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Are You a US Citizen Living Outside the US Contemplating Expatriation (or not) – File An Extension Request Today?

06/11/2019|John R. Dundon II, EA|,

International Taxpayers Extension Request is for US taxpayers residing outside of the USA. Your 2018 income tax forms are due June 17th 2019. That date is coming up here soon and it usually catches people off guard.

If this might be you, worry not…

Simply file IRS Form 4868 – Application for Automatic Extension of Time to File US Individual Income Tax Return.

Filing this form gives you an additional 4 months (until October 15th) to file your income tax forms. However you still must estimate what your federal income tax liability will be and get that payment into the US Treasury ASAP. That payment was actually due April 15th 2019.

If you live outside of the US you should not be penalized for late payment if you pay by June 15th, but you will be assessed interest for the late payment.

An income tax filing requirement generally applies even if you qualify for tax benefits like the Foreign Earned Income Exclusion or the Foreign Tax Credit reducing US taxable income to $0. These tax benefits are only available if you file your U.S. income tax return and as such add to the significance of filing an extension request, particularly if you are contemplating expatriation.

You qualify for the special June 17 filing deadline if both your tax home and primary residence are outside the United States and Puerto Rico or if you served in the military outside the U.S. and Puerto Rico on on April 15th.

Be sure to attach a statement indicating which of these two situations above apply.

Should you find yourself in need of more time, in addition to the automatic extension provided via Form 4868, taxpayers who are out of the country can request a discretionary 2-month additional extension of time to file their returns until December 15.

To request this additional 2 month extension, you must send the IRS a letter explaining the reasons why you need the additional 2 months. Send the letter by the extended due date (October 15 for calendar year taxpayers) to the following address:

Department of the Treasury
Internal Revenue Service
Austin, TX 73301-0045

This means if you have a June 15 filing deadline, you can for sure have have until October 15th to file and potentially as late as December 15 to file a timely income tax return without late file penalization.

You will not receive any notification from the IRS about the December 15th deadline extension request unless it is denied.

Note

Why is the extension request so important?

As this time of year rolls around many US taxpayers outside of the USA ask about expatriation. The point of this post is to provide a general overview about this seemingly innocuous term that brings with it profound implications.

With the proclivity of toxic discourse from our ‘esteemed’ elected officials on both sides of the aisle, who could blame anyone outside of the US from at least considering the renunciation of their citizenship. Those of you in this position should know there are two types of expatriates: covered expatriates, and non-covered expatriates.

Use the extension request as a tool to your advantage.

Taxpayers who relinquished their U.S. citizenship or ceased to be lawful permanent residents of the United States during 2018 must file a dual-status alien tax return, attaching Form 8854, Initial and Annual Expatriation Statement.

A copy of the Form 8854 must also be filed with Internal Revenue Service, Philadelphia, PA 19255-0049, by the due date of the tax return (including extensions). See the instructions for this form and Notice 2009-85 (PDF), Guidance for Expatriates Under Section 877A.

If you file Form 8854 late, you automatically become a covered expatriate which can be a royal pain in the proverbial ass. This applies to people who consider themselves “too poor” to be a covered expatriate and even to people who paid no income tax and had zero net worth.

Also, a penalty of $10,000 may be assessed if you file Form 8854 late.

Becoming a covered expatriate and filing the 8854 form late are compelling reasons to file an extension request over and above the traditional late filing penalties (4.5%/month).

The ‘Deemed’ Sale of All Assets

Covered expatriates are obligated to create a ‘pretend’ sale of all their worldwide assets on the day before expatriation and pay tax on fictional or in IRS speak ‘purported’ gains. There are a few types of assets to which other special tax treatments apply if you are a covered expatriate addressed further down should you have the stomach to continue reading.

Non-covered expatriates do not have to ‘pretend’ to sell their assets for tax purposes. They are required to merely inform the IRS about their expatriation on IRS Form 8854, Initial and Annual Expatriation Statement, but without enduring the humiliation of a ‘recognition’ event.

Tests for covered expatriate status

  1. Certification test
  2. Net worth test
  3. Net tax liability test

The general rule is that if you meet any one of these tests, you are a covered expatriate. There are also a couple exceptions you might be able to use to avoid covered expatriate status.

Certification Test

You will become a covered expatriate under the certification test if the following are true:

  • You are not up to date with all of your Federal tax obligations; or
  • You are late filing Form 8854 after your expatriation event; or
  • You misrepresent facts on your tax returns or Form 8854.

Basically the IRS will look to see that you have tax returns on file and you have paid all of your taxes for five tax years before the year of expatriation. DO NOT File IRS Form 8854 if you do not have the past 5 years of income tax forms filed!

If you did not have a requirement to file tax returns because you had no income and were not required to file any information returns, I generally recommend filing tax returns to report zero income for 2 reasons:

  1. It triggers the statute of limitations to begin to run on that tax year
  2. It proves that you have met your 5 years of filing tax obligation.

There is no risk to you for filing the returns late if reporting $0 income because if you have no income and you have no information return filing requirements, no penalties or interest will be assessed.

The expatriation certification must be made on a timely-filed Form 8854 as an attachment to your expatriation year income tax return.

Note

The certification requirement applies to all federal tax obligations, including information returns. Conceptually then, this means all Title 26 (Internal Revenue Code) obligations are included in the certification.

What about obligations such as FinCEN Form 114, reporting signature control or a financial interest in foreign financial accounts? These are obligations under Title 31, and thus arguably someone out of compliance for filing these forms would nevertheless be able to certify compliance with his or her Title 26 obligations.

If you expatriate it is best that you make a clean break with the US.

Net Worth Test

The most common way to become a covered expatriate is by having $2,000,000 or more in personal net worth. That figure does not get adjusted for inflation but does include ALL personal assets and liabilities.

For married couples, each spouse determines his or her net worth separately. This often means reviewing the marital property laws that apply to understand specifically what belongs to each spouse.

The assets included are “any interests in property” that would be taxable as a gift if you gave them away the moment before you expatriated.

An “interest in property” is a carefully defined term. It does not matter whether the property produces income or not. It includes the right to use property, as well as ownership.

Look at the gift tax rules to see if you would trigger a gift tax by giving the assets away.

Gift tax exemptions and deductions are ignored in calculating net worth. These include the annual exclusion, transfers to certain minor’s trusts, transfers for certain medical and education expenses, the exemption for certain waivers of pension rights, and the exclusion of certain loans of artwork.

In addition, the gift splitting, gift tax charitable deduction, gift tax marital deduction, and limitation on deduction rules are ignored for the net worth test in determining covered expatriate status.

On the bright side you do get to include debts as an offset in calculating your net worth. For example if you own a house worth $5,000,000 and you have a mortgage with a principal balance of $4,000,000, your house’s net worth is $1,000,000.

The method of establishing value

The gift tax rules are defined by IRS section 2512 and accompanying regulations issued under that section.

You cannot invoke prohibitions or restrictions as a method for creating discounted value. You can however use good faith estimates of value.

Formal appraisals are not required when you are determining whether you meet the $2,000,000 net worth test.

If you are a beneficiary of a trust, you must calculate the value of that beneficial interest to determine whether you reach the $2,000,000 threshold for being a covered expatriate.

Net tax liability test

A covered expatriate is someone who is “rich enough” for the IRS to care about. Someone who pays a lot of income tax must be rich, at least according to the IRS.

$165,000 for 2018

Look at your tax returns for the five years before the year in which you expatriate. Look at your federal income tax liability for each year. Add up all five years’ of tax liability, then divide by five. That’s (a simplified version of) the number you use for the net tax liability test.

If the amount exceeds $165,000 (this is the number you use if you expatriated in 2018), you will be a covered expatriate under the net tax liability test.

The number you use for the net tax liability test is indexed for inflation, so each year it increases slightly.

In reality, it’s a LOT more complicated

The rule to apply here is from Notice 97-19, section III, 1997-1 C.B. 394.

Even though this Notice applies to the prior expatriation tax regime under section 877, it also applies to the current rules under section 877A.

For purposes of the tax liability test, an individual’s net US income tax is determined under section 38(c)(1). This means you will need to look at your tax returns for the five years before expatriation and make the adjustments required under that section to arrive at the tax liability for each year.

Once you calculate the tax for each year using that section, those are the numbers you add together and divide by five to arrive at the number you use for the net tax liability test.

If you are a married taxpayer filing a joint tax return

You must use the number from the joint income tax return without reduction. If two spouses both expatriate, they still use the full number without reduction.

For example, if you and your spouse filed joint income tax returns and paid $200,000 per year of federal income tax, you would think the fair thing to do would be divide by two, and treat each spouse as if they paid $100,000 of tax each year.

Not so! You each must use the entire $200,000 in your calculations. It is not fair, but nevertheless is the rule.

As part of an overall tax planning expatriation strategy you will want to consider filing separately.

Exceptions

If you fail the certification test, you will be a covered expatriate. 

But if you meet the certification test and fail one of or both of the other tests – the net worth test and the net tax liability test – you may be able to use one of the exceptions to covered expatriate status.

If you can use one of the exceptions below, you will be a non-covered expatriate, even if your net worth or net tax liability is too high under the IRS rules for expatriates.

Dual Citizen at Birth

You can qualify for the “dual citizen at birth” exception to covered expatriate status if you satisfy all of the following conditions:

  • You became a US citizen at birth; and
  • You also became a citizen of another country at birth; and
  • On your expatriation date you “continue” to be a citizen of that country; and
  • On your expatriation date you “continue” to be taxed as a resident of that country; and
  • On your expatriation date you were not a US resident for 10 of the 15 tax years that end with the year that you expatriated.

Note that you will still have to certify that you are up to date with all US tax requirements; in other words, you must meet the certification test to use this exception. Failure to meet the certification test will render you a covered expatriate even if you satisfy all of the dual citizen exception requirements.

Relinquishing While Under 18.5 Years Old

The second exception to covered expatriate status is available to people who relinquish their citizenship before age 18 ½. The specific requirements you must satisfy in this situation are:

  • You relinquish your US citizenship before age 18 1/2; and
  • You were not a US resident for more than 10 taxable years before the date of relinquishment.

By relinquishing citizenship before age 18 1/2 you will avoid the impact of the net worth or net tax liability tests. But you will still be required to certify full compliance with all US tax requirements, and failure to do so will render you a covered expatriate.

Conclusion

Before you expatriate, check whether you will be a covered expatriate. Do this by checking the certification test, the net worth test, and the net tax liability test. If you fail any of these three tests, consider doing some planning and/or work to fix your tax compliance, reduce your net worth, or reduce your net tax liability before you expatriate.

I routinely help people seeking clarity on their status as either covered or non-covered expatriates and help them in the planning stages before giving up US citizenship or permanent residence. The key is the International Taxpayers Extension Request.

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