The IRS publishes new proposed regulations for tax on transfers from covered expatriates

The IRS published new proposed regulations last week regarding the tax on gifts and bequests from covered expatriates last week.

Section 2801 basically provides that if a U.S. citizen or resident receives a “covered gift” or “covered bequest,” a gift or estate tax applies to the value of such gift or bequest which tax is borne by the person receiving the gift or bequest. This, of course, is the one exception to the rule that donees of gifts, and legatees of bequests, do not pay tax on the receipt of gifts or bequests, even if they are U.S. citizens.

The tax applies on the value of the gift or bequest that is in excess of the “annual exclusion” amount ($14,000 currently) and the applicable tax is reduced by any gift or estate tax paid to a foreign country with respect to that gift or bequest. Exceptions are also provided for taxable gifts by a covered expatriate and for taxable estates of a covered expatriate, i.e., property that is otherwise subject to U.S. gift or estate tax by the covered expatriate or his/her estate. Finally, an exception is also provided for property transferred to a spouse that qualifies for the marital deduction and for transfers to qualifying charities.

A “covered gift” is any gift acquired from an individual who is a “covered expatriate” and a “covered bequest” is any bequest acquired because of the death of a “covered expatriate.”

A “covered expatriate” is an individual who is regarded as such under the mark-to-market exit tax regime under §877A(g)(1), i.e., a U.S. citizen who gives up U.S. citizenship, or a long-term resident (holder of a green card for eight out of the last 15 years) who ceases to be a lawful permanent resident, and whose average annual income tax liability for the past five years equals $160,000 (current inflation index) or whose net worth at the time of expatriation equals or exceeds $2,000,000, or who is not able to certify U.S. tax compliance for each of the past five years. (Exceptions exist for certain dual citizens at birth and certain minors.)

 Tax on gifts and bequests from covered expatriates

Before the enactment of Section 2801, US expatriates were subject to US gift and estate tax for at most a 10-year period following their loss of citizenship. Accordingly, an expatriate could avoid estate tax by merely surviving for 10 years. Congress enacted Section 2801 in an effort to level the playing field between US expatriates and US citizens and domiciliaries, who are subject to gift and estate tax on their worldwide assets. Section 2801 imposes a tax equal in rate to the US gift and estate tax (currently 40%) on virtually any gift or bequest from a covered expatriate to a US person, including a citizen or resident individual, US domestic trust or non-US trust that has elected to be treated as a US trust for purposes of Section 2801. Section 2801 applies to gifts and bequests made by a covered expatriate on or after the later of June 17 2008 or the covered expatriate’s date of expatriation.

However, Section 2801 contains no mechanism for paying this tax. Accordingly, while any covered gift or bequest made on or after June 17 2008 is potentially taxable under Section 2801, to date it has not been possible to pay the tax. The proposed regulations clarify not only when and to whom gifts and bequests are taxable, but also create a mechanism for paying the Section 2801 tax.

Direct and indirect gifts and bequests taxable under Section 2801

With limited exceptions, any direct or indirect gift from a covered expatriate to a US person is taxable under Section 2801. For example, if a covered expatriate makes a gift or bequest to a non-US trust and that trust subsequently makes a distribution to a US beneficiary, the distribution is taxable under Section 2801 to the extent that it is attributable to the gift or bequest from the covered expatriate. If the non-US trust were to subsequently migrate to the United States, it would likewise be taxable under Section 2801 to the extent that the trust property includes gifts or bequests from the covered expatriate. The exercise, grant or release of a general power of appointment in favour of a US person is also taxable under Section 2801.

Before the publication of the proposed regulations, it was unclear whether Section 2801 would apply to property acquired after the covered expatriate’s date of expatriation. The proposed regulations confirm that it does. The proposed regulations also clarify that Section 2801 applies to a covered expatriate’s gift or bequest to a US trust that qualifies as a charitable remainder trust, but not to the portion of the gift or bequest attributable to the charitable remainder interest.

Exceptions for certain charitable and marital gifts and bequests

Gifts and bequests from a covered expatriate that are already subject to US gift or estate tax are not taxable a second time under Section 2801. For example, any non-US individual’s gift of US real estate is subject to US gift tax, and therefore not taxable under Section 2801 if that individual is a covered expatriate. Similarly, if a covered expatriate were to die a domiciliary of the United Sates, his or her worldwide assets would be subject to US estate tax, not Section 2801 tax.

In addition, gifts and bequests to a covered expatriate’s US citizen or resident spouse or to charity are exempt, provided that they qualify for the marital or charitable deduction. However, indirect gifts or bequests frequently do not qualify for these deductions.  With proper planning it is possible for a covered expatriate to avoid the imposition of US tax on a gift or bequest to his or her spouse or to charity.

Recipient liable to pay Section 2801 tax

Pursuant to Section 2801, the US recipient of the gift or bequest is liable for the payment of the tax. If the gift or bequest is made to a US trust or a non-US trust that has elected to be treated as a US trust for purposes of Section 2801, the trust is liable for the tax. Conversely, if the gift or bequest is made to a non-US trust that has not elected to be treated as a US trust for purposes of Section 2801, the trust is not liable for the tax. On a subsequent distribution from the non-US trust to a US beneficiary, the beneficiary is taxable under Section 2801 to the extent that the distribution is attributable to a gift or bequest from a covered expatriate.

In calculating the tax, the amount of gifts and bequests from a covered expatriate are reduced by the amount of the annual gift tax exclusion ($14,000 for 2015 and 2016). The US recipient is also entitled to a credit for any gift or estate tax paid to a country other than the United States with respect to the gift or bequest.

Possible disclosure of expatriate’s return information

The US recipient is responsible for determining whether a gift or bequest is taxable under Section 2801. The proposed regulations authorize the IRS to, in certain circumstances, disclose to the US recipient the donor or decedent’s return or return information. This disclosure provision is a new feature of the proposed regulations that is not in Section 2801.

US return of gifts or bequests from covered expatriates

The proposed regulations clarify that the Section 2801 tax is payable with a timely filed Form 708 – US Return of Gifts or Bequests From Covered Expatriates. The IRS has yet to publish a draft of Form 708. Accordingly, US recipients of gifts or bequests from a covered expatriate must still wait to pay their Section 2801 tax. For US recipients of distributions from non-US trusts in particular, the long delay may make payment more complicated as they will need to keep track of the extent to which each distribution is attributable to a gift or bequest from a covered expatriate to that trust without necessarily having the requisite information to do so.

In summary, if a wealthy individual does not intend to make gifts or leave inheritances to U.S. persons, then expatriating can result in substantial transfer tax savings.  Otherwise, the regulations create a major roadblock to transfer tax avoidance for covered expatriates.