Avoiding Cross-Border Tax Traps: Covered Expatriate Status

Moving from the United States to Canada is a significant life change, especially for US citizens and long-term Green Card holders. One major tax concern that can arise during this transition is the imposition by the IRS of the punitive “Covered Expatriate” status, which can potentially result in serious immediate and long-term financial consequences.

Covered expatriate status is an IRS designation that applies to US citizens who renounce their citizenship, or to Green Card holders who formally relinquish their Green Card after holding it for any portion of 8 of the prior 15 calendar years (classified as “long term residents”). Keep in mind that since the IRS measures this in calendar years, it could be as little as 6 full years depending on how far into the year you received or relinquished your Green Card.

Green Card holders who are not long-term residents can rest assured that they will not meet the covered expatriate criteria. This means that, barring other considerations, they can safely relinquish their US taxpayer status after permanently moving out of the United States.

Criteria for Covered Expatriate Status

To be classified as a covered expatriate, you must meet one of the following three conditions:

1. Net Worth Test: Your individual net worth at the date of expatriation is $2 million USD or more. This amount is not indexed for inflation.
2. Net Income Tax Test: Your average annual US tax liability over the past five years exceeds $201,000 USD (as of 2024), indexed annually for inflation.
3. Compliance Certification Test: You fail to certify that you have satisfied and complied with all US tax obligations and filings over the last five years.

If you meet any of these criteria, you will be considered a covered expatriate and will be subject to several simplified tax implications addressed below.

Implications of Covered Expatriate Status

1. Mark-to-Market Tax

The mark-to-market tax is effectively a capital gains tax on the unrealized appreciation of your worldwide assets, as if they were sold at fair market value on the day before your expatriation. This resembles Canadian departure tax and applies to worldwide real estate, stocks, bonds, business interests, or personal property such as art or collectibles.

The IRS does provide an $866,000 USD exclusion (as of 2024, indexed annually for inflation) on deemed gains, meaning that only gains above this threshold are subject to taxation. It is important to note that the US Home Sale Exclusion does not apply in this tax calculation, therefore the entire gain on your principal residence may become taxable.

2. Deferred Compensation Items

Deferred compensation (such as pension plans, 401(k)s, stock options, etc.) is treated differently, depending on whether it is classified as eligible or ineligible.

Eligible Deferred Compensation:

• If your deferred compensation is part of a US-based plan (such as a qualified US employer pension plan) you can elect to have a 30% withholding tax on future distributions. To be eligible, the payor must be a US entity and you must formally notify them of your expatriation. Without this election, your deferred compensation will be considered ineligible.

Ineligible Deferred Compensation:

• For plans that are not US-based, the IRS will treat the entire present value as if it were paid out the day before expatriation. This means that you will pay tax on the full present value upfront, even if you have not yet received any payments.

3. Specified Tax-Deferred Accounts

Certain tax-deferred accounts (like IRAs, Roth IRAs, 529 plans, and HSAs) would also be subject to immediate taxation. The entire value of the account is treated as if it were paid out the day before expatriation and taxed as ordinary income.

For Roth IRAs, it is worth noting that although they are on the list of specified tax-deferred accounts subject to immediate taxation, only the growth component of these accounts could potentially become subject to this tax (under specific IRS rules). This is because the original contributions consist of after-tax capital – which has already been taxed.

For those considering expatriation, proper planning can help manage the tax burden or potentially spread it over multiple years.

4. The 40% Gift and Estate Tax

Perhaps the most significant ongoing consequence is the permanent 40% gift and estate tax. If a covered expatriate gifts or leaves assets to a US person, those transfers will be subject to this tax. Note that covered expatriates can no longer utilize the $13.61 million USD (as of 2024) gift and estate tax exemption.

It is crucial to point out that, unlike the regular US gift / estate tax, this tax applies to the recipient (the US person receiving the gift or inheritance) and not the expatriate themselves.

Because covered expatriate status is permanent, it is essential to engage in cross-border planning before deciding to expatriate.

Steps to Avoiding Covered Expatriate Status

1. Renounce Before the 8-Year Green Card Limit: If you are a Green Card holder nearing the 8-year mark, consider relinquishing your Green Card before reaching this threshold.
2. Reduce Your Net Worth: If your net worth is approaching or above the $2 million threshold, consider legitimate ways to reduce it before expatriating. This could involve gifting assets to family members (after considering gift tax implications), charitable donations, or other estate planning techniques.
3. Minimize Your Tax Liability: Review your past five years of US tax returns and ensure that your average annual tax liability is below the threshold. Working with a cross-border tax professional can help you manage or reduce your tax burden.
4. Stay Compliant: Ensure that you are fully compliant with your US tax obligations for the last five years before expatriation. This means filing all required returns, paying any taxes due, and avoiding any filing discrepancies or mistakes.

Thoughtful Planning is Essential

Expatriating from the US to Canada comes with a variety of financial, legal, and tax considerations. Covered expatriate status is just one example that can have serious financial consequences, but with careful planning and strategic timing, you can mitigate or avoid these risks altogether.

Whether you are a Green Card holder or a US citizen contemplating a move to Canada, it is essential to work with a cross-border tax and financial planning team who understands the intricacies of both the US and Canadian tax systems. At MCA Cross Border Advisors, our team of experts can help you navigate these complex issues through a customized cross-border financial plan tailored to your unique needs.

For more information on how our team can help make your journey as seamless as possible, please do not hesitate to request a consultation.