Insidious New Exit Tax

Tuesday, February 13, 2007

Today's comment is by Mark Nestmann, The Sovereign Society's Wealth Preservation and Tax Consultant and President of The Nestmann Group.

Congress is on the verge of passing an outrageous law that would impose the first-ever "exit tax" on expatriates (former U.S. citizens or long-term residents).

Like many outrageous laws, this ridiculous bill is cleverly hidden within another Act. In this case, it's buried in the "Small Business and Work Opportunity Act." Sounds innocent enough right?

The Small Business and Work Opportunity Act includes an increase in the minimum wage along with tax breaks for small businesses. That means once this bill emerges from the conference committee, and both houses of Congress approve the bill, it would be political hari-kari for President Bush not to sign it.

Right now, this bill is stuck in a conference committee in Congress. If it passes, it could include a little-known provision, which demands that expatriates pay a tax on all unrealized gains of their worldwide estate. The gains will be assessed based on the fair market value of the expatriate's assets and the tax due within 90 days of expatriation.

Legislative Overkill!

This exit tax applies to assets held in retirement plans and trusts, both domestic and foreign. The only thing it doesn't apply to is U.S. real estate investments, which remain subject to U.S. tax under existing law.

Presumably, the phantom gain would be taxed as ordinary income (at rates as high as 35%) or capital gains (at either a 15% or 25% rate), as provided under current law. When the assets are actually sold, no further U.S. tax will be due (although the gain might be taxed again by the country in which the expatriate resides, leading to double taxation on the same income).

The section of the bill that applies to retirement plans is particularly unfair. First, these gains are generally taxed at the expatriate's top marginal tax rate - up to 35% - and usually aren't eligible for the more favorable 15% long-term capital gains rate. Also, expatriates who must withdraw assets from retirement plan to pay this tax, and are under 59-1/2 years old, will be hit with a 10% penalty tax on top of the exit tax. And finally, when distributions are actually made, the country where the expat resides could tax those distributions a second time. Talk about legislative overkill!

In all cases, the first US$600,000 of gains will excluded from the exit tax (US$1.2 million in the case of married individuals filing a joint return, both of whom relinquish citizenship or terminate long-term residence). That exclusion will increase each year as the cost of living adjusts.

There are two exemptions to this horrific bill. Unfortunately, neither of these exceptions applies to most "covered expatriates:"

An individual born with citizenship both in the United States and in another country. They are exempt provided that

(a) as of the expatriation date, the individual continues to be a citizen of, and is taxed as a resident of another country, and

(b) the individual was not a resident of the United States for the five taxable years ending with the year of expatriation.

A U.S. citizen who relinquishes U.S. citizenship before reaching age 18 1/2, provided that the individual was a resident of the United States for no more than five taxable years before he or she expatriated.

Plugging the "Billionaire's Loophole"

The uproar over expatriation wouldn't even exist if there weren't an existing quirk in the U.S. Tax Code. U.S. citizens, unlike citizens of almost every other country in the world, are taxed on the basis of their citizenship, not their residence.

Individuals living in the United Kingdom, Japan, Australia, or almost every other country merely need to leave those countries and become non-resident for an extended period to stop paying taxes in their home country. But not the United States: it taxes all the earnings of all its citizens, whether they live in Miami, Montreal, Moscow, or Mumbai.

Since the publication of an article in Forbes magazine in 1994 describing how a handful of billionaires had given up their U.S. citizenship to escape the clutches of the IRS, the image of former U.S. citizens living tax-free in some tropical paradise has been an irresistible populist target.

Sam Gibbons, a now-retired Florida Democrat, referring to expatriates, spoke of "the despicable act of renouncing allegiance to the United States." Former Congressman Rep. Martin Frost, a Texas Democrat, supported an exit tax on the basis of "basic patriotism and basic fairness."

Given attitudes like these, it's not surprising that our political solons have decided to enact an exit tax on "rich" expatriates. However, the tax will affect many more than just a handful of wealthy Americans who become tax exiles by giving up their U.S citizenship. It will also affect hundreds of thousands of wealthy long-term green card holders (many of whom no longer reside in the United States) who are not U.S. citizens.

If anything, it's very likely that this new exit tax will inspire these wealthy non-citizen residents to leave the U.S., if they haven't already lived here for eight years. Not to mention, it will discourage successful foreigners from taking up residence in the U.S. at all.

How Are You Supposed to Pay This Exit Tax?

But if you're affected by the exit tax, there are much greater practical problems to consider. The most obvious one is how do you come up with the cash to pay the tax without selling the underlying assets? For illiquid, highly appreciated assets, such as a closely held business, it may be impossible to come up with the necessary cash to pay the tax.

For such situations, there are provisions in the law to permit deferral of the exit tax, but they come with a stiff price.

First, interest is charged for the period the tax is deferred at a rate two percentage points higher than the rate normally applied to individual underpayments

Second, deferral is possible only if the expat invests in a U.S. Treasury bond that matches the amount of the deferred tax. For owners of illiquid property that can't easily be sold or borrowed against, the only way they will be able to post the necessary bond will be to pledge the property itself to the U.S. government.

There's also a stinger to consider for those who might be tempted not to comply. This new law states that anyone who does not comply with the new U.S. Tax Code will be denied entry to the United States.

By enacting an exit tax, the United States joins the ranks of Nazi Germany and the former Soviet Union, which confiscated part (and sometimes all) of the assets of wealthy emigrants. Apartheid South Africa imposed a similar levy on emigrating whites.

And for what? The exit tax is estimated to raise only US$250 million over the next five years. That's a drop in a bucket compared to the annual US$250 billion federal deficit. Of course, these estimates don't include the losses in revenue from highly talented individuals who may not ever establish U.S. residence or citizenship because they want to avoid such harsh tax consequences.

A Glimmer of Hope - Buried in Our Constitution

One possible glimmer of hope is that U.S. courts may declare the exit tax unconstitutional. The right to expatriate is fundamental in American law. Indeed, the Declaration of Independence cited it as a "law of nature." The U.S. Constitution guarantees the right to end U.S. citizenship, to live and travel abroad freely, and to acquire citizenship from other nations. All of these rights have been affirmed by the U.S. Supreme Court.

Will America's highest court have the courage to defend what populists scornfully refer to as the "billionaire's loophole?" I'm not holding my breath-and neither should you.

MARK NESTMANN, Wealth Preservation & Tax Consultant & President of the Nestmann Group