- Expatriation has increased significantly in 2020, with a record 6,047 individuals expatriated during the first three quarters of 2020, compared to the previous annual record of 5,411 expatriates in 2016.
- The increase in expatriation has caught the attention of the U.S. Treasury Inspector General for Tax Administration (TIGTA), which emphasized in its Sept. 28, 2020, report that the Internal Revenue Service (IRS) enhance its enforcement efforts and implement a centralized compliance effort to create disincentives to expatriate.
- The TIGTA report and recommendations to the IRS are summarized in this alert.
The U.S. Treasury Inspector General for Tax Administration (TIGTA) recently audited the Internal Revenue Service's (IRS) programs to ensure compliance by expatriates with the provisions under Sections 877 and 877A of the Internal Revenue Code. As a result of the rising number of taxpayers expatriating, TIGTA recommended that the IRS enhance controls to enforce the U.S. tax and reporting provisions applicable to expatriates.
TIGTA's Expatriation Audit Revealed Several Areas in Need of IRS Attention
Expatriates' Tax and Reporting Requirements
When a U.S. citizen renounces or relinquishes U.S. citizenship or when a U.S. "green card" holder classified as a "long-term resident"1 ceases to be treated as a lawful permanent resident of the United States, the expatriating individual is required to file Form 8854 (Initial and Annual Expatriation Statement) to certify compliance with all U.S. federal tax obligations for the five taxable years preceding expatriation and to comply with the reporting requirements under Code Section 6039G.
In addition, if an expatriate meets any of the following three tests, he or she will be a "covered expatriate" (unless the expatriating individual qualifies for an exception) and subject to the Code Section 877A so-called mark-to-market "exit tax" as well as to the taxation regimes applicable to the three categories of assets not covered by the "exit" tax.
- The Tax Liability Test. An expatriate who has an average annual net income tax liability for the five preceding taxable years ending before the expatriation date that exceeds a specified amount adjusted for inflation. For 2020, the amount is $171,000.
- The Net Worth Test. An expatriate who has a net worth of $2 million or more (but not adjusted for inflation as of the expatriation date).
- The Certification Test. An expatriate who fails to certify, under penalties of perjury, compliance with all U.S. federal tax obligations for the five taxable years preceding the taxable year that includes the expatriation date, including, but not limited to, obligations to file income tax, employment tax, gift tax and information returns, if applicable, and obligations to pay all relevant tax liabilities, interest and penalties. This certification is made on IRS Form 8854 and must be filed by the due date of the taxpayer's federal income tax return for the taxable year that includes the day before the expatriation date.
Covered Expatriates subject to the mark-to-market exit tax generally are treated as having sold their worldwide assets on the day before their expatriation date. The gain on the deemed sale is taxed at applicable ordinary or capital gains tax rates on gains in excess of $600,000 (indexed for inflation; $737,000 for 2020).
In addition, Covered Expatriates also will be subject to U.S. federal income taxation on income from three categories of assets not subject to the exit tax – deferred compensation items, specified tax deferred accounts and on distributions from non-grantor trusts.
Further, under Code Section 2801, U.S. persons who are recipients of "covered gifts or covered bequests" from the Covered Expatriate will be subject to the highest rate of gift or estate taxation on these inter vivos or testamentary transfers.
The TIGTA Audit
The TIGTA audit was initiated to determine the effectiveness of the IRS' compliance efforts with respect to the U.S. federal tax and reporting requirements for expatriates under Code Sections 8872 and 877A. The TIGTA's findings are summarized below.
The IRS Lacks Controls to Ensure Compliance by Expatriates
The TIGTA found that the IRS lacked the requisite controls to ensure compliance by expatriates. The Small Business/Self-Employed (SB/SE) Division's Low-Income Housing Credit (LIHC) unit in Philadelphia is tasked with entering information in the IRS' expatriate database. However, the focus of the LIHC is to collect and publish data on expatriates and not to track their compliance with the IRC Section 877A exit tax obligations. The TIGTA found that the IRS has inadequate controls in place to ensure that taxpayers who qualify as Covered Expatriates file Forms 8854 and pay their requisite amount of exit tax.
Many Expatriates Are Not Filing Form 8854
Based on the data analyzed, the TIGTA found that many expatriates are not filing Form 8854 with the IRS' Philadelphia campus. From June 2008 through December 2018, 41 percent of expatriates who received a Form DS-4083, Certificate of Loss of Nationality (CLN), did not send a copy of Form 8854 to the Philadelphia campus as required. Further, because the LIHC Unit does not focus on compliance, it was not following up with such expatriates by mailing either Letter 2399C (Failure to File – Initial Form 8854) or Letter 4135C (Failure to Respond to Initial Form 8854 Request) – two letters previously developed by the IRS that have not been updated since July 2005 and 2006, respectively.
Expatriate Database is Not Sufficient to Enforce the Exit Tax
The TIGTA found that the expatriate database is not sufficient to enforce the exit tax. The LIHC unit is responsible for maintaining the expatriate database and for transcribing certain data from Form 8854. However, the LIHC unit does not transcribe data from three significant parts of Form 8854, including: 1) Part IV, Section B, Line 8, which details the expatriate's property owned on the date of expatriation and calculates the gain or loss on the deemed sale of such property (important for computing exit tax); 2) Part V, Schedule A, Balance Sheet listing the expatriate's assets and liabilities (important for determining whether an expatriate satisfied the net worth test); and 3) Part V, Schedule B, Income Statement (important for determining whether an expatriate satisfied the income test). Tracking this data is key in determining whether an expatriate is a Covered Expatriate and in paying the necessary exit tax on net unrealized gains from the deemed sale of his/her worldwide assets and on the three categories of income from assets excluded from the exit tax.
High-Net-Worth Expatriates Appear to Not Be Paying Exit Tax
The TIGTA reviewed 61 expatriate cases (26 were Covered Expatriates based on the tax liability rule and 35 were Covered Expatriates based on the net worth rule) for potential compliance issues. Because the TIGTA did not examine these expatriates' last tax return or exit tax calculations, it cannot state with certainty whether these 61 expatriates were not compliant. However, it is noteworthy that of the 26 tax liability cases, in 12 cases, the expatriates reported only 15 percent in capital gains compared to net worth, and in the other 14 cases, the expatriates either did not report any gain on their final tax return despite reporting a combined net worth of over $73 million or did not file a tax return. And, of the 35 net worth cases, in 29 cases, the expatriates reported nearly 1 percent in capital gains compared to net worth, and, in the other six cases, the expatriates did not report any gain on their final tax returns despite having a combined net worth of more than $65 million. Given the combined net worth of $1.2 billion of these 61 Covered Expatriates, expatriates failed to properly pay the required exit tax.
Examination Rate of an Expatriate's Final Tax Return Is Low
Based on the data tracked in the IRS' Audit Information Management System, there were 18,790 expatriates from 2015 through 2018, and only 63 closed expatriate examinations for that same time period. There is a mismatch of information tracked by the LIHC Unit in the expatriation database with the information tracked by the IRS Individual Master File. The LIHC Unit enters an expatriate's name, the date the expatriate received his/her CLN, the expatriate's address and the expatriation date into the expatriation database. When an expatriate attaches Form 8854 to his/her Form 1040NR, the IRS identifies the expatriate on the Individual Master File with an Audit Code K (note that this information is not tracked if an expatriate instead attaches Form 8854 to a Form 1040). In order for the IRS to effectively identify expatriates who fail to file Form 8854, it must consolidate information from the LIHC's expatriate database and the IRS' Individual Master File Audit Code K Data.
TIGTA Recommends Five IRS Action Items to Increase Compliance Efforts for Expatriates
The TIGTA recommended that the IRS should take the following five actions:
- Coordinate with the U.S. Department of State to add a Social Security Number field to the CLN to better track the filing of Form 8854 and payment of an exit tax, and allow the IRS to obtain an electronic copy of the CLN to reduce delays in the transmission of this information.
- Update Letter 2399C (Failure to File – Initial Form 8854) and Letter 4135C (Failure to Respond to Initial Form 8854 Request), and develop Internal Revenue Manual (IRM) procedures to issue these letters when a taxpayer has been issued a CLN but hasn't filed Form 8854.
- Determine what data fields from Form 8854 should be added to the expatriate database to evaluate and follow up on tax compliance issues (at a minimum, the information for property owned on the date of expatriation, the balance sheet and the income statement should probably be added to determine whether an expatriate is a Covered Expatriate and to calculate the appropriate exit tax).
- Develop IRM procedures for transcribing Form 8854 data, correct Form 8854 data when information is missing or incomplete, and prepare analysis as needed to determine if the expatriate is a Covered Expatriate and subject to tax.
- Establish a process to compile information on all expatriates, whether they filed Form 8854 with their Form 1040NR or with the LIHC unit and use this information to identify high risk expatriate returns for tax and reporting compliance.
It should be noted that the IRS Large Business & International Division (LB&I) announced a new compliance campaign on July 19, 2020, to focus on U.S. citizens and long-term residents who expatriated on or after June 17, 2008, and have not met their tax or reporting obligations. The LB&I Division is utilizing a two-pronged approach in developing its cases. First, the IRS will issue soft letters (Letter 6272) to expatriates who have not submitted Form 8854. Second, the IRS will conduct examinations of expatriates identified from certain campaign-developed filters that use information from the IRS' Individual Master File and the expatriation database to identify cases for examination.
For more information and questions regarding the topics covered in this alert, contact the authors.
1 A "long-term resident" is any individual (other than a U.S. citizen) who is a lawful permanent resident of the United States; i.e., a "green card" holder in at least eight taxable years during the period of 15 taxable years ending with the taxable year during which the "long-term resident" expatriated.
2 Code Section 877 primarily deals with expatriation taxation prior to Jun 17, 2008.
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