed on all of Lars’ property that passes to U.S. individuals regardless of when or how Lars acquired those assets.
  • Exceptions: There are a few exception to this federal inheritance If the transfer of the assets would also be exposed to the federal estate tax, then only the federal estate tax will apply. If the recipient is the surviving spouse of the covered expatriate who is also a U.S. citizen, then the inheritance tax will not be imposed because the bequest will qualified for the federal estate tax unlimited marital deduction (and the transferred assets will be exposed to federal estate taxation on the surviving spouse’s death.) If the surviving spouse is not a U.S. citizen, the inheritance  tax can be avoided if the decedent covered expatriate’s assets are directed to a qualified domestic trust [QDOT] for the non-citizen surviving spouse’s lifetime benefit (as federal estate taxes will be collected from the QDOT as principal distributions are made to the surviving spouse.) Small gifts covered by the federal annual exclusion amount ($15,000) are also excluded from this federal inheritance tax.

Federal Transition Tax: This tax was created as part of the 2017 Tax Act. If more than 50% of a controlled foreign corporation is owned by U.S. shareholders, this tax is imposed and is immediately due and payable by the shareholder.  A U.S. shareholder is a U.S. person if he or she owns 10% or more of the controlled foreign corporation. If the controlled foreign corporation has accumulated profits, i.e. deferred income, the tax is imposed on that controlled foreign corporation’s accumulated income. This tax is due regardless of whether (or not) the earnings are actually distributed to the U.S. shareholder. Again, there is a deemed distribution which results in an immediate income tax that is due. What makes this transition tax difficult to understand is that it is subject to numerous stock attribution rules, so that a U.S. individual may indirectly be treated as a U.S. shareholder who is subject to this tax, e.g. a U.S. shareholder will be treated as owning stock in a foreign controlled corporation if he/she a beneficiary of a trust or an estate that holds that foreign corporate stock.

  • Installment Payment Election: S. Shareholders possessed the right to make an election on April 15, 2018, to defer the payment of the transition tax. [IRC 965(h).] A shareholder who makes this election would pay the transition tax in eight installments: 8% for each of the first five years, 15% in year six, 20% in year seven, and 25% in year eight. Failure to timely pay an installment results in the entire federal transition tax becoming immediately payable, what the Regulations actually call a triggering event. [Reg. 1.965-7(b) (3).]
    • Example: Karl, a U.S. citizen, is a beneficiary of his late Swedish grandfather’s trust. Karl owns indirectly as trust beneficiary, pursuant to the complex attribution of ownership rules, stock in a controlled foreign corporation. An election was made on April 15, 2018 to defer the transition tax due on the controlled foreign corporation held in the trust for Karl. Karl dies. According to the Treasury Regulations, Karl’s death is a triggering event that will require the immediate payment of the deferred federal transition [Reg. 1.965-7(b) (3).] In short, a trust beneficiary’s death will accelerate the deferred transition tax, which becomes a liability of Karl’s estate. Karl’s children now owe the federal transition tax solely because of their father’s death, yet Karl did not actually own the stock that caused the imposition of the transition tax, and Karl’s children may not even be the beneficiaries of the trust that created this transition tax liability.

Conclusion: The federal inheritance tax regime can follow a covered expatriate, like a former Green-Card holder, for years after he/she has officially abandoned permanent resident status in the U.S. To that extent, it is something of a stealth tax that many heirs are unaware of but may nonetheless be liable to pay. As for the federal exit tax, it is not so much a stealth tax as a reminder that those who wish to flee the U.S. and its transfer tax regime will have to pay a tax in order to leave the country. And as for the federal transition tax, it can easily become a problem for trust beneficiaries (or their heirs) if the trust owns a controlled foreign corporation; while that transition tax can be deferred with a timely 2018 election, that same tax liability can be accelerated if the trust beneficiary has the misfortune of dying. Hopefully, these federal stealth taxes will seldom be encountered in conventional estate planning. However, they are a constant reminder of just how far the U.S. tax system reaches in its insatiable search for revenues.