Interested in moving to, or moving back to, Canada from the United States? I was recently speaking with a client that moved to the U.S. from Canada because of a “six-month” job assignment. Twenty years, three jobs, and four different states later, he was hoping to move back. His kids, and most importantly grandkids, still lived in Winnipeg and he was ready to spend his retirement years attending his grandkids hockey games. There was just one problem; the move back to Canada was going to cost him, and it was going to cost him big. This article discusses the U.S. exit tax and planning opportunities to help avoid a big tax hit when you move to Canada from the U.S.
What is the U.S. Exit Tax?
The U.S. exit tax, or known as the Expatriation Tax, is a tax on U.S. citizens and green card holders that permanently move out of the U.S. to another country. The expatriation tax provisions apply to U.S. citizens who have renounced their citizenship. The exit tax is also imposed on green card holders who have held a green card for 8 out of the last 15 years (referred to as ‘long-term residents’). All people “exiting” the U.S. must complete an IRS Form 8854, which helps determine if you are subject to the Exit Tax.
There are a lot of advantages to being a U.S. citizen or permanent resident. However, there is one major drawback; you owe taxes on worldwide income no matter where you live. Therefore, if you are already a Canadian citizen, you may decide to renounce your U.S. citizenship or green holder status and move back to Canada. This would allow you to stop paying U.S. taxes on worldwide income, but it will require a potentially large Exit Tax.
What is the Reason for the U.S. Exit Tax?
Simply put, the U.S. wants its money. A person may have amassed a large IRA or brokerage account with large unrealized capital gains. Moving out of the country may allow a person to avoid paying the U.S. government any taxes when he sells his investments or withdraws from his IRA. In order to combat this situation, the U.S. imposes an Exit Tax.
Now, there is a good chance that you won’t have a $600 million Exit Tax like this Facebook co-founder. He was planning to move to Singapore to escape some of the heavy tax burden of staying in the U.S. He decided that the Exit Tax would be less than paying taxes annually if he stayed a U.S. citizen. It just so happens that Singapore doesn’t have a capital gains tax, making his $600 million Exit Tax seem relatively small. However, you don’t need to have $4 billion before being subject to the Exit Tax.
Who is Subject to the U.S. Exit Tax?
Not everyone is subject to the Exit Tax. If you have a smaller amount of savings or taxable income, there is a good chance that you won’t be subject to the Exit Tax. Here are the qualifications for being a “Covered Expatriate” and being subject to the Exit Tax. There are different rules for when you exit the country, but these are the rules that are in place today.
From the IRS Website, if any of these rules apply, you are considered a “Covered Expatriate”:
1. Your average annual net income tax for the 5 years ending before the date of expatriation or termination of residency is more than a specified amount that is adjusted for inflation ($168,000 in 2019)
2. Your net worth is $2 million or more on the date of your expatriation or termination of residency.
3. You fail to certify on Form 8854 that you have complied with all U.S. federal tax obligations for the 5 years preceding the date of your expatriation or termination of residency.
The two reasons you may be subject to the U.S. Exit Tax
Assuming you are paying your taxes on time, there are really two things that will trip the Exit Tax; having over $2 million of net worth or paying over $168,000 in taxes per year.
First, we are talking about paying over $168,000 in taxes, not making $168,000 in income. A single individual would have to make well over $500,000 a year in order to have over $168,000 in taxes in 2019, assuming no large capital gains or other types of income.
So, the main trigger here is having over $2 million net worth. This $2 million net-worth is on an individual basis, not for a family. This includes all world-wide assets, including your home.
Exceptions to the Covered Expatriate Treatment
You may have over $2 million in net worth, and still not be considered a Covered Expatriate. According to the Internal Revenue Code, there are two exceptions to the Covered Expatriate Rule:
- If the taxpayer is a dual national of the country in which she was born AND she has not lived more than 10 out of the last 15 years in the U.S.;
- The individual originally expatriated before she was 18.5 years of age and did not live in the U.S. for more than 10 out of the last 15 years.
However, if you haven’t compiled with U.S. tax law you will be considered a covered expatriate, even if you meet an exception. So, pay your taxes.
How much is the U.S. Exit Tax?
The amount of the Exit Tax depends on the number of assets that a person has when he exits the U.S. According to the IRS, all property of a covered expatriate is deemed to be sold for its fair market value on the day before the expatriation date. Therefore, if you are subject to the Exit Tax, the tax can be very large and may give you pause before leaving the U.S.
However, it may not be all that bad when exiting the U.S. to move to Canada. In 2019, the first $725,000 of capital gains from deemed sales are excluded from the exit tax. Therefore, even if you are a covered expatriate, if you don’t have massive gains on your accounts you may not be subject to any exit tax.
Here is a good explanation from the NY Society of CPAs regarding the Exit Tax:
How Covered Expatriates are TaxedCovered expatriates face the prospect of being forced to pay tax in return for being allowed to escape the U.S. tax system’s worldwide tax net. The general principles are easy to understand:
Pay tax as you receive income. If the IRS can rely on tax withholding rules to assure full collection of income tax, the covered expatriate pays tax at a 30% rate on U.S. source income as it is received.
Pay tax on everything now. If the IRS cannot be assured of timely collection of tax at the source, the usual tax fiction of a deemed sale or deemed distribution (from an IRA, for instance) forces immediate recognition and taxation of unrealized income and capital gain while the individual is still a U.S. taxpayer.
As a result of the U.S. and Canada tax treaty, only 15% is required to be withheld from U.S. IRA withdrawals to satisfy the U.S. tax requirement. To take advantage of the 15% tax withholding, the plan owner will need to file IRS Form “W-8BEN: Certificate of Foreign Status of Beneficial Owner for U.S. Tax Withholding” with the plan administrator or IRA trustee.
However, if you are subject to the Exit Tax, you will be required to have the 30% withheld on IRA and 401(k) withdrawals.
Start Planning Now
If you are planning on exiting the U.S. and you may be considered a Covered Expatriate, the time to start planning is now. If you wait until you are about to leave the U.S., it may be too late. Leave the U.S. and have over $2 million of worldwide assets, you can potentially start to do things that can help lower your overall net -worth, while not hurting you financially. For example, you may start a gifting program, especially if you are married, to start to lower your net worth. Also, you may consider Roth conversions while here in the states to lower your net worth and give yourself tax-free income in retirement. You may even consider keeping your U.S. citizenship or green card after retirement to utilize a lower tax rate before leaving.
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