German Who Gave Up U.S. Residency Liable for Exit Tax

By James A. Beavers, J.D., LL.M., CPA, CGMA

The Tax Court held that a taxpayer had expatriated in November 2010 when he surrendered his legal permanent resident status and therefore was subject to Sec. 877A. In addition, the court held that installment payments he received in 2010 before he expatriated were not excluded from his income under the United States-Germany tax treaty.

Background

Gerd Topsnik was born in Germany and became a lawful permanent resident (LPR) of the United States in 1977. In 2004, his LPR status was renewed through 2014.

In 1986, Topsnik started a joint venture named Gourmet Foods Inc., with its principal place of business in California. Topsnik agreed, on July 30, 2004, to sell his stock in Gourmet Foods for $5,427,000 in an installment sale, receiving an initial down payment of $1,600,000 and then monthly installments of $42,500 until the remaining $3,827,000 was paid. At the time of the sale, Topsnik's tax basis in the Gourmet Foods stock was $748,418, and his gross profit from the installment sale was $4,678,582.

Topsnik received the down payment and monthly installment payments as planned, with the buyers making the final monthly installment payment on Sept. 3, 2013. In 2010, Topsnik received 12 monthly installment payments of $42,500 for a total of $510,000. As of Nov. 19, 2010, the amount of unpaid principal and accrued interest on the remainder of the installment agreement had a fair market value of $1,373,374.

On Nov. 20, 2010, Topsnik formally abandoned his LPR status. Since that time, he has not met the certification requirements of Sec. 877A(a)(2)(C). These include filing Form 8854, Initial and Annual Expatriation Statement, and certifying, under penalties of perjury, that he has complied with all of his U.S. federal tax obligations for the five tax years preceding the tax year that includes the expatriation date, including his obligations to file income tax returns and obligations to pay all relevant tax liabilities, interest, and penalties. Topsnik did not file all his U.S. income tax returns and was not in payment compliance on the tax owed for the five years before his expatriation.

In March 2011, the IRS made a jeopardy assessment of tax, penalties, and interest against Topsnik for the years 2004-2009 and later levied on his installment payments from the Gourmet Foods sale to satisfy his liabilities. In August 2011, Topsnik filed a complaint in district court requesting a review of the IRS's assessment and levies. In that case, the government moved to dismiss the case for lack of jurisdiction because Topsnik resided in Germany. The district court, finding that he resided in Germany, dismissed the case.

Also in August 2011, Topsnik, taking the position that he was a German resident for 2010, filed a delinquent Form 1040NR, U.S. Nonresident Alien Income Tax Return, for 2010. On this return he reported $439,671 ($510,000 × 86.21% gross profit percentage) as being exempt under Article 13 (Gains) of the U.S.-Germany tax treaty.

The IRS determined that Topsnik was not a German resident in 2010 and was liable for an income tax deficiency for 2010 attributable to the gain on his installment sale of stock. It also determined that Topsnik was a "covered expatriate" who expatriated in 2010 and must recognize gain on the deemed sale of his installment obligation on the day before his expatriation under Sec. 877A.

Topsnik did not agree with the IRS's determination and filed a petition with the Tax Court, claiming he was a German resident in 2010 so he was not subject to Sec. 877A or tax on his income as a resident for 2010 and that Sec. 877A did not apply to his right to receive installment payments. Topsnik filed a motion, and the IRS filed a cross-motion, for summary judgment in the case.

Tax Court's Decision

The Tax Court held that Topsnik was a U.S. resident until he abandoned his LPR status in November 2010 and he was liable for tax on the installment payments from the Gourmet Foods sale that he received before he abandoned LPR status. The court further held that, because he surrendered his LPR status, Topsnik was a covered expatriate who expatriated in 2010, and, consequently, he was required to recognize gain on the deemed sale of his property on the day before his expatriation. The court further determined his property for purposes of Sec. 877A included his right to receive installment payments that he held on his expatriation date, even though the transaction that gave rise to the payments occurred in 2004, before Sec. 877A was enacted.

German residency: Topsnik made two arguments in favor of his being a German resident. First, he claimed that the IRS was precluded under the doctrine of judicial estoppel from claiming that he was not a German resident by the decision in his earlier district court case, in which the court dismissed the case because it found Topsnik was a German resident (Topsnik, No. 2:11-cv-06958-JHN-MRW (C.D. Cal. 1/17/12), aff'd, 554 Fed. Appx. 630 (9th Cir. 2014)). The Tax Court, citing its earlier decision in Topsnik, 143 T.C. 240 (2014) (Topsnik IV), found that judicial estoppel did not apply because Topsnik's status as a German resident in the district court case involved different years, and his residency for 2010 was not argued by the parties or at issue in that case.

Topsnik in the alternative argued that based on his German contacts, he was a German resident under the provisions of the U.S.-Germany tax treaty. Among other things, Topsnik claimed he owned the Schwarze Pfütze inn in Oerlenbach, Germany, and had a room there. He also held a German driver's license and passport. Having reviewed the treaty and secondary explanatory material about it, the court determined that the treaty test for residence in a contracting state (i.e., either the United States or Germany) is the individual's liability to pay tax to the state as a resident, which, in the case of Germany, means that the individual must be taxable on his or her worldwide income.

Under this test, the court observed that Topsnik's contacts with Germany were only relevant "insofar as they served to subject him to German taxation of his worldwide income." The court found that Topsnik was not a resident because he did not allege he was subject to German taxation on his worldwide income, and the other evidence before the court, in particular the information received by the IRS from the German competent authority regarding Topsnik's German residency status, was uniformly to the contrary. The information from the German tax authorities indicated that he was registered as a nonresident of Germany in 2010, did not file a German tax return in 2010, did not have a registered residence in Germany, and occasionally resided in a room in Freiburg, free of charge.

Covered expatriate: Topsnik ­argued that he was not a covered expatriate under Sec. 877A, so he did not have to include the gain from a deemed sale of his property in income in 2010. Under Sec. 877A(g)(5), an expatriate includes a long-term resident of the United States who ceases to be an LPR. A long-term resident is defined as an individual other than a U.S. citizen who is an LPR in at least eight tax years during the period of 15 tax years ending with the tax year of expatriation. Based on Topsnik's 2010 expatriation date, this period began in 1996.

The court noted that in Topsnik IV it had found that Topsnik was a resident in the years 2004-2009 and that it was finding in the current case that he was a resident in 2010. In addition, Topsnik did not argue he was not a resident in 1996-1998 or present evidence that he was not. Thus, the court found he had been a resident for 10 years of the 15-year measuring period and accordingly was an expatriate.

The court then considered whether he was a covered expatriate. An expatriate is covered if he or she meets at least one of the requirements set out in Secs. 877(a)(2)(A)-(C). Subparagraph (C) provides that a person is a covered expatriate if "such individual fails to certify under penalty of perjury that he has met the requirements of this title for the 5 preceding taxable years or fails to submit such evidence of such compliance as the Secretary may require." Notice 2009-85 explains that for purposes of certifying tax compliance for the five years before expatriation pursuant to Sec. 877(a)(2)(C), the taxpayer must file Form 8854.

The court found that, for the year of his expatriation, Topsnik failed to complete and file a Form 8854 certifying under penalties of perjury that he had complied with all of his U.S. federal tax obligations for the five tax years preceding the tax year that included his expatriation date. Furthermore, the IRS provided evidence that he did not file all of his U.S. income tax returns before expatriating and was not in payment compliance for taxes owed for the five years before expatriation in tax year 2010, proving that Topsnik could not have certified under penalties of perjury on a Form 8854 that he had been in tax compliance for the five years before expatriation. Consequently, Topsnik was a "covered expatriate" as defined by Sec. 877A(g)(1)(A), and he was required under Sec. 877A to include the gain from the deemed sale of his property on the day before his expatriation in his income.

Application of Sec. 877A to the right to receive installment payments: Topsnik also argued that Sec. 877A did not apply to his right to receive installment payments because Sec. 877A was passed in 2008, and his installment payments arose out of a transaction in 2004, thus making the application of the statute to the property retroactive.

The court found that Topsnik was wrong in arguing that the statute was being applied to the 2004 Gourmet Food sale transaction, which gave rise to his receipt of installment payments. Rather, the court said, it was being applied to the property he held the day before his expatriation, which was the right to receive the remaining payments due under the installment sale agreement. The court explained that Notice 2009-85 stated that for purposes of Sec. 877A, a covered expatriate is considered to own any interest in property that would be taxable as part of his gross estate for federal estate tax purposes as if he or she had died on the day before the expatriation date as a citizen or resident of the United States. Citing Gump, 124 F.2d 540 (9th Cir. 1942), the court found that the right to receive the installment payments is includible in a decedent's gross estate.

Reflections

Although the case only discusses the Sec. 877(a)(2)(C) certification test for being a covered expatriate, an expatriate will also be considered covered if he or she has average annual net income tax for the five-year period ending before the date of expatriation of greater than $124,000 ($161,000 for 2016, adjusted for inflation) or has a net worth of $2 million or more as of the date of expatriation. Although a covered expatriate can exclude up to $600,000 ($693,000 for 2016, adjusted for inflation) of the gain from the deemed sale of his or her property from income, as this case shows, it can still make expatriation an expensive proposition for some high-wealth taxpayers.

Topsnik, 146 T.C. No. 1 (2016)

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