The Heroes Earnings Assistance and Relief Tax Act of 2008 (the HEART Act) created a “mark-to-market” exit tax applicable to certain U.S. citizens and long-term green card holders who expatriate or relinquish their green cards, as well as a succession tax on U.S. citizens or residents who receive certain gifts or bequests from these persons. For a discussion of the substantive provisions of the HEART Act, please see McDermott’s On the Subject dated June 23, 2008, entitled “HEART Act Applicable to Expatriates and Long-Term Residents.”
On October 15, 2009, U.S. Treasury released promised guidance concerning the exit tax and related issues in Notice 2009-85 (the Notice). Guidance on the succession tax will be issued separately. Until Treasury issues regulations, taxpayers may rely on the Notice.
Taxpayers Subject to Exit Tax
The Notice provides that the application of the tax liability and net worth tests, which are used to determine whether a taxpayer is subject to the exit tax, continues to be governed by Section III of Notice 97-19, issued in connection with a predecessor expatriation tax regime. Notice 97-19 provides that the entire net income of joint filers is included for purposes of the tax liability test, and that all property subject to gift tax if owned by a U.S. person, and all property in which a use right is held, are included for purposes of the net worth test.
Exit Tax Base
The Notice helpfully amplifies the substantive provisions of the exit tax. A taxpayer who is subject to the exit tax (a “covered expatriate”) will include in his exit tax base any interest in property that would have been taxable as part of his gross estate for federal estate tax purposes had he died a citizen or resident of the United States on the day before expatriating. The Notice directs that the assets be valued in accordance with the rules governing the valuation of assets for estate tax purposes, which contemplate the use of discounts for illiquid assets or minority interests. The Notice requires that a covered expatriate obtain a fair market value appraisal of his property and attach the appraisal to his final U.S. income tax return.
The Notice states that, for purposes of determining the exit tax base, the covered expatriate will be deemed to own his beneficial interest (the extent of which is determined by applying the principles of Section III of Notice 97-19 and the value of which is determined under gift tax valuation principles without regard to any prohibitions or restrictions on the interest) in each nongrantor trust (defined, for this purpose, as any trust that is not treated as a grantor trust as to the covered expatriate) that would not constitute part of his gross estate and that is not a nongrantor trust subject to the statutory withholding regime. The Notice provides that a covered expatriate may elect out of the withholding regime for distributions from nongrantor trusts by electing to include his interest in the trust in his exit tax base. A private letter ruling as to value is a condition of this election.
Computation of Exit Tax and Deferral
The Notice provides that the exclusion of the first $600,000 (adjusted annually for inflation, $626,000 for 2009) of net gain from the exit tax is to be allocated pro rata among all assets included in the exit tax base. This method is significant because a taxpayer may elect to defer the exit tax payable with respect to a particular asset, provided that security for the ultimate payment of the tax is posted and interest is paid over the deferral period. The Notice contains the form of deferral agreement an electing covered expatriate must enter into with the Internal Revenue Service and the required components of a deferral request, but provides no further guidance on what constitutes “adequate security” beyond what is already provided by statute. Losses may be taken into account only to the extent permitted by the Internal Revenue Code (i.e., subject to the annual capital loss limitation of $3,000), except that the wash sale rules prohibiting the recognition of loss on the sale of securities if substitute securities are purchased within one month before or one month after the sale do not apply.
Basis Adjustments and Step Up for Inbound Persons
A covered expatriate receives a basis adjustment for the amount of gain or loss deemed realized without regard to the lifetime inflation-adjusted $600,000 exclusion amount, although this is of little value for property other than U.S. situs real estate since nonresident aliens are generally not subject to U.S. tax on capital gains. The Notice warns that Treasury intends to exercise its regulatory authority to exclude generally from the rule allowing inbound nonresident aliens a step up in basis for property held on the first day the alien becomes an income tax resident of the United States any property that is a “United States real property interest” and any property used or held for use in connection with the conduct of a trade or business within the United States.
Filing and Reporting Obligations
The Notice provides that a covered expatriate who is a beneficiary of a nongrantor trust who does not elect to include the value of his interest in the exit tax base must file a new Form W-8CE with the trustee. Similarly, recipients of “ineligible deferred compensation” (basically, deferred compensation for which the payor is not a U.S. person or does not otherwise assume the responsibility for withholding) must file a W-8CE with the payor. The payor is required to provide a written statement to the covered expatriate within 60 days of receipt of the Form W-8CE setting forth the present value of the covered expatriate’s accrued benefit on the day before the expatriation date, which amount is then included in the covered expatriate’s exit tax base. A covered expatriate who was a citizen or long-term resident for only part of the taxable year must file a dual status return (a Form 1040NR with a Form 1040 attached as a schedule). In addition, all covered expatriates must file with their final income tax return a certification, made under penalties of perjury, on Form 8854 that the covered expatriate has been in compliance with all federal tax laws during the five years preceding the year of expatriation. A covered expatriate with any interest in a nongrantor trust on the day before his expatriation date must file Form 8854 annually to certify that no distributions have been received or to report the distributions received, unless the covered expatriate elected to have his entire interest in the trust included in the exit tax base.
The Notice reaffirms Notice 97-19 for purposes of determining whether a taxpayer is a covered expatriate, provides guidance as to the parameters of the exit tax base and illustrates how to allocate the tax among the assets comprising that base. The Notice provides reassurance to those who feared that Treasury would use its regulatory authority to deny covered expatriates the benefit of valuation discounts, as well as a warning to inbound aliens that U.S. real and business property will not be stepped up to fair market value upon commencement of U.S. residency.