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Congress squeezes expatriates

For nearly a decade, Congress has been obsessed that a handful of wealthy people were able to escape U.S. income and estate taxes by renouncing their U.S. citizenship.

Last October, as part of a big corporate tax act, politicians took another shot at these individuals tightening up a law enacted in 1996 that was supposed to extract ten years of taxes from tax-motivated expatriates prior to their departure from the U.S. The new, tougher version will cause pain for some moderately well-off expatriates, but the very wealthy and tax averse will still be able to plan around it.

Under the old law expatriates can apply to the IRS for a ruling which confirms they had departed the U.S. for nontax reasons and therefore were exempted from the ten-year levy. This was quite a large loophole. Half the 270 people who applied between 1997 - 2002 received favorable rulings, while only 11 did not. The others recieved "neutral" rulings that allowed them to proceed as if they didn't owe the tax. In theory the IRS could later audit the "neutral" folks and assess a tax. But there is no evidence this occurred.

This loophole has been closed and, under the new law, (which is retroactive to June 4, 2004), anyone who expatriates and has over $2 million in assets or has paid over $620,000 in federal income taxes five years prior to leaving is presumed to have left for tax reasons. Only a select number of dual citizens and minors having few ties to the U.S. are able to get exemptions from the ten years of tax.

Expatriates who do not fit one of the narrow exceptions will owe U.S. income tax on a wide range of U.S. source income, estate and gift taxes on U.S. assets for ten years. If they should spend more than 30 days in the U.S. during any one of those ten years, they'll be taxed for that year, just like other U.S. citizens, on all their income from any source. "This is the stinger in the tail," says Dyke Davies, a tax lawyer with Bryan Cave. There is a word of warning for expatriates who are ill: Don't come back to the U.S. for medical treatment. It should also be noted that, should an expatriate die within a year where he's spent 30 days or more in the U.S., his entire estate is subject to U.S. estate tax.

This new law also requires post-June 3, 2004 expatriates to file extensive disclosures with the IRS regarding their worldwide income, days in the U.S., etc., annually for ten years. This is going to be annoying to people who have settled abroad and later expatriate because they're tired of paying accountants' and lawyers' fees in order to comply with U.S. as well as, for example, U.K. law, says Davies. "Lots of people give up U.S. citizenship because the compliance drives them nuts," she says. "Now they will still have compliance costs for ten years."

There is a final consideration: A separate 1996 law prevents U.S. citizens who have expatriated for tax reasons from returning to the U.S. This could be a threat for many people who may technically be considered to have left for tax reasons. "People are nervous," says Loretta Ippolito, an international tax lawyer with Willkie Farr & Gallagher. "They don't want to take the chance they can't come back to visit their family or for business."

But there is good news for anyone who may be contemplating leaving the U.S. for tax reasons, and that is the new law isn't the feared "exit tax" that was recently passed by the Senate. The new law also leaves huge holes that the rich and well-advised are able to use to avoid having to pay U.S. taxes. "For someone wealthy enough that expatriation tax is an issue, it's worth paying someone to avoid it," says Richard LeVine, an international tax lawyer with Withers Bergman.

A wealthy expatriate can simply hold on to his assets, such as U.S. publicly traded stock, avoiding the gains tax for that ten-year period. Or he can invest through variable annuities whose payout is deferred for at least a decade. Should he has control of a U.S. corporation, he can defer paying himself dividends. And if he should need cash sooner he can borrow against his U.S. assets. (Loan proceeds don't count as income.)

To avoid being subjected to the U.S. estate tax an expatriate must reside for over ten years after expatriation or die in 2010, the year in which the U.S. estate tax disappears for a year. But he can minimize the potential bill of his estate during that ten-year window by using the techniques wealthy U.S. citizens use, such as family limited partnerships

It would have been more difficult getting around the Senate-passed exit tax. Under that system, upon departing from the U.S., expatriates would have had to pay a one-time tax on all unrealized gain, beyond a $600,000 exemption. Here's a planning note: The new laws requires the Treasury Department to report on its effectiveness after its first year. If the 2004 law fails to raise the projected $377 million of revenue over ten years, or if Congress casts about for more cash, the exit tax idea could be revived. So if you have plans on becoming become an expatriate, start packing your bags now.