Cross posted from RenounceUScitizenship.

“Get out while the getting is semi-good.  Don’t wait for more time.  More time means more laws.”

– Phil Hodgen – “Why people expatriate”

Anybody who reads this blog is surely familiar with Phil Hodgen’s blog. Mr. Hodgen is California based tax lawyer who appears to have moved firmly into the practice of “Expatriation Law” – AKA helping people to renounce U.S. citizenship or  get rid of that green card. Mr. Hodgen’s latest blog post about “Why people expatriate” is proof that good things can come from long flights. Speaking of “good things”: one commentator wrote that:

This the best, even-handed analysis I’ve seen of the pros and cons of a US citizen bailing out. It should be required reading for every congressman and senator  in the US — as well as the president.

Sadly, it’s clear that Phil has little hope for an improvement. As he points out, it is the citizenship-based taxation that is the root of all this evil, and he sees very little chance of that ever changing.

When great powers begin their decline into eventual irrelevancy, it is rarely just one thing that historians finger as a root cause. But for the US, this may well be it.

In any case:

1. Thanks to Mr. Hodgen for a wonderful objective analysis of the reason(s) why people renounce U.S. citizenship;

2. Mr. Hodgen’s objectivity underscores why we DO need lawyers. In an earlier moment, Mr. Hodgen noted that “U.S. citizenship is a problem to be solved“. His post explains how to solve that problem. For the most part, the solution lies in expatriation – and he is absolutely correct.

Given the complexity of citizenship-based taxation, it is now an “emotional impossibility“, “financial impossibility” and  “practical impossibility” for U.S. citizens who intend to live outside the United States, to retain U.S. citizenship. Mr. Hodgen prognosticates (and I agree that this problems of U.S. citizenship will get worse). He suggests that:

I expect the future to be more of the same.  Expect the same exit tax rules, but more of them, and worse.  Expect more expatriations.  The floggings will continue until morale improves.

In short, Mr. Hodgen’s post is a superb intellectual analysis of the reality that “U.S. citizenship is a problem to be solved”. His advice is to solve the problem sooner rather than later – in other words, Get out while you can!

In life we experience things on both an intellectual and an emotional level. This needs also to be understood on an emotional level. The level of desperation and fear experienced by many U.S. citizens living abroad needs to  be acknowledged.  Many U.S. expats have been among the most patriotic and loyal U.S. citizens. They have been repaid for their patriotism and loyalty, by an attack by the IRS that has treated Ambassador Jacobson’s “70 year old grandmothers” the same way that it treats criminals who have laundered billions of dollars. The perverse effect of this is that it has offered the wealthy criminal (who knew he was breaking the law) a very good deal to get back into the system. It has destroyed the lives of hard working middle class expats (with no knowledge of Mr. FBAR) who have tried their best to save for retirement. The expats have saved for retirement  by investing in RRSPs, mutual funds and other forms of PFICs. Some of them purchased life insurance policies that are punished by the IRS. The list goes on and on.

From the point of view of the IRS:

“The law in its majesty prohibits both the rich and the poor from sleeping on the park bench”.

The criminal U.S. tax cheat can come back into the system and retain 75% of his assets. In all probability he will live happily ever after and PROVE THAT CRIME DOES PAY!

The middle class expat who attempts to fix any compliance problems can do so only at the cost of their retirement savings (which incidentally is “after tax” money) DEMONSTRATING THE CLEANING UP PAST COMPLIANCE PROBLEMS MAY NOT PAY.

Steven Mopsick in an insightful post noted that “Becoming compliant is not easy to do.”

Furthermore, the legal and accounting fees are so high, that many U.S. citizens abroad cannot fix past compliance problems and have simply been forced underground. They cannot bring themselves into tax compliance. (The rules are such  that when it comes to U.S. tax, there are only degrees of non-compliance). As Mr. Hodgen notes, 5 years of tax compliance is a necessary condition to ensure that one is NOT a “covered expatriate”. But, having 5 years of tax compliance is not a sufficient condition for showing  that you are NOT a “covered expatriate”. (Life associated with U.S. citizenship (aka “Form Nation” is nothing but a series of forms. It’s just that some forms are more important than others.)

Why renunciations are increasing – an additional perspective

The most productive, law abiding and responsible U.S. citizens abroad now live in a state of terror. Their lives have now been “stolen from ” by the fear of the IRS. Only those who have experienced the magnitude of this assault from the U.S. government can, on an emotional level, understood it. In order to “reclaim their lives” and have a hope of living “productive lives” they feel they must escape the reign of terror that has been unleashed by the Obama administration. This necessitates the relinquishment of U.S. citizenship. But, severing ties with the U.S. is NOT easy. The difficulty in cutting ties with the U.S. has been compared to the difficulties of leaving the former Soviet Union.

In the same way that the “Midnight Express” was Billy Hayes way of escaping prison in Turkey, expatriation is the only way that U.S. citizens can escape the tyranny of the U.S. government.  Furthermore, people are willing to pay lots of money in the form of an Exit Tax to for a ticket on the “Midnight Express”. To put it another way, if you are a U.S. citizen living outside the U.S.:

You have a choice of being a U.S. citizen or having a life!

Expatriation is the new “Midnight Express”.

Renouncing U.S. Citizenship Without Being Able To Certify 5 Years of Tax Compliance

Does a failure to demonstrate a lack of five years of  tax compliance mean that one cannot renounce U.S. citizenship? Yes and no. One can expatriate without being tax compliant. It’s just that expatriation will NOT solve past tax issues. It will end any tax obligations going forward. Although one can get a CLN (certificate of Loss of Nationality) without being tax compliant, it appears that the IRS will learn of your expatriation. Mr. Hodgen notes that:

You might or might not have to pay income tax because you expatriated.  The IRS looks at you as either an “expatriate” (and you do paperwork only) or a “covered expatriate” (you do paperwork plus pay some tax).

So, what’s a “covered expatriate?” Continuing the discussion he notes:

A covered expatriate is someone who is rich by IRS standards.  You had an average Federal income tax liability of more than $151,000 (for expatriations in 2012) for the prior five years?  Or your net worth is $2,000,000 or more?  Either way, you are rich.  You are a covered expatriate.

A covered expatriate is also someone who–regardless of net worth or prior Federal income tax liability–cannot say under penalty of perjury that the prior five years of Federal tax obligations are fully satisfied.  Finally, a covered expatriate is someone who is late filing the exit year income tax return on time.

If you cannot certify under penalties of perjury that you have been tax compliant for the five years prior to the date of expatriation, then you are a covered expatriate.

Okay, you are a covered expatriate – now what? Well it means that you are treated as having disposed of your assets on the day prior to the day of expatriation. So, what does this mean? According to Mr. Hodgen:

If you’re a covered expatriate, here’s how you calculate your exit tax. Pretend all of your IRAs, HSAs, and similar tax-deferred accounts distributed everything to you on the day before your appointment at the Embassy.  It’s all taxable income.  There is no early distribution penalty.

Some pensions are treated as your entire pension benefit is distributed to you as a lump sum.  You pay U.S. income tax on this make-pretend distribution although you might be decades away from retirement. If you are a beneficiary of a trust, generally you will be taxed as taxable distributions are made.

As for everything else, pretend that you sold it the day before your appointment at the Embassy.  In investment jargon, your assets are marked-to-market.  Calculate the capital gain, deduct the exemption amount ($651,000 in 2012), and pay tax on the rest at the normal tax rates.  If it is long term capital gain, pay tax at 15%.  If it is short term capital gain, pay at those rates.  If it is depreciation recapture, ordinary income, whatever–apply the relevant tax treatment to it.

After you have filed that final year income tax return, you have no further tax obligations to the United States, whether you are a covered expatriate or merely an expatriate.  After you expatriate, you will owe income tax to the United States only if you have U.S. source income.

(Note that those with a net worth of $2,000,000 or more are “covered expatriates”. This is $2,000,000 U.S. dollars. Some things – based on comments to Phil’s post – to keep in mind:

1. General inflation can easily mean that this who are under the threshold today, could easily be at the $2,000,000 tomorrow. Think of rising house prices in Toronto or Vancouver.

2. A devaluation of the U.S. – which is very likely – can easily put somebody over the $2,000,000 mark.

3. The law could easily be changed to make everybody a “covered expatriate”.

My point? Get out now!)

Does “Compliance Going Forward” Allow One To File Just One More Return?

Much of the public discussion and many of the assumptions assume that 5 years of tax compliance is a requirement for expatriation. Is this really true? 

Remember:

1. Your relinquishment of U.S. citizenship is governed by S. 349 of the INA (Immigration and Nationality Act). It does not mention the IRS or the Tax Code.

2. You are entitled to and indeed people are receiving the CLN based on the loss of U.S. citizenship and not based on tax compliance

3. The relinquishment of U.S. citizenship will end future tax obligations to the U.S. (The ExPatriot Act is not yet law and even if it becomes law it would only apply to U.S. source income)

4. The relinquishment of U.S. citizenship will NOT solve past tax compliance problems.

5. The inability to certify that you have been tax compliant for the five years prior to expatriation means that you will be a “covered expatriate”

6. As a “covered expatriate” you may or may not have to pay an Exit Tax . I suspect that many will NOT.

7. Who knows what the IRS might or might do in relation to past non-compliance? You need advice from a good lawyer on this point. I suspect that the advice you receive will depend on your circumstances.

Certainly, if there is little or no tax liability, you might ask your lawyer the following question:

What happens if  I expatriate without filing the past five years of tax returns? I then just file the appropriate returns in the year I expatriate. What are my risks in relation to my past non-compliance?  The question is whether “compliance going forward” can also be our tax return(s).

Obviously, this is not legal advice. But, the law clearly states that the effect of past non-compliance (for the previous 5 years) makes one a “covered expatriate”. Being a “covered expatriate” does  NOT guarantee that tax will be owed.

Conclusion: If you are too poor to bring yourself into tax compliance for the previous five years. Perhaps you just say: okay, I guess I am a “covered expatriate”. Now we will see whether you owe any tax. My hunch is that if one cannot afford to do the past five years of tax filings, that one is unlikely to owe an “Exit Tax”.

A Friendly Reminder: this does NOT mean that any past compliance issues will go away. It’s just a question of what the IRS will do about it. (On this point, it is obvious that everybody should pay their taxes. But, there are people who live very simple lives (my preferred way of living) and therefore do not owe taxes.)

I would be interested in the comments of our resident lawyers with respect to this possible approach.

As Phil Hodgen notes:

Federal politicians don’t care about you, since (a) you are overseas; and (b) you’re going to stop voting anyway.  So they can use you as a political punching bag and I think you should expect this.  The IRS will do what it always does–write rules and regulations–which are invariably bad for carbon-based life forms.  For every regulation written to “answer a question” the IRS creates four more questions, each an order of magnitude more difficult than the one that was “solved.”  Get out while the getting is semi-good.  Don’t wait for more time.  More time means more laws.