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Way, Way Back: Retroactivity in the Proposed 2801 Regulations

Individuals who relinquished U.S. citizenship since 2008 may find themselves with U.S. tax exposure for gifts they made before they expatriated under proposed regulations announced by the IRS. Under the current expatriation tax regime which came into effect on June 17, 2008, certain individuals who expatriate are subject to tax on transfers made to U.S. citizens or residents. Under the recently proposed regulations, that tax may apply to certain gifts made long before the expatriation was even considered.

The proposed regulations (Prop. Treas. Reg. § 28.2801-0, et seq., 80 Fed. Reg. 54447 (Sept. 10, 2015)) will occupy a new part 28 of Title 26 of the Code of Federal Regulations. Once final, the proposed regulations will be applicable to all “covered expatriates” and all “covered gifts or bequests” made after June 17, 2008. (Broadly speaking, a covered expatriate is someone who had a net worth in excess of $2 million on the date of expatriation or a net income tax liability in excess of certain thresholds.)

Notably, one provision in the proposed regulations appears to be unlimited in its backward reach. Prop. Reg. § 28.2801-3(b)(2) defines “covered bequest” to include property or an interest in property acquired by reason of a covered expatriate’s death “[t]hat was transferred by the covered expatriate during life, either before or after expatriation, and which would have been includible in the covered expatriate’s gross estate” under §§ 2036-2038 had the covered expatriate been a U.S. citizen at the time of death (emphasis added). Sections 2036, 2037, and 2038 bring in to the gross estate various “incomplete gifts”, such as gifts with retained life interests (such as a life interest in real property) or retained voting rights (such as certain rights in family limited partnerships), transfers taking effect at death, and revocable transfers in to trust (such as standard grantor trusts used in estate planning).

In most cases, the applicability of Section 2801 was thought to begin at expatriation. Taxpayers (and their advisors) may therefore have difficulty reconciling the language of Prop. Reg. § 28.2801-3(b)(2) with other parts of the proposed regulations and with the Internal Revenue Code. For example, the preamble to the proposed regulations states that “if an expatriate meets the definition of a covered expatriate, the expatriate is considered a covered expatriate for purposes of section 2801 at all times after the expatriation date . . .” (80 Fed. Reg. 54449, emphasis added). This is consistent with Code Section 2801(f) and Section 877A(g)(1) which imply that the label of “covered expatriate” is branded on to an individual at expatriation, not before.

It would seem that the applicability of Prop. Reg. § 28.2801-3(b)(2) to pre-expatriation transfers the IRS’s approach to reconcile Sections 2036, 2037, and 2038 with Section 2801. Whether or not the proposed regulation exceeds the statutory authority granted to the IRS will be a question that is resolved over the long term.