Expatriation: Covered Expats & Deferred Compensation - Form W-8CE
As you might expect, there are rules and regulations that cover US expatriates. This article will explore some issues that US citizens should be knowledgeable of before deciding to give up their United States citizenship.
The first, and most important, step to take is to ensure you are not going to be considered a “covered expatriate”.
Exit Tax Considerations
If you are labeled a covered expat, one potential consequence is an exit tax that can be imposed. Avoiding being a covered expatriate can take some planning, and some time. One example is using your gift allowance (currently USD 5.49 mil) to reduce net worth to under the USD 2 million limit discussed below. Doing this could delay the point where you can expatriate without significant tax consequences.
How to be non-covered:
If you can answer YES to all of these issues:
1. Net worth below $2 million
2. Tax liability (on average) for the previous 5 years is below USD 162,000
3. Has fulfilled all US tax filing obligations during those same 5 years
4. Filed form 8854 on time with your final tax return for the year of expatriation
Exceptions to covered status
If you are a dual citizen, and were born outside of the U.S., and did not live in the United States for over ten years of the fifteen years that ends with the year they expatriated, you may qualify for an exception to covered expat status concerning the net worth limits and the average tax requirement. However, the taxpayer must still comply with the requirement for the previous 5 years of tax filings.
If you do become a covered expat, don’t forget to file W-8CE
Unfortunately labeled a covered expat? Do you have a 401(k) plan or other forms of deferred compensation? Read carefully as there are still some steps you should take.
What is deferred compensation? This is income that was earned in the past, but you have not received. The most common of these are pension plans, 401(k) plans, or stock options.
For most taxpayers, this compensation is a pension plan, a 401(k) plan, or their stock options (vested as well as unvested). If these are not handled correctly, they will be subject to tax at the time of expatriation.
It is vital to file form W-8CE with the appropriate plan administrator 30 days before expatriation, or prior to the day before the first plan distribution occurring on or following the date of expatriation, whichever occurs first. (see image below of form 8854)
A 401(k) plan by its nature is an eligible deferred compensation plan.
Form W-8CE needs to be presented to the plan administrator to prevent accidental and irrevocable conversion of US assets from an eligible deferred compensation item into an ineligible deferred compensation item.
- The 401(k) plan administrator needs to know that 30% tax should be withheld from future distributions from the plan. Otherwise the lump sum tax on deemed distribution will be applied.
- The deadline to present the form to the plan administrator or other fiduciary of the deferred compensation is 30 days after the covered expatriate’s repatriation date as defined in section 877A(g)(3)).
Failing to file this form will cause the deferred compensation to be considered an ineligible compensation item. What does this mean? Ineligible compensation is subject to lump sum tax. Put bluntly, this means that you must pay tax on the entire amount as if you received it all on the day of expatriation, even if you have not received any distributions. No bueno.
If a taxpayer files their W-8CE properly, the plan will withhold taxes at a rate of 30% on all distributions. In particular cases, an expat may be eligible for more favorable tax rates under the various tax treaties than what they would pay under United States tax rules. As an example, residents of Switzerland can avoid United States taxes on their US pension payments by invoking the Swiss/US tax treaty. This treaty says that the resident country of the taxpayer is the jurisdiction with the ability to tax distributions from pensions. The taxpayer would have to file form 1040NR in order to claim this treatment under the treaty and request the IRS to refund the tax that was withheld.