For some Americans who are living and working more permanently overseas with no intention of returning to the United States to live, the decision to renounce their citizenship makes sense. There are tax benefits, like not having to pay income tax to the U.S. government anymore, that come with the renunciation of an individual’s citizenship. For certain individuals, this renunciation will come with one final tax payment: the exit tax. The Orange County expat tax lawyers at Evolution Tax and Legal are breaking down the exit tax: what it is, who must pay it, and how much it would cost.
What Is the Exit Tax?
When U.S. citizens or residents choose to permanently sever their citizenship ties with the United States, they are required to pay any outstanding tax debts and obligations. For some individuals, these obligations include an exit tax. This tax is not a penalty, rather it is viewed as a final bill for any tax obligations on capital gains which have been unpaid. It could include any assets that have not yet been taxes like capital gains on any homeownership or funds in retirement accounts. It can also include any unfiled tax payments that have not been made.
U.S. Exit Tax & IRS Requirement
To determine if an individual must pay an exit tax, it must be determined whether or not they are a covered expatriate. If an individual is determined to be a covered expat, they will have to conduct an exit tax analysis using Form 8854 to determine the amount that will be paid. Covered expats will be required to pay income tax on any net unrealized gain on property, which will be determined by calculating the gains as if the property had been sold at fair market value. This applies to most types of properties held by expats.
Who Is Subject to the U.S. Exit Tax?
U.S. Citizens
U.S. citizens who have chosen to renounce their citizenship are the most common individuals to pay an exit tax. They must be determined to be covered expatriates in order to pay the exit tax, and the IRS qualifies an individual as a covered expat if they meet one of the following thresholds:
Net Worth
If an individual’s net worth exceeds $2 million at the time of renunciation, they will be considered a covered expat. The IRS will calculate your net worth by adding the value of all of your assets, including unrealized capital gains, and treat them as if they have been sold on the day of expatriation to determine the exit tax amount. This math can be complicated due to different qualifying factors and exceptions to tax determinations. Working with a tax professional is recommended to ensure compliance with exit tax requirements.
Annual Net Income Tax
If an individual’s annual net income tax over the previous five years exceeds a set threshold, they are considered a covered expat. The threshold for 2022 was $178,000 for the prior five years.
Tax Filing Compliance
Upon filing Form 8854 individuals will be asked whether they have been in compliance with taxes over the previous five years. If an individual has not been in compliance with tax filing requirements, they will be considered a covered expat.
Long-Term Residents
Green Card holders who have been residents of the United States for at least eight of the previous 15 years may be considered covered expats regardless of their annual net income tax, determined net worth or tax filing compliance.
How To Calculate the Exit Tax
The purpose of the exit tax is to pay off any outstanding debts to the U.S. government before officially leaving the country permanently. The amount you owe will depend on what tax obligations you still have at the time of renouncing your citizenship or green card. This includes any taxes owed on income or capital gains. The exit tax only deals with unpaid taxes, so you don’t need to be concerned about double taxation. Any income that has already had taxes paid on it will not be included in your exit tax bill. The determination of your exit tax payment is complicated, so working with a professional to determine your liability is recommended to ensure you can cover the costs of this tax.
How Can I Avoid U.S. Exit Tax?
If you currently qualify as a covered expat and are hoping to avoid paying the exit tax, there may be ways to modify your qualification as a covered expat and maybe avoid paying this tax. Some examples of modification include strategically distributing assets among you and your spouse, to avoid your net worth exceeding $2 million. There are legal ways to distribute assets that may help you be classified as non-covered expat, however if you do something illegal in order to avoid paying the tax the effects can be devastating. Working with a professional to ensure compliance and legality in this situation is imperative.
If the cost of the exit tax is higher than you wish to pay, you can also consider not renouncing U.S. citizenship. You can still live and work abroad as an expat, while keeping your U.S. citizenship and avoiding an exit tax. You will be required to file a U.S. tax return each year, and potentially a few other forms, but it is common for U.S. citizens living abroad to pay little to nothing in taxes each year. The team at Evolution Tax and Legal has experience in these citizenship and tax situations and can provide guidance on citizenship renunciation, as well as taxes for expats and the exit tax for covered expats.