The Tax Relief Bill of 2005 that was expected to be passed in 2005 has been deferred until 2006. The Senate version of the bill that was approved in November 2005 significantly changes the method in which United States citizens who relinquish their United States citizenship and foreign nationals who have resided in the United States for at least 8 years will be subject to tax,

 

 

Under current tax law, if a United States citizen relinquishes their citizenship, they are faced with a mechanical test that determines if the individual relinquished their United States citizenship for tax avoidance reasons.

 

If an individual passes the test, then any future United States source income they receive is taxed the same as any other foreign national.

 

If an individual flunks the test, then any future United States source income they receive over the next 10 years is taxed as if the individual was a United States tax resident.

 

 

The proposed tax legislation would introduce a so called “mark to market” rule. Simply, any property that an individual owns as of the day they relinquish their citizenship would be deemed to have been sold on the day before at the current fair market value.

 

Gains and losses would be netted and each individual would be allowed to exclude $600,000 of net gains from tax. The current fair market value of the assets would then become the cost basis for measuring gain or loss when the asset is eventually sold.

 

Real estate situated in the United States would be exempt from the “mark to market” rule. And there are certain other exceptions in the Senate version of the bill.

 

The proposed legislation contains a special provision relating to pension plans. If the taxpayer has a vested right to a pension, the present value of the taxpayers vested accrued benefit will be deemed to have been distributed to the taxpayer on the day before United States citizenship is relinquished. Thus, is an individual has an accrued benefit in a 401(k)plan, the entire fair market value of the plan would be deemed to be taxable income. This present value then becomes the cost basis for determining the taxable portion of actual future distributions.

 

Individuals who have an interest in a U.S. situs or foreign trust would be also subject to income tax on their entire interests in the trust. Taxable income for a U.S. situs trust will be computed differently than a deemed distribution from a foreign trust.

 

Generally, a United States citizen is not subject to tax when they receive a gift or inheritance. However, under the proposed legislation if a United States citizen receives a gift or inheritance from a former United States citizen who has relinquished their citizenship, the value of the gift or inheritance would be considered taxable income.

 

The effective date of the proposed legislation is the date of enactment.

 

 

Now that the 2005 tax year has come to an end, it is time to start collecting information that will be needed to prepare the 2005 tax return. One piece of information that many United States citizens who live in Bermuda and work for a local company will not receive is a Form W-2 with respect to their compensation.

 

It would benefit these individuals to obtain a letter from their employer detailing the amount of compensation received they received in 2005. Why? In the absence of proof of what compensation was received, on audit, the internal Revenue Service will conduct a “net asset” test that requires an individual to account for every deposit to a checking account, savings account, brokerage account, etc. Given that an audit will occur two to three years after the tax return is filed, many individuals have to scramble to obtain the massive amount of information that the Internal Revenue Service can demand.

 

If you are participating in a local Bermuda pension plan, it is likely that the pension plan is deemed to be a “non-qualified” plan by the Internal Revenue Service. As noted in earlier columns, once you have a vested interest in the plan, which usually happens within two years of employment, the employer contribution to the plan is considered taxable income to you, the employee contribution to the plan is considered nondeductible, and any accrued investment income within the plan is considered taxable income to you. If this information is not given to you this month, you will need the plan administrator to provide you with this information for inclusion in your 2005 US Federal individual income tax return.

 

 

If you are in need of a speaker on U.S. individual income taxes for a club or association meeting, please contact us.

 

The tax advice given by this column is, by necessity, general in nature. You should, of course, check with your own U.S. tax consultant as to how specific transactions affect you since tax advice varies with individual circumstances.