Truly Offshore Solutions to Offshore Bank Accounts May Not Be So Good

In the latest highly publicized spate of IRS initiatives against the use of offshore accounts to mitigate U.S. tax liability (that sounds better than to cheat on U.S. tax liability, although it is semantics), some U.S. persons decided that they would just avoid the problem (including past problems) by leaving the U.S. There are some downsides to that U.S. tax mitigation strategy.  One was a topic of comment at the recent ABA tax section meeting in San Antonio.  Practitioners were cautioned to make sure those persons who are or become their clients are advised about the potential tax costs of leaving the U.S. See § 877A. So, I pass this tip on to my readers.

The IRS has recently provided guidance under Section 877A in Notice 2009-85. And, the ABA Tax Section Newsquarterly has a point to remember article discussing this new guidance - Michael A. Spielman, Service Issues Guidance on Section 877A Exit Tax. Here is some excerpts from the article to whet your appetites (I have cut and paste this out of order for readability purposes here, but it is all in the article except as I indicate in brackets).

Under new section 877A [enacted in June 2008], Tax Responsibilities of Expatriation, covered expatriates (generally, U.S. citizens or long-term residents with a five-year average income tax liability exceeding $124,000 as indexed for inflation ($145,000 in 2009 and 2010) (“tax liability test”) or net worth of $2 million or more (“net worth test”), are immediately taxed on the net unrealized gain in their property exceeding $600,000 ($626,000 in 2009 and $627,000 in 2010) as if they sold the property for fair market value the day before relinquishing U.S. citizenship or terminating their U.S. residency (“expatriating”). This mark-to-market tax regime applies to all property of the covered expatriate, other than deferred compensation items, specified tax deferred accounts, and interests in a nongrantor trust of which the covered expatriate was a beneficiary on the day before the expatriation date. Separate provisions apply with respect to these items.

In addition to section 877A, HEART also introduced a new succession tax under section 2801 that imposes a tax on U.S. persons who receive a gift or bequest from an expatriate who was subject to the rules of section 877A. Generally, the rules under section 2801 require the recipient of the gift or bequest to pay tax on the fair market value of the property received at the highest gift or estate tax in effect on the date of receipt. Gifts or bequests to a qualified charity or U.S. spouse are exempt from the tax if made in a form that would be eligible for a deduction under the relevant estate or gift tax Code section. Although Notice 2009-85 does not provide guidance on section 2801, it indicates that future guidance on section 2801 will be issued separately.

Prior to the enactment of HEART, covered expatriates were subject to a 10-year alternative tax regime (1) on their U. S. source income and gain under section 877 and (2) a modified estate and gift tax regime under sections 2107 and 2501. In its most recent incarnation, as modified by the American Jobs Creation Act of 2004 (“AJCA”), section 877 became applicable solely on the basis of objective tests that measured an expatriating individual’s net worth and net income tax liability, without regard to whether the individual had a tax avoidance purpose for expatriating. AJCA also added a third test, which caused expatriating individuals to become subject to the 10-year alternative tax regime if they failed to certify compliance with all U.S. federal tax obligations for the five preceding taxable years. In addition, AJCA added section 877(g), which caused covered expatriates to be treated as U.S. citizens for all federal tax purposes for any year during the 10-year period in which they spent 30 days or more in the U.S. This 30-day rule was not carried over to new section 877A.