Planning for change

Thursday, 01 April 2010
Three particularly significant new aspects of the expatriation provisions of the US Heroes Act.

On 15 October the IRS issued Notice 2009-85, which provides detailed information as to the mechanics of the application of the Section 877A ‘mark-to-market’ rules to those who expatriate. By way of brief recap, on 17 June 2008 President Bush signed new expatriation legislation unanimously passed by Congress as part of the Heroes Earnings Assistance and Relief Tax Act of 2008(H.R. 6081) (the Heroes Act). There are three particularly significant new aspects of the expatriation provisions of the Heroes Act, which are summarised below.

‘Mark-to-Market’ tax

The Heroes Act dramatically changed the former income tax regime applicable to certain US citizens who expatriate and certain long-term US residents (e.g. ‘green card holders’) who end their US residency (referred to collectively herein as Covered Individuals).

Covered Individuals are taxed under new Code Section 877A (the mark-to-market tax) as if their worldwide assets had been sold for their fair market value on the day before expatriation or residency termination. New Code Section 877A allows an exclusion for only the first USD600,000 of net gain (as adjusted for inflation in future years).

In addition, any assets held by any trust or portion of a trust that the Covered Individual was treated as owning for US income tax purposes (i.e. a grantor trust) are subject to the mark-to-market tax.

The Covered Individual may elect to defer the mark-to-market tax due to one or more designated assets until his or her death. However, the deferred tax will be subject to interest until payment after death.

Transfer tax

The Heroes Act also imposes an additional new tax of potentially far-reaching scope: gifts and bequests to US persons from Covered Individuals (beyond annual exclusion gifts, which are exempt) will be subject to US transfer tax imposed on the US transferee at the highest federal transfer-tax rates then in effect (currently 45 per cent) under new Code Section 2801.

Withholding from non-grantor trust distributions

A further change to former law is that trustees of certain‘non-grantor’ trusts (i.e. trusts of which Covered Individuals or others are not treated as the owners for income tax purposes) must withhold 30 per cent of each distribution to a Covered Individual if that distribution would have been included in the gross income of the Covered Individual if he or she were still a US taxpayer. No treaty of any country with the United States may be invoked to reduce this withholding requirement. Further, if the trustee distributes appreciated property to a Covered Individual, the trust will be treated as if it has sold the property to the Covered Individual at its fair market value. This treatment of distributions to Covered Individuals applies to all future distributions to the Covered Individual: there is no time limitation.

Covered Individuals

An individual falls within the scope of the Heroes Act expatriation provisions if, as of the date of expatriation or termination of US residency, (i) the individual’s average annual net US income tax liability for the five year period preceding that date is USD139,000 or more (to be adjusted for inflation), (ii) the individual’s net worth as of that date is USD2 million or more, or (iii) the individual fails to certify under penalties of perjury that he or she has complied with all US federal tax obligations for the preceding five years.

If an individual is treated as a Covered Individual under items (i), (ii) or (iii) above, there are two limited exceptions which will prevent taxation under the Heroes Act. The individual will not be taxed as a Covered Individual if he or she certifies compliance with all US federal tax obligations and either: (i) he or she was a citizen of the United States and another country at birth and if (a) he or she is still a citizen and tax resident of the other country and (b) he or she has resided in the US for no more than 10 of the 15 taxable years prior to expatriation or giving up long-term residence; or (ii) he or she renounces US citizenship before the age of 18 and a half years, if he or she was not residing in the US for more than 10 years before the renunciation or the termination of long-term residency.

The former tax regime applicable to expatriates and those who relinquish their long-term residency, which created an alternative 10 year tax regime, will not apply to anyone who expatriates after 17 June 2008, the date of the enactment of the Heroes Act. Those individuals who already expatriated or gave up long-term residency before the date of enactment will continue to be subject to the former 10 year tax regime.

Foreign Account Tax Compliance Act

In addition to Foreign Bank Account Reports (FBARs), Tax Information Exchange Agreements (TIEAs), and Guidance for Expatriates Under Section 877A, as a further tool in its arsenal to clamp down on what it perceives to be international tax evasion, on 27 October 2009, the House Ways and Means Committee unveiled its Foreign Account Tax Compliance Act. The legislation provides the IRS with new administrative tools to detect offshore tax abuses. The legislation requires broad disclosure of foreign accounts and certain payments received.

Conversion to a Roth IRA

A significant change announced this year is that, starting in 2010, the existing USD100,000 income test for converting a traditional IRA to a Roth IRA will no longer apply. This change offers unique planning opportunities to subject retirement assets to taxation at current income tax rates, which may be lower than rates in the future. In addition, once the accounts are converted, future growth will not be subject to any income tax going forward as long as you meet the qualification of a tax free distribution. In order to qualify for tax free distributions, you must have had a Roth IRA for more than five years and be either over the age of 59 and a half years, disabled or deceased. Roth IRAs do not have required distributions at age 70 (unlike traditional IRAs), so the money can accumulate for a longer period of time. If you choose not to withdraw the funds, you may transfer your Roth IRA at death without income tax liability to the recipient, which may provide a significant benefit. For conversions that occur in 2010, half the taxable converted amount may be taxed in 2010 and the other half taxed in 2011.

Planning in an uncertain economy and against estate and gift tax uncertainty

The country experienced continued economic difficulties in 2009. While the stock market made a significant recovery, asset values have remained significantly depressed, as have interest rates. While these changes have been unsettling, they have created significant estate planning opportunities. Low interest rates and low asset values create a unique environment in which to transfer assets with little or no gift or estate tax consequences, because a number of techniques turn on assets outperforming the IRS’ assumed rates of return. For example, if the IRS assumes that an asset will earn a return of 3 per cent and you have assets that are significantly depressed in value, you may transfer the ‘spread’ between the 3 per cent assumed rate of return and the actual future increase in value to your children or others with minimal or no gift or estate tax cost. There are a number of estate planning techniques that become significantly more valuable with depressed stock prices and low interest rates: charitable lead annuity trusts, private annuities, sales to ‘defective’ grantor trusts and GRATs. Two of the most frequently used techniques are summarised below.


A GRAT provides you with a fixed annual amount (the annuity) from the trust for a term of years (as short as two years). (Note the Obama administration’s proposal that all GRATs be for a duration of at least 10 years.) The annuity you retain may be equal to 100 per cent of the amount you use to fund the GRAT, plus the IRS-assumed rate of return applicable to GRATs (which for gifts made in January 2010 is 3 per cent).

Because you will retain the full value of the GRAT assets, according to the IRS’ assumptions, if you survive the annuity term, the value of the GRAT assets in excess of your retained annuity amount will then pass to whomever you have named with no gift or estate tax, either outright or in further trust.

Sales to ‘defective’ grantor trusts

Another option for transferring assets without any transfer tax is an instalment sale to a ‘defective’ grantor trust (a trust as to which you would be treated as the owner for income tax purposes and to which you would pay the income taxes on the income generated by the assets there from, but which is not included in your taxable estate upon your death).

You would sell assets likely to appreciate in value to the trust in exchange for a commercially reasonable down payment and a promissory note for the balance. From an income tax perspective, no taxable gain would be recognised on the sale of the property to the trust because the trust is a defective grantor trust, which makes this essentially a sale to yourself. For the same reason, the interest payments on the note would not be taxable to you or deductible by the trust.

If the value of the assets grows at a greater pace than the prevailing Applicable Federal Rate (which for sales in January 2010 is as low as 0.57 per cent), as with a GRAT, the appreciation will pass free of gift and estate tax. An additional benefit is that this type of transaction allows you to transfer assets to your grandchildren free from GST tax.

A very limited category of assets is excluded from the mark-to-market tax and subject to special rules: certain deferred compensation items, certain tax-deferred accounts and interests in non-grantor trusts.

Author block
Joshua Rubenstein

Joshua Rubenstein TEP is New York Co-Managing Partner at Katten Muchin Rosenman LLP.

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