3 steps to prepare wealthy clients for higher tax rates

Throughout the tax-the-rich political environment of 2020, I have been using the analogy that my wealthy American clients are living in a “Tax the Rich” wildfire zone. In advising how they should protect themselves, I have guided them toward the logic of a fire prevention, fire insurance and fire escape plan.

One Silicon Valley founder client is a perfect illustration of the effectiveness of this approach, as we prepared him for the current situation over an extended time period.

A few years ago, we engaged in prevention, moving him from high-tax California to Texas. We also advised him to gift some of his founder shares to family members, using up his $11.7 million unified credit. At the time, he was able to use some discounting of the value of his pre-IPO shares.

Then, in the last two years we also advised him to implement insurance by acquiring a citizenship by investment in an European Union country and residence by investment in New Zealand, Singapore and Canada. Along with the right to live in any of the latter countries, his EU country also gave him the ability to live in any one of the 27 countries of the European Union.

It is worth noting that none of these citizenships or residences automatically made him tax resident in any jurisdiction. Whether he ever becomes tax resident in any of these jurisdictions will be a function of whether he decides to spend more than six months in any one country in the future. How much tax he would pay would depend completely on the laws of that country, with many of them having tax regimes, or legal pre-immigration tax planning, that allow him to limit his future global tax liability to zero or a tiny fraction of his U.S. tax liability. He can also spend effectively 120 days (or more if he avails himself of a tax treaty position) in the U.S. without reacquiring the status of a U.S. taxpayer.

The final step was to design an asset-by-asset escape plan should he decide to use his fire insurance and leave the U.S. tax regime through an expatriation strategy. Since this client was clearly a "covered expatriate," he was going to be subject to the Internal Revenue Code s.877a expatriation tax regime. Simply put, this would be a deemed disposition of approximately $200 million in unrealized capital gains. Given that he would no longer have a state capital gains tax and the size of his gains, let’s assume for the sake of argument that he would be paying approximately 23.8% in federal capital gains tax. That would translate into approximately $47.6 million in capital gains tax triggered upon expatriation.

Then, throughout 2020 this fully prepared client watched political and legislative events unfold. Finally, when he saw the Democratic Party win the trifecta of the White House and both houses of Congress, he decided that the wildfire was getting too close for comfort. Therefore, we arranged a renunciation appointment at a U.S. mission abroad for him on April 27, 2021. Given the plethora of residences and EU citizenship that he had previously acquired, he was able to travel relatively easily to the U.S. Embassy for his appointment, despite Covid travel restrictions.

When he expatriated, he was deemed to have sold his worldwide assets as of that day’s fair market value. Therefore on that date he fixed his capital gain (i.e., $200 million) and his capital gains tax rate (i.e., 23.8%) and the amount of tax he owed (i.e., $47.6 million).

However, he does not need to actually pay this tax until April 2022! This gives him all of 2021 and the first quarter of 2022 to deal with lock-up restrictions and selling enough of his shares to have the liquidity to pay the tax. His other option is to fully or partially take advantage of the current low interest rates to borrow against his shares to meet his tax obligation. As an added benefit, any increase in value of his shares (which has happened) that occurs after April 27, 2021, are not subject to U.S. tax.

As it turns out, on the day after my client’s expatriation, President Biden announced a proposed increase in the top federal capital gains rate from 23.8% to 43.4%. Later in President Biden’s Green Book, the administration suggested the applicable date for this increase would be April 28, 2021. This means that should this rate increase and implementation date become law, the client just avoided an increased tax obligation of $39.2 million! Compared to the potential hit to his fiscal house, the “premium” that he paid in investing in fire prevention, insurance and an escape plan was minuscule.

For those advisers or taxpayers who believe that they have missed the opportunity to achieve a similar outcome, it is worth remembering that both the rate increase and implementation date are aspirational. In reality, in the wake of the ProPublica hysteria, the rate increase has probably become more likely. However the practical realities of an April 28 implementation makes Jan. 1, 2022, a more probable effective date. This gives those who want to follow in the path of my client a short but still possible runway.

With daily announcements of new proposals that limit the effectiveness of techniques such as GRATs, the wisdom of getting the insurance of an alternative citizenship and residence is obvious. Only with this insurance in hand, can one have the optionality of joining the record number of wealthy Americans who are triggering escape plans. Whether they ultimately use this strategy will depend on their own sense of whether the wildfire will hit their own fiscal house.

David Lesperance of Lesperance & Associates is an international tax and immigration adviser.