Small case study

We are a family considering relinquishing U.S. citizenship. We have questions like these before we proceed:

• Someone who obtained the green card 24 years ago, has resided outside of the U.S. (in France) for the past 18 years, is giving up the green card. What are the exit tax obligations?
• Someone who obtained U.S. citizenship and the citizenship of another country at birth, has resided outside of the U.S. (in the U.K.) for the past 20 years, is relinquishing the U.S. citizenship. What are the exit tax obligations?
• If the person did not file tax returns because the income was below the filing requirement, can the person still be considered to have fulfilled all the tax obligations for the past five years?
• Is it a good idea to file past five years returns?

This presents some interesting problems that need to be solved. This family is living at the intersection of the exit tax rules and the IRS's Holy War on Americans abroad--everyone who hasn't filed a tax return must be a criminal.

The Certification Test Is The Problem

The critical problem facing the family members--the green card holder and the citizen--is the Certification Test. To see it, pull up a copy of Form 8854. At the bottom of page 3, you will see an apparently innocent question. Line 6. That's where the rubber meets the road. The Certification Test applies to people who give up citizenship or green card status. It asks whether--for the previous five years--all tax returns have been filed and all tax payments have been made. If the answer is "No", then the person is automatically a covered expatriate. This means:

• The expatriate will pretend to sell everything he or she owns, and capital gain will be taxed by the U.S. (after an exemption amount). For this family that has lived two decades outside the United States, it is reasonable to expect that they might have assets that have gone up substantially in value. This will be a big tax bill to pay the IRS.
• If these people have any IRAs or similar accounts left in the United States from their time living here, those accounts will be treated as distributing everything to them in a lump sum. This creates additional taxable income.
• If these people have pensions, a variety of ill effects will result. The worst of these would be that the pension will be treated as being distributed as a lump sum for U.S. tax purposes--even if retirement age is decades away.
• If the expatriates are beneficiaries of trusts, unpleasant income tax problems might result.
• If younger generations remain U.S. citizens or residents, gifts or inheritances received by the younger generations will be taxed. In other words, the normal tax rule (gifts or inheritances are tax-free to the recipient) is turned on its head. After all, the covered expatriate has successfully escaped and cannot be taxed by the IRS. Like a lover scorned, Uncle Sam can only inflict pain on the children and grandchildren of the covered expatriate. This is truly an instance of kicking the dog because your spouse walked out on you.

At the moment, both the green card holder and the U.S. citizen in this family will be covered expatriates because they have filed no income tax returns for the previous five years.

Faced with the certainty that you will fail the Certification Test and become a covered expatriate, the question is "What should I do?"
A quick bit of emergency room triage is necessary. Do you fix the problem (and prevent covered expatriate status, perhaps?) or do you simply expatriate and walk away?

If this family is not wealthy, and if all of the bad tax results I have listed will not create a significant tax problem, then maybe they will just concede covered expatriate status for themselves. They ignore the past. They expatriate in 2014, and file the necessary 2014 income tax returns and Form 8854.

For instance, let's assume that the two family members do not have any IRAs or similar accounts, and they do not have pension plans. They just have modest investments and cash. As long as the total capital gain on a "pretend" sale of the investments would create a capital gain of $680,000 or less, there will be zero exit tax.

At that point, the decision is with the IRS--will they pursue these two people for unfiled tax returns and unpaid income tax going back for years and years? One wonders.

If the family will not ever return to the United States and will never invest in U.S. assets, this might be a viable strategy.

The alternative is to clean up those prior five years. File five years of tax returns. Pay the tax, penalties, and interest, thereby fully satisfying the Certification Test and preventing covered expatriate status.

If the family members might want future contact with the United States, or just believes in cleaning up messes, this is a good strategy.

Other Ways to be a Covered Expatriate

Someone can be a covered expatriate by failing the Certification Test, as noted above--tax returns and tax payments are not 100% satisfied for the previous five years.

But the person can also be a covered expatriate by being too wealth ($2,000,000 net worth or higher), or by having a high average net tax liability over those five prior years ($157,000 on average for a net tax liability over those years).

Someone who is considering the "fix it" strategy might find this to be a useless exercise because net worth exceeds $2,000,000, for instance.

The moral of this story is that cleaning up the prior five years of tax filings is not sufficient to make an expatriate escape the dreaded status of covered expatriate. A full analysis of the situation is necessary.

How to Fix It?

Assume the family decides that the "fix it" route is the best. They want to clean up the prior five years of tax problems before they expatriate. How do they do this? There are three options:

• Voluntary Disclosure Program. Commit financial hari-kari by following these procedures, the highlight of which is probably a 50% hit to your net worth, after paying eight years of income tax, etc. and a 27.5% penalty computed on most of your net worth. Give the U.S.A. half of your wealth just to give up the passport? Hmmm. Let me think.
• Streamlined Procedure. This allows American taxpayers abroad to clean up prior years of tax filings and pay the tax, without penalties. If this applies, it is an attractive solution. It is likely to be an incomplete solution, because it only covers three years of tax filings, and you need five years in the system before you can expatriate cleanly. This means waiting a couple of years until you can expatriate.
• Obey the Law. Some people call this "quiet disclosure". It is better to call this the "obey the law" strategy. The IRS says you have to file tax returns, even if they are late. Fine. File them.

There is no way to figure out which of the three strategies is optimal without doing the hard work. You are looking for the expected outcome: if everything goes to hell and the IRS unleashes the Dogs of War on you, what is your exposure?

The family needs to do some hard work to figure out how to fix the prior five years of tax filings (or maybe "if" to file). But there are a couple of possible escape hatches available.

For the green card holder, the objective is to get this person configured in such a way that he or she passes the certification test, has a net worth below $2,000,000, and average net tax liability below the $157,000 level. For most people, the net worth test is the hard one.

Consider using gifts to the U.S. citizen to reduce the green card holder's net worth below $2,000,000. For instance, if the green card holder has a personal net worth of $5,800,000, then make a gift of $4,000,000 to the U.S. citizen family member. Now the green card holder has a net worth below the $2,000,000 level, and if the certification test problem can be solved, the green card holder can expatriate without being a covered expatriate.

The $4,000,000 gift to the U.S. citizen could theoretically be taxable, but the unified credit rules give plenty of room for tax-free gifts of this type. Make the gift, file the gift tax return, claim the unified credit (covering up to $5.34 million of gifts at the moment), and the gift is tax-free.

The reason this is particularly interesting as a possibility is that the U.S. citizen qualifies for an exception the the "covered expatriate" problem, regardless of wealth. This is the "dual citizen" exception. Look on Form 8854, page 3, in Part IV, Section A. Look at Line 3 and Line 4. If you can answer these two questions in the right way, and if you pass the certification test, then the U.S. citizen can expatriate without being a covered expatriate.

Using these strategies would mean some sort of remedial cleanup strategy for both family members. But it may be that five years of cleanup for two people is relatively cheap, and it is a nice feeling to know that you are not being chased by unresolved potential tax problems that the IRS might chase you for later. It is indeed a good feeling to know that you can move about the planet freely, without fear.

Summary

It isn't going to be easy for the family. At the moment, both the green card holder and the citizen face the full force of the exit tax because they fail the Certification Test--they haven't filed tax returns or paid tax in the prior five years.

They need to figure out whether it is worth fixing the problem or not. If they decide fixing the problem is the right strategy, they then need to figure out how to fix the old tax return years.

All of this should be done before actually expatriating. Do not rush to the Embassy and turn in that green card or passport until you have figured this stuff out ahead of time.
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