This post appeared on the RenounceUScitizenship blog.
— U.S. Citizen Abroad (@USCitizenAbroad) July 14, 2013
My recent post discussed the importance of renouncing U.S. citizenship before becoming a covered expat. For those who need a reminder (and this is not a substitute for careful legal advice) a “covered expatriate” is one who meets any of the following tests:
1. The Income Test – Has the composition of income hat has resulted in a U.S. tax bill of approximately 140,000 for each of the last three years (this is a paraphrase, look it up yourself);
2. The Asset Test – Has a net worth of two million dollars or more
3. The Compliance Test – Is unable to certify compliance with U.S. tax laws for each of the five years prior to expatriation. Note that this is intended to include having filed all relevant information returns. (I would argue that since FBAR is a Title 31 requirement it is irrelevant to Title 26 compliance). Interestingly, if you do not meet either the asset test or the income test, you have a huge incentive to ensure that you have five years of tax compliance.
When it comes to U.S. tax compliance:
The only thing worse than the fear of non-compliance is the certainty of compliance. Why?
Tax compliant U.S. citizens abroad have locked themselves into the “prison of U.S. citizenship-based taxation”. The complexity, cost, anxiety, fear and anger is like being in a permanent state of OVDP. The amount of time stress and fear of penalties is simply unbelievable. One tax compliant U.S. citizen abroad reports that:
“This year I started dealing with my IRS Return in January 1st and tomorrow July 14 I will send my return with Puralator to make sure that it will arrive.”
The vast majority of U.S. citizens abroad want to be in compliance with the law. The reality is that for U.S. citizens abroad, U.S. tax “compliance is somewhere between very difficult and impossible“.
Only the most wealthy U.S. citizens abroad can afford to keep U.S. citizenship
Unless they are exceptionally wealthy and can afford the costs of U.S. tax compliance, double taxation and constant anxiety (no middle class American abroad can) they have have only two options:
1. They must go and live in the U.S. – this is not really an option for long term citizens abroad
2. They must Relinquish their U.S. citizenship – this can be costly for “tax compliant” people who are also “covered expats”.
The current laws of the United States are forcing tax compliant Americans abroad to choose between their U.S. citizenship and their lives. These ideas are well covered here.
The two kinds of tax compliant Americans who must consider relinquishing U.S. citizenship
1. Those who are NOT covered expatriates – They will avoid the 877A Exit Tax
2. Those who are covered expatriates – They will be subjected to the 877A Exit Tax
Incredibly: there are no worse living conditions than being a tax compliant U.S. citizen abroad who is a “covered expat”. A “covered expat” is subject to the Section 877A Exit Tax.
A “covered expatriate” is something that you do NOT want to be!
Like the undesirables in Nazi Germany and the undesirables in the Soviet Union, “covered expats” are required to pay the U.S. government for their freedom. (You can tell a country by the company that it keeps.)
The Asset Test – $2,000,000 dollars and a Toronto home owner
The truth is that $2,000,000 doesn’t mean much. The truth is that any responsible saver will reach it through investments and general inflation. The truth is that most Toronto home owners, who also have an RRSP and few other assets are there! These so called “billionaires” are your neighbors. These so called “billionaires” drive Toyotas. These so called “billionaires” shop at Costco and Walmart. They are demonized only because they have chosen to be responsible with their money. But, I digress …
The Asset Test is interesting because …
It is triggered by a net worth of $2,000,000 U.S. dollars on the day you relinquish. Some points worthy of note are:
1. The calculation is computed in U.S. dollars. Use the exchange rate on the date of your relinquishment.
2. If you have $1,900,000 you are free but if you have $2,000,000 you are subject to the tax. This demonstrates that the purpose of the tax is simply to punish the PEOPLE who have accumulated $2,000,000 of assets. After paying the Exit Tax, the person with $2,000,000 MAY end up with SIGNIFICANTLY less than the person who had only $1,900,000. Clearly, if this were a tax on ASSETS then one would expect the amount in excess of $2,000,000 to be subject to the tax.
3. I will do a separate post on the how the Exit Tax actually works. For those who can’t wait, here is a clear exposition by Robert Wood. This post is about what triggers the “Exit Tax” and how to avoid the $2,000,000 trigger. Furthermore, this post is to describe the reality of “tax compliant U.S. citizens abroad”. The following points should be clear to those of you who are “tax compliant Americans Abroad”:
- as I wrote in my last post, you must relinquish your U.S. citizenship. It’s very sad, but there is simply no way to live as a tax compliant U.S. citizen abroad
- you must take every reasonable step to avoid being a “covered expatriate” when you relinquish. As Phil Hodgen commented: “failing the 3 tests is a good thing.”
4. Although I am not using this post to discuss how the Exit Tax works, I do want include two important considerations:
A. You can have approximately $660,000 of capital gains which are excluded from the tax (and indexed for inflation) before the tax kicks in. U.S. citizens abroad who CANNOT certify 5 years of tax compliance take note.
B. Those of you who were born dual citizens (and meet some additional requirements avoid the Exit Tax all together. Is this discrimination based on citizenship?)
Therefore, the Exit Tax is aimed at:
The Tax Compliant U.S. Citizen abroad who meets one of the above three tests and was unlucky enough to not have a second citizenship from birth. Furthermore, by taxing the person (as opposed to the property) the U.S. is levying a tax on “foreign assets”.
Failing the “Asset Test”: Consider turning your over $2,000,000 big assets into less than $2,000,000 little assets – When less is really more
You are a U.S. citizen. Therefore you are exceptional. You were born in a special place and therefore special principles apply to you. You hold the only citizenship on the planet where you will actually make money – by losing money.
Think of it as a weight reduction program!
Here are some thoughts on how to achieve weight reduction:
Strategy 1 – Realize your gains – Your net worth may include unrealized capital gains – Realize those gains and pay the taxes
Example 1 – No Debt
For example, let’s say that as a responsible person you invested in a small property. To keep it simple, let’s assume no debt. You bought it for $500,000. Today it is worth $1,000,000. It would be treated as worth $1,000,000 for the purposes of the net worth test. You have an unrealized gain of $500,000. ($1,000,000 – $500,000). How can you reduce value of the property? The answer is sell the property. You will have to pay tax on $500,000 of capital gains. The amount of the tax will not be less than $125,000 and could well be more. Amazing you have just reduced your net worth.
Example 2 – Debt
Same example. Let’s say that as a responsible person you invested in a small property for $500,000. Let’s say that you financed the property with 100,000 down and a mortgage of $400,000. Let’s say that today the property is worth $1,000,000. Let’s assume that the mortgage is still $400,000.
A. The net worth of the property for Exit Tax purposes would be $600,000. ($1,000,000 – $400,000). This is the amount that you would include as part of your net worth.
B. Let’s say you sell for $1,000,000. What happens? Basically the same thing. The capital gain is still $500,000 ($1,000,000 – $500,000). Of course you will use the proceeds of the sale to pay off the $400,000 debt. So, you are left with $600,000. You will still have to pay the capital gains tax which will reduce your net worth (still probably at least $125,000).
But, what’s different this time is that you may recognize a gain or loss on the payout of the mortgage. Part of the problem of being a U.S. citizen abroad is that you are subject to the phantoms gains and losses of currency fluctuations. This is complicated but, if your goal is to reduce your net worth (which it is) this is something that should be considered. I analyzed this problem in an earlier post.
Strategy 2 – Consider selling your principal residence
This is an interesting topic. For those who don’t know, the U.S. does tax the gains on your principal residence. But, you do have the $250,000 tax free capital gain (making it different from strategy 1). If you have a spouse, half of that gain may belong to them.
Selling your principal residence prior to expatriation may make sense for two reasons:
1. If you sell the principal residence prior to expatriation, the sale will NOT be subject to the 877A rules. This ensures that you get the benefit of the $250,000 exclusion. It is NOT clear whether the $250,000 exclusion is available if the sale of the house becomes part of the 877A calculation. This issue is identified by both Robert Wood and Phil Hodgen.
2. Expatriation may involve life changes. You want to move anyway. Therefore, this might be a way to kill two birds with one stone.
To see what the savings are, simply multiply the capital gains tax rate by $250,000. It is significant.
Strategy 3 – Gifts
U.S. citizens can pay the gift tax now or the estate tax later. Make gifts to the extent that you can. I am not an expert on the tax consequences of gifts (although I have been told I am a generous person), but you are allowed to make gifts. As a citizen of “Form Nation”, your gifts will require a form. That said, here are three things you can consider:
A. Gifts of $13,000 per year to a large number of people. Hey, if you only have a couple hundred thousand to get rid of, why not?
B. The revenge of the alien spouse – $143,000 erosion per year
What if you don’t have a spouse? Why not just go out and get one? Run an ad:
“U.S. person requires spouse of convenience to give $143,000 per year to.”
(Even a U.S. person could find a spouse with this promise.)
(ii) The Gold Digger/Hostile Spouse – When it comes to the depletion/erosion of financial assets, there is nothing better than a hostile spouse. When the hostilities begin you can either give your money to a lawyer or give your money to a spouse. Perhaps a hostile spouse would be a way of getting around the $143,000 limitation on spousal gifts.
Now, I would tread lightly on this one. Phil Hodgen had an interesting post on this topic, that you really should read (and maybe consult Phil). That said, from a common sense perspective, the marriage of convenience (or any other marriage) is a great way to erode assets.
And finally, although you might have to advertise for the spouse who will accept the $143,000 a year, you won’t have to advertise for the “Gold Digger/Hostile Spouse”. They just happen.
(iii) Combine the Alien Spouse with the Gold Digger/Hostile Spouse (strategies i and ii) - This could be very effective. While you are being taken to the cleaners, and paying for lawyers, you can make the $143,000 payout in addition.
(Now, I do realize that U.S. persons are no longer attractive as marriage partners. If you need help, I can help you find a very attractive “Alien Gold Digger/Hostile Spouse” to erode your assets. Contact me.)
C. Financing an education for your child – Now I really feel that I am on a roll. I never realized how many opportunities for asset depletion there are. I am not sure on this one. But, is a U.S. person allowed to finance an education for his child? Does it matter whether the child is a U.S. citizen of not? This is an interesting question. But, if this is possible (and I suspect it is) perhaps you can prepay a degree for your child. Find something that takes many years. Better yet, send your child to law school. Encourage the child to study tax and family law. But, hey, if educational expenses allow you to bypass the gift tax exemptions, then this would be another well known way to erode your assets. Note that the payment must be made directly to the educational institution and must be for tuition.
Warning! Make sure that the child renounces U.S. citizenship. A child born abroad to a U.S. citizen may not be a U.S. citizen). You want to be able to get some of this money back in your older age.
D. Medical Expenses – Really who needs OHIP anyway? If your family members need expensive medical care it might be smart to pay for it directly. Of course, there are rules, forms, etc. Of course the health of many U.S. citizens abroad has been damaged over the last few years. Why not let the U.S. government subsidize part of the cost.
Strategy 4 – Stop Working and live off your capital until you are below the 2,000,000 mark. Take your trip around the world. No point in waiting until you are too old. Enjoy your money. Just spend your way below the two million mark. (This dovetails nicely with the hostile spouse option described above.)
I have talked to a number of U.S. citizens abroad who are seriously considering just stopping working. There is no point in it.
Strategies 1 – 4 are for those of you who are tax compliant.
Strategy 5 – What if you are not tax compliant and want to become tax compliant?
Okay that’s fine. But, you need to understand that the moment you become tax compliant (unless you are exceptionally wealthy) you will need to relinquish. You will be unable to deal with the forms and life restrictions.
Here is a wonderful way to clean it all up at once and move forward. Again all of these options should be done only under the supervision of a lawyer.
Here is an interesting strategy. There is a certain group of people who might consider this one. Again, only under professional supervision …
If you have never filed taxes or if you have recently learned that you have not been filing correctly (you have mutual funds, etc.) you could:
1. Enter OVDP
2. Pay the penalties
3. Get a clean bill of health on your taxes
4. Pay your lawyers fees
5. Watch your net worth erode to below the two million. (If the IRS doesn’t take it your lawyer will.)
This is a wonderful way of turning IRS OVDP penalty abuse to your advantage!
No doubt some of you will find the final suggestion amusing. Run the numbers. I can imagine scenarios where it could make sense.
In 1997 James Dale Davidson, writing about U.S. tax laws and their application to U.S. citizens abroad implied that:
U.S. tax laws as applied to Americans abroad are so punitive that many would be further ahead by simply paying the Exit Tax (at this time it was the Clinton Exit tax) and moving on.
In other words, maybe you purchase your freedom (wasn’t there a period in U.S. history when certain people purchased their freedom) and move on. After all, the simple truth is that the U.S. government does have a property right in its citizens.
Conclusion, this is all very very sad …
Speaking of Phil Hodgen, in a recent blog post, where he was discussing exiting the U.S.A. and the Exit Tax he closed by saying:
We have squillions of brain cells in our office dedicated to Section 877A and expatriation. My only advice to you (and others) who are going through the expatriation process is this: remember your Primary Purpose to exit the United States cleanly, so you can move about the planet freely for the rest of your life. Don’t f— that up by playing games with your taxes.
“Your money or your life?” That is the question you are being asked. Choose life.
You are a U.S. citizen. Therefore you must choose between your money or your life. It’s too bad U.S. citizens can’t have both!
Put, that way, yes Mr. Hodgen is correct:
You lost the birth lottery – Take life!!
Disclaimer!! This post is and is not intended to be legal advice or any other kind of advice. You must seek advice appropriate to your circumstances.