By Michael A. Spielman, Esq., CPAErnst & Young LLP, Cleveland, OH
The Service has issued long-awaited guidance, Notice 2009-85, on the mark-to-market exit tax regime under §877A that applies to certain expatriates. These new rules were enacted by the Heroes Earnings Assistance and Relief Tax Act of 2008 (HEART), and apply to certain individuals who, on or after June 17, 2008, relinquish their U.S. citizenship or cease to be a lawful permanent resident of the United States. The 65-page Notice addresses several aspects of §877A, including how to determine whether an individual is a “covered expatriate,” allocating the gain exclusion amount, basis adjustments, deferral of the payment of tax under the mark-to-market regime, definitions and guidance on “eligible deferred compensation items” and “ineligible deferred compensation items,” interests in nongrantor trusts, and filing and reporting requirements.
HEART also introduced a new succession tax under §2801 that imposes a tax on U.S. persons who receive a gift or bequest from an expatriate who was subject to the rules of §877A. Generally, the rules under §2801 require the recipient of the gift or bequest to pay tax on the fair market value of the property received at the highest gift or estate tax in effect on the date of receipt, subject to limited exceptions. The Notice does not provide guidance on §2801, and indicates that future guidance on §2801 is expected to be issued.
Under new §877A, Tax Responsibilities of Expatriation, covered expatriates (generally, U.S. citizens or long-term residents with a five-year average income tax liability exceeding $124,000 as indexed for inflation ($145,000 in 2009 and 2010) (tax liability test) or net worth of $2 million or more (net worth test), will be immediately taxed on the net unrealized gain in their property exceeding $600,000 ($626,000 in 2009 and $627,000 in 2010) as if they sold the property for fair market value the day before relinquishing U.S. citizenship or terminating their U.S. residency. The calculation of net unrealized gain is first determined individually for each item of property deemed owned by the covered expatriate, taking into account the worldwide holdings of the covered expatriate. Net gains are required to be recognized to the extent that they exceed $600,000 (increased by a cost-of-living adjustment factor for years after 2008 as noted above). At the election of the taxpayer, payment of the exit tax may be deferred if adequate security is provided. Such deferral is irrevocable, carries an interest charge, and requires the taxpayer to waive any treaty rights relative to the taxation of the property. However, the taxpayer has the option to end the deferral at any time and pay the amount of the deferred tax and accrued interest.
This mark-to-market tax regime applies to all property of the covered expatriate, other than deferred compensation items, specified tax-deferred accounts, and interests in a nongrantor trust of which the covered expatriate was a beneficiary on the day before the expatriation date. Separate provisions apply with respect these items.
Highlights of the Notice include the following:
Individuals Covered. Notice 2009-85 clarifies that for purposes of determining whether a person is a covered expatriate under the tax liability and net worth tests, the guidance provided in Notice 97-19 is applicable.
Identification of a Covered Expatriate's Property. Notice 2009-85 treats a covered expatriate as owning any property interest that would be taxable as part of his or her gross estate for federal estate tax purposes as if he or she had died on the day before the expatriation date as a citizen or resident of the United States. In addition, a covered expatriate is deemed to own his/her beneficial interest in each trust that would not be a part of the gross estate. A covered expatriate's beneficial interest in such a trust is to be determined by applying the rules set forth in Section III of Notice 97-19.
Determination of Fair Market Value. Notice 2009-85 provides helpful guidance on the determination of fair market value. In general, the Notice applies estate tax valuation principles.
Allocation of the Exclusion Amount. Notice 2009-85 requires the exclusion amount under §877A(a)(3) to be allocated among all built-in gain property subject to the mark-to-market regime and owned by the covered expatriate the day before the expatriation date and provides that each individual is limited to one lifetime exclusion amount.
Basis. Notice 2009-85 clarifies that the basis of an asset is adjusted by the amount of gain or loss taken into account under §877A(a)(2)(A) and (B), without regard to the exclusion amount provided in §877A(a)(3). Thus, basis adjustments are available for the amount of built-in gain deemed realized with respect to an asset, even if such gain is not recognized due to the exclusion amount.
In-Bound Step-Up in Basis for Nonresident Aliens Becoming Resident Aliens. Under §877A(h)(2), solely for purposes of determining the tax under §877A(a), property held by a nonresident alien on the day that individual became a resident of the United States will be treated as having a basis of not less than the fair market value on such date. The Notice indicates that the Service and Treasury intend to exercise their regulatory authority to exclude the basis step-up for U.S. real property interests or property used or held in conjunction with a U.S. trade or business.
Deferred Compensation. Deferred compensation items are not subject to the mark-to-market regime of §877A(a). Instead a separate set of rules apply to these items under which either a deemed distribution occurs or a special withholding regime is applied. Notice 2009-85 provides welcome guidance on the definition and treatment of eligible and ineligible deferred compensation items, and suggests that additional guidance may be issued.
Interests in Nongrantor Trusts. Direct or indirect distributions of property to a covered expatriate who was a beneficiary on the day before the expatriation date are subject to withholding equal to 30% of the taxable portion of the distribution. Notice 2009-85 defines the term "beneficiary" and provides guidance on: (1) trust distributions of built-in-gain property; (2) conversions of nongrantor trusts into grantor trusts; and (3) the application of §871, which subjects a covered expatriate's nongrantor trust distributions to tax, and §877A(f)(1)(A), which subjects the payment of such tax to the withholding rules under §877A(f)(1)(A). The Notice also distinguishes between a trustee's obligation to deduct and withhold on distributions and a covered expatriate's obligations to inform the trustee of his covered status and report on his income tax return any tax not withheld. Under §877A(f)(4)(B), covered expatriates who were nongrantor trust beneficiaries before expatriating waive their right to reduced withholding on those distributions under U.S. tax treaties unless they follow certain procedures. Until further guidance is issued, Notice 2009-85 outlines the procedures that covered expatriates must follow to preserve their treaty rights.
Deferral of Payment of Tax Under the Mark-to-Market Regime. Section 877A(b) allows a covered expatriate to make an irrevocable election (deferral election) for any property deemed sold by reason of §877A(a) to defer the payment of additional tax attributable to the property (deferral assets). The election is made on an asset-by-asset basis. To make the election, the covered expatriate must provide adequate security and must irrevocably waive on Form 8854 any right under any U.S. treaty that would preclude assessment or collection of tax imposed by §877A.
Notice 2009-85 requires each covered expatriate that makes a deferral election to enter into a tax deferral agreement with the Service and provides a template of a tax deferral agreement. If the Service accepts the agreement, then the security provided by the covered expatriate is considered adequate security. The tax deferral agreement must be submitted as a request to the Service by the due date of the covered expatriate's tax return for the taxable year that includes the day before the expatriation date, and is subject to extensive supporting documentation requirements. It appears that the expatriation must occur before a tax deferral agreement can be requested.
Filing and Reporting Requirements. Notice 2009-85 imposes rules that covered expatriates must follow to report information until regulations are issued under §877A. Most notably, the rules require covered expatriates to file Form 1040NR with Form 1040 attached for the year of expatriation and, in certain cases, Form 1040NR for subsequent years. The Notice clarifies that all U.S. citizens who relinquish their U.S. citizenship and all long-term residents who cease to be lawful permanent residents of the U.S. are required to file Form 8854 in order to certify that they have been in compliance with all federal tax laws during the five years preceding the year of expatriation. Individuals who fail to make such certification will be treated as covered expatriates within the meaning of §877A(g), whether or not they also meet the tax liability test or the net worth test.
For more information, in the Tax Management Portfolios, see Klasing and Francis, 918 T.M., Section 911 and Other International Tax Rules Relating to U.S. Citizens and Residents, and in Tax Practice Series, see ¶7120, Foreign Persons' U.S. Activities.