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Normally capital-gains taxes on equity are only owed when the gain is realized, i.e. when the shares are sold. Does this change (in the US) if the gains are the result of an IPO or if the person realizing the gains is a co-founder of the corporation?

As one specific example, Eduardo Saverin apparently gave up his American citizenship rather than pay taxes.

Why would he have owed taxes? Does the American tax system indeed ask someone to pay capital-gains taxes on shares even if he does not sell them? Or did Saverin intend to sell his shares?

If you have expertise this broad, a quick comparison with other advanced (G7/G8) economies would be nice.

7

Normally, you don't pay capital gains tax until you actually realize a capital gain. However, there are some exceptions.

The exception that affected Eduardo Saverin is the expatriation tax, or exit tax. If you leave a country and are no longer a tax resident, your former country taxes you on your unrealized capital gains from the period that you were a tax resident of that country. There are several countries that have an expatriation tax, including the United States. Saverin left the U.S. before the Facebook IPO. Saverin was perhaps already planning on leaving the U.S. (he is originally from Brazil and has investments in Asia), so leaving before the IPO limited the amount of capital gains tax he had to pay upon his exit. (Source: Wall Street Journal: So How Much Did He Really Save?)

Another situation that might be considered an exception and affects a lot of us is capital gain distributions inside a mutual fund. When mutual fund managers sell investments inside the fund and realize gains, they have to distribute those gains among all the mutual fund investors. This often takes the form of additional shares of the mutual fund that you are given, and you have to pay capital gains tax on these distributions. As a result, you can invest in a mutual fund, leave your money there and not sell, but have to pay capital gains tax anyway. In fact, you could owe capital gains tax on the distributions even if the value of your mutual fund investment has gone down.

  • I am not familiar with the specifics of this case, but it is interesting to note that note only does the US tax on expatriation, but also on renunciation of citizenship (as the US taxes based on citizenship as well as residency). – Grade 'Eh' Bacon Jun 29 '16 at 18:58
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    @Grade'Eh'Bacon The U.S. is unique in that it taxes its citizens on worldwide income, even if they are no longer residents of the U.S. So simply leaving the country but retaining U.S. citizenship does not trigger the exit tax for an American, because he is still under the U.S. tax jurisdiction. In Canada, the way I understand it, you can leave the country and keep your citizenship, but cease to be a tax resident of Canada. That would trigger the Canadian exit tax. – Ben Miller - Reinstate Monica Jun 29 '16 at 19:17
  • Another exception: Exercising, but not selling stock options that have appreciated. Strike price @ grant = $10, Share price @ exercise = $15. You owe tax on the $5 gain whether or not you sell your shares. – Alex B Jun 29 '16 at 19:33
  • @AlexB In that case, is it considered a capital gain, or ordinary income? – Ben Miller - Reinstate Monica Jun 29 '16 at 19:41
  • @BenMiller I'm not sure. I know it is one of the likely triggers of AMT they ask you about in tax prep software, but I don't know whether it's ordinary income or capital gain. – Alex B Jun 30 '16 at 17:22
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In addition to the expatriation case already mentioned by Ben Miller, traders/investors are required to use mark-to-market accounting on certain investments. These go by Section 1256 contracts due to the part of the law that defines them. Mark-to-market is also required on straddles (combination of a long and and a short position in equities that are expected to vary inversely to each other).

Mark-to-market means that you have to treat the positions as if you closed them at their end-of-year market value (even if you still have the position across the new year).

2

This is really an extended comment on the last paragraph of @BenMiller's answer.

When (the manager of) a mutual fund sells securities that the fund holds for a profit, or receives dividends (stock dividends, bond interest, etc.), the fund has the option of paying taxes on that money (at corporate rates) and distributing the rest to shareholders in the fund, or passing on the entire amount (categorized as dividends, qualified dividends, net short-term capital gains, and net long-term capital gains) to the shareholders who then pay taxes on the money that they receive at their own respective tax rates. (If the net gains are negative, i.e. losses, they are not passed on to the shareholders. See the last paragraph below). A shareholder doesn't have to reinvest the distribution amount into the mutual fund: the option of receiving the money as cash always exists, as does the option of investing the distribution into a different mutual fund in the same family, e.g. invest the distributions from Vanguard's S&P 500 Index Fund into Vanguard's Total Bond Index Fund (and/or vice versa). This last can be done without needing a brokerage account, but doing it across fund families will require the money to transit through a brokerage account or a personal account. Such cross-transfers can be helpful in reducing the amounts of money being transferred in re-balancing asset allocations as is recommended be done once or twice a year. Those investing in load funds instead of no-load funds should keep in mind that several load funds waive the load for re-investment of distributions but some funds don't: the sales charge for the reinvestment is pure profit for the fund if the fund was purchased directly or passed on to the brokerage if the fund was purchased through a brokerage account.

As Ben points out, a shareholder in a mutual fund must pay taxes (in the appropriate categories) on the distributions from the fund even though no actual cash has been received because the entire distribution has been reinvested. It is worth keeping in mind that when the mutual fund declares a distribution (say $1.22 a share), the Net Asset Value per share drops by the same amount (assuming no change in the prices of the securities that the fund holds) and the new shares issued are at this lower price. That is, there is no change in the value of the investment: if you had $10,000 in the fund the day before the distribution was declared, you still have $10,000 after the distribution is declared but you own more shares in the fund than you had previously. (In actuality, the new shares appear in your account a couple of days later, not immediately when the distribution is declared). In short, a distribution from a mutual fund that is re-invested leads to no change in your net assets, but does increase your tax liability. Ditto for a distribution that is taken as cash or re-invested elsewhere.

As a final remark, net capital losses inside a mutual fund are not distributed to shareholders but are retained within the fund to be written off against future capital gains. See also this previous answer or this one.

  • +1, Thanks for the clarification. This explains why mutual funds work the way they do. When you see the value of your mutual funds go down, and yet you still have to pay capital gains tax without selling anything, it is not obvious why this is the case. – Ben Miller - Reinstate Monica Jun 30 '16 at 16:20
  • This expands on the answer by @BenMiller but it doesn't actually answer the OP's question. This OP asked for exceptions to the rule, and this answer explains why the mutual fund case is NOT an exception that rule. The fact that you have a deal with the mutual fund manager to re-invest the gain without sending you the cash does not mean that you didn't realize the gain. – user32479 Jun 30 '16 at 19:08

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