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By Edward Tanenbaum, Esq.
Alston & Bird LLP, New York, NY
On October 15, 2009, the IRS issued Notice 2009-85 1 ("the Notice") providing for immediate taxpayer guidance under §877A pending the issuance of regulations. The Notice is well written and is helpful in terms of clarifying a number of issues left unanswered in the statute. At the same time, however, a number of specific issues are left for future guidance.
Section 877A came into the law in the Heroes Earnings Assistance and Relief Tax Act of 2008.2 This new individual expatriate tax regime applies to all "covered expatriates" who expatriate on or after June 17, 2008. It replaces the former tax regime (which remains applicable to those expatriating prior to June 17, 2008) pursuant to which an alternative tax applied to expatriates for a 10-year period following expatriation.
The new expatriation provisions impose a mark-to-market exit tax on individuals who are "covered expatriates." A covered expatriate is subject to U.S. income tax on the net unrealized gain in his or her property as if the property had been sold for its fair market value on the day before the expatriation or termination of U.S. residency. Because the exit tax is deemed to take place on the day before expatriation, no treaty protection is available.
The Notice states that property is deemed owned if it would be considered a part of that person's gross estate for U.S. estate tax purposes, inclusive of beneficial interests in trusts. Any net gain on these assets in excess of $626,000 (as already adjusted for inflation for 2009) on the deemed sale is recognized. The Notice also makes clear that the exclusion is to be allocated among all the built-in gain property that is subject to the exit tax (whether or not an election is made to defer the tax (see below)). That the exclusion amount is calculated on an asset-by-asset basis makes sense because proper adjustment "is to be made in the amount of gain or loss realized subsequent to the deemed sale, without regard to the $626,000 exclusion amount, on any actual asset sale, e.g., FIRPTA-type asset, etc."
A taxpayer may irrevocably elect to defer payment of the mark-to-market tax until the taxpayer actually disposes of the property. Interest accrues on the unpaid tax and the taxpayer must post adequate security. Waiver of treaty protection is a pre-condition. The Notice provides that the deferral election is applied on an asset-by-asset basis which, again, makes perfect sense and is consistent with the approach taken throughout the Notice. A template of a tax deferral agreement is provided as an appendix in the Notice. A U.S. agent must also be appointed to receive communications from the IRS.
In the case of a resident alien, property held by an individual on the date the individual first became a resident of the United States is treated as having on such date a basis of not less than its fair market value (unless the individual irrevocably elects otherwise on a property-by-property basis). The Notice states, however, that the IRS intends to exercise its authority to exclude from the basis step-up rule U.S. real property interests as well as assets used in connection with a trade or business in the United States held by the taxpayer at the time of first becoming a U.S. resident (unless, under a treaty, the business is not carried on through a permanent establishment).
In general, a covered expatriate is defined with reference to prior law. A covered expatriate is an expatriate: (1) whose average annual net income tax for the five taxable years preceding expatriation exceeds $145,000 (as already adjusted in 2009 for inflation); (2) whose net worth is $2 million or more on the date of expatriation; or (3) who fails to certify under penalty of perjury that he or she has complied with all U.S. federal tax obligations for the five preceding taxable years or fails to submit such evidence of compliance as the IRS may require. The Notice is quite clear in indicating that the tax certification applies to all income, employment, gift, and other taxes, including the filing of information returns. The certification is to be made on Form 8854, as revised.
Certain dual citizens and persons who relinquish U.S. citizenship before reaching 18 1/2 years of age are not treated as covered expatriates. Similar rules are not provided, however, in the case of long-term residents.
An expatriate is a U.S. citizen who relinquishes his or her citizenship, or any long-term resident of the United States (i.e., an individual who is a lawful permanent resident of the United States (has been lawfully accorded the privilege of permanently residing in the United States as an immigrant) in at least eight of the 15 taxable years ending with the taxable year in which the individual terminates U.S. residency) who ceases to be a lawful permanent resident of the United States.
The mark-to-market tax does not apply to interests in certain deferred compensation items, i.e., interests in qualified pension, profit sharing, bonus plans, etc. For this purpose, any property right issued in connection with the performance of services is included to the extent not previously taken into account for §83 purposes. According to the Notice, property is taken into account if, prior to the expatriation, the property has become substantially vested or a valid §83(b) has been made. The Notice further provides that such property right includes statutory and non-statutory stock options, stock appreciation rights, restricted stock units, etc.
In the case of certain "eligible" deferred compensation items, i.e., the payor is a U.S. person or a non-U.S. person who elects to be treated as such, the payor must deduct and withhold 30% of a taxable payment (i.e., a payment that would be includible in income if the recipient were a U.S. citizen or resident) made to a covered expatriate. This withholding requirement applies in lieu of any other withholding requirements under current law, but items that are subject to the withholding requirement are nevertheless subject to tax under §871. The Notice defers until a later time guidance that would provide rules for non-U.S. persons to elect to be treated as a U.S. person. Again, waiver of treaty protection, at least with respect to the withholding tax, is a pre-condition to receiving "eligible" deferred compensation.
In the case of deferred compensation items that are not "eligible," an amount equal to the present value of the item is generally treated as having been received by the covered expatriate on the day before expatriation.
In addition, in the case of certain specified tax-deferred accounts (i.e., IRAs, tuition plans, HSAs, etc.), the individual is treated as having received on the day before the expatriation date a distribution of his entire interest in that account.
Section 877A(d)(5) provides that the rules relating to eligible and ineligible deferred compensation do not apply to the extent attributable to services rendered outside the United States while the covered expatriate was not a citizen or resident of the United States. The Notice provides that, until further guidance is issued, taxpayers may use any reasonable method in establishing the relevant allocable portion.
The mark-to-market tax applies to assets held by a portion of a trust for which the covered expatriate is treated as the owner under the grantor trust provisions of the Code. In contrast, a 30% withholding tax applies to direct or indirect distributions from the portion of any nongrantor trust of which a covered expatriate is a beneficiary. In this case, the trustee must deduct and withhold from the distribution an amount equal to 30% of the distribution that would be includible in the gross income of the covered expatriate if such person continued to be subject to tax as a U.S. citizen or resident. This portion of the distribution is subject to tax under §871. Treaty benefits are deemed waived with respect to such distributions unless the expatriate agrees to other treatment as prescribed in regulations. Further, if the fair market value of any property distributed exceeds its basis in the hands of the trust, gain must be recognized by the trust as if the property were sold to the covered expatriate at fair market value.
The new rules subject U.S. citizens and residents who receive certain gifts or bequests from a covered expatriate to a current transfer tax of 45%. This new transfer tax represents a significant departure from the general rules under which donees and heirs do not normally pay tax on the receipt of gifts or bequests. The transfer tax applies to property directly or indirectly acquired by gift from an individual who, at the time of the transfer, is a covered expatriate, or to any property directly or indirectly acquired by reason of the death of an individual who was a covered expatriate immediately before death. However, the first $13,000 (as already adjusted in 2009 for inflation) of gifts received by the U.S. citizen or resident from a covered expatriate in any taxable year is exempt from the transfer tax. Further, the tax is reduced by any foreign gift or estate taxes paid in connection with the property. In addition, any U.S. situs property that is subject to U.S. estate or gift tax if given or bequeathed by a nonresident alien of the United States, and for which an estate or gift tax return is filed, is not subject to the above taxes. Unfortunately, the Notice does not provide any immediate guidance as to these rules, although the Notice states that satisfaction of the reporting and tax obligations for covered gifts and bequests received is deferred pending issuance of that guidance. Moreover, the guidance will provide a "reasonable period of time" between the issuance of guidance and the date prescribed for such reporting and tax obligations.
The Notice does clarify a number of issues and sets forth some very clear examples of how many of the foregoing concepts are intended to work. However, further guidance would obviously be welcomed, especially with respect to §2801 and treaty coordination.
This commentary also will appear in the February 2010 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Bissell, 907 T.M., U.S. Income Taxation of Nonresident Alien Individuals, and 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, and ¶7130, U.S. Persons' Foreign Activities.
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