Enforcing the Exit Tax Against Expatriates: California State Bar Recommends Change

In theory, surrendering your U.S. citizenship for tax purposes can be expensive. However, the IRS sometimes has difficulty enforcing the exit tax against expatriates. Now the State Bar of California is recommending legislative changes that would make enforcement easier and expatriation more expensive.

How do you enforce a law that relies on voluntary disclosures by people hoping to sever ties with the government enforcing it? For years, the Internal Revenue Service (IRS) has been facing this challenge when it came to enforcing the exit tax against expatriates. Now Helen S. Cheng and Dina Y. Name of Withers Bergman LLP have issued a report recommending legislative changes to make Section 877A of the Internal Revenue Code more enforceable.

Expatriation and the Exit Tax

Section 877A of the Internal Revenue Code imposes an expatriation tax against U.S. citizens and long-term residents (green-card holders) who choose to relinquish their United States citizenship or residency status for tax reasons. People choose to revoke their U.S. citizenship for a wide variety of reasons. However, many of those reasons include, or can appear to include, trying to avoid paying U.S. taxes when a person has decided to live in another country. Section 877A imposes a one-time tax liability on those expatriating individuals who qualify as “covered expatriates”.

With few exceptions, a “covered expatriate” includes anyone who:

• Have a five-year net income tax liability of over $162,000 (as of 2017)
• Have a net worth of $2 million at the time of expatriation
• Fail to file Form 8854 certifying they have properly filed taxes for the past five years and do not fit under either of the above categories.

When a “covered expatriate” revokes his or her citizenship, the IRS imposes an exit tax based on the net unrealized gain on all their worldwide assets. In other words, the IRS acts as though an expatriate sold all of his or her worldly possessions for their fair market value on the date of expatriation. That gain is reduced by $699,000 (in 2017), and then the mark-to-market tax is applied to most of those assets. There are special rules for deferred compensation and tax-deferred items, such as retirement accounts, as well as non-grantor trusts. Everything else, however, is taxed as of the date of expatriation.

For more wealthy taxpayers, enforcing the exit tax upon expatriation can come with a hefty toll. Even those who fall below the assets and income thresholds can be required to pay exit taxes simply by failing to file the necessary paperwork. However, expatriates are now finding that what the government does not know has not hurt them.

Challenges Enforcing the Exit Tax

The challenges the IRS faces in enforcing the exit tax are the basis for the State Bar of California’s “Proposal to Enhance Implementation, Enforcement of Exit Tax” issued on November 29, 2017. These challenges can be summarized as follows:

• Expatriate taxpayers have little incentive to voluntarily disclose when they relinquish citizenship
• Lack of communication between the IRS, State Department, and Department of Homeland Security make getting information difficult
• Jurisdictional limits to enforcing U.S taxes in foreign courts hinder the IRS’s ability to collect exit taxes.

Together, this system makes it difficult for the IRS to identify expatriates and impose exit taxes before the former taxpayer removes his or her assets from U.S. jurisdiction. Here’s how it works.

A U.S. taxpayer chooses to relinquish citizenship or permanent resident status. She files the necessary paperwork with the Department of State (for citizens) or the Department of Homeland Security (for permanent residents). She is also required to file Form 8854 with the IRS, but no one in the expatriation process is required to inform her of that obligation. The IRS may learn of the expatriation after the process is complete, but the forms obtained from the Departments of State or Homeland Security are missing crucial information for the IRS to impose the exit tax.

Instead, the IRS must seek out that information from the expatriate, who is often already living overseas. Once an exit tax is assessed, the IRS has authority to place tax levies on the person’s domestic accounts, but has limited authority to collect the amount owed from any property held overseas. This leaves the IRS largely unable to enforce the exit tax against expatriates without their voluntary cooperation, and can cause expatriates to live with extensive tax levies they did not know they had. If the expatriate returns to the U.S., transfers assets to a U.S. financial institution, or dies leaving assets to a U.S. citizen, those assets could be suddenly and unexpectedly seized.

California Bar Recommends Legislative Changes to Improve Enforcement

To correct this, the State Bar of California’s proposal recommends that the U.S. legislature amend the Internal Revenue Code and related laws to close the information gaps and improve communication between the departments. The proposed laws, if adopted would essentially change the order of filing, requiring a U.S. taxpayer to complete Form 8854 and pay the exit tax before completing expatriation through the State Department or Department of Homeland Security. They would also allow the departments to exchange information about expatriating taxpayers, to the extent necessary to enforce the exit tax.

In addition, the Bar recommends requiring expatriates to consent to ongoing personal jurisdiction in the U.S. for five years. This would allow the IRS to seek enforcement in U.S. courts, rather than filing tax collection matters abroad.

The changes proposed by the State Bar of California seem minor. However, taken together they could close the gap that makes enforcing the exit tax against expatriates difficult for the IRS. This would raise the cost of expatriation substantially, but it would also ensure that U.S. taxpayers were given notice and an opportunity to participate in the process, defending themselves against unnecessary taxation.

Attorney Joseph R. Viola is a tax attorney in Philadelphia, Pennsylvania with over 30 years experience. If you have questions regarding expatriation or the Exit Tax, contact Joe Viola to schedule a consultation.