Were You an American? Thinking of Making a Gift to an American? Think Again.

I’ve written before about American citizens giving up citizenship, and green-card holders giving up that status. I’ve done it in my blog and also in a full-length article for the Canadian Tax Foundation.

Some of the people in this category, who exited after June 16, 2008, will be “covered expatriates.” There are some unpleasant tax consequences for these individuals. And remember, once you’re a covered expatriate, you’re one forever (assuming you don’t return to live in the United States).

One of these consequences is that transfers made to Americans (U.S. citizens and tax residents) are subject to an excise tax of 40%. Writ large, a transfer is a lifetime gift or a bequest on death. Since the expatriate is no longer subject to U.S. jurisdiction, it is the recipient who is subject to the tax. 

The expatriation rules were legislated in 2008 as part of the HEROES Act. But it is taking a long time for the regulations to be put in place. Well, the Department of the Treasury has finally proposed regulations on this item just now (September 10, 2015). The plan to roll this out includes a public hearing in January and comments afterwards. Eventually, we will see final regulations (these new rules are not applicable until then).

Covered gifts and bequests

The rule imposes tax at the highest estate tax rate (currently 40%), on a U.S. person who receives a “covered” gift or bequest. These definitions cover direct and indirect transfers. Not surprisingly, transfers made by way of a trust are caught: When the American receives a distribution from a foreign (non-U.S.) trust designed to pass on these funds, he is subject to this tax in the same way as if he received the transfer directly.

A foreign trust can make an election to be treated as a U.S. domestic trust solely for this purpose, at which point the tax is applied on the transfer into it, instead of payments out of it. Sometimes the certainty and convenience are desirable. It may also be beneficial if the value of the underlying assets is expected to increase substantially.

Where the covered expatriate controls (has a “general power of appointment” over) property in a trust, and the beneficiary is a U.S. person, the exercise, release or lapse of that power is considered a covered gift or bequest.

Exceptions

There is an exclusion for the first US$14,000 per year (indexed for inflation). This is the same de minimis rule that applies to ordinary gifts among U.S. persons, or to U.S.-situs gifts made by non-Americans.

Transfers covered by ordinary U.S. gift or estate tax are excluded, but they have to be reported on a timely filed gift or estate tax return. If a covered expatriate transferred U.S. real property, for instance, then it would fall into this category.

There are some more technical exceptions, such as “qualified disclaimers” (where the covered expatriate refuses to accept property transferred to him by someone else) and charitable donations.

A Qualified Terminable Interest in Property (QTIP) trust is one where the income beneficiary does not get the capital portion of the trust. A typical QTIP trust is one created by a husband upon his death. The wife is entitled to all the income from the trust during her lifetime, but the capital goes to their children.

If, in this case, the husband is a covered expatriate, and the wife is a U.S. citizen, and the trust is (or makes an election to be treated as) a U.S. trust, then the transfer will be exempt from the special tax. When the wife dies, her estate will be subject to the ordinary estate tax, but here there is a US$5.43M exemption available

Reporting

A U.S. person must report transfers received from non-U.S. persons on form 3520. This requirement has been in place for some time. The penalty for failure to report a gift (over the threshold, which is usually $100,000), is as much as 25% of the transfer.

There will be cases where a recipient will not know whether the transferor was previously a U.S. person (remember, he’s not one at the time of the transfer). The form asks for the transferor’s U.S. tax identification number. How is the recipient to know to ask? If the transferor is a decedent that relinquished citizenship decades earlier, it is reasonably likely that nobody will know. In some cases, proper reporting is a practical impossibility.

The IRS will issue a new form 708, once these proposed regulations are finalized. At that point, taxpayers will be given some time to file to report these transfers (yes, going back to June 17, 2008). No interest will not be charged until that due date.