From Phil Hodgen’s blog (all rights reserved, used with permission)
Americans are giving up citizenship and permanent resident (“green card”) status in increasing numbers. It is a significant part of our law firm’s practice, and discussions with people in the Middle East were a major part of my visits to Beirut and Dubai on this trip.
People are giving up U.S. citizenship even though the rules from 2008 onward make it expensive to do so. The current tax rules can impose a substantial–and immediate–income tax on someone who gives up citizenship.
They do it because keeping U.S. citizenship is getting more expensive, in economic and non-economic terms. Many of the non-economic reasons people expatriate are due to tax enforcement policies and a culture of fear encouraged by the IRS.
Expatriations have visible costs and hidden costs of lost opportunity to the United States. People who give up citizenship are forever outside the U.S. tax system. There is no further hope of tax revenue from them. But more important, there is an opportunity cost to the USA. Productive people opt out of the U.S. system. They invest their money elsewhere, creating businesses, jobs, and wealth in other countries. This weakens the United States and strengthens other countries.
Equally important, millions of Americans abroad living ordinary lives is an undisguised good thing. They are unpaid goodwill ambassadors, living in other countries and making friends. Every expatriation removes one such goodwill ambassador, converting him or her into someone who grumbles about expatriation at cocktail parties. This is important. Maybe more important than we realize.
Keep doing what you’re doing and you will keep getting what you’re getting. We should expect expatriations to continue because government policies will not change.
How to expatriate
Let’s start with a little technical background–how someone expatriates. I am going to refer to citizens terminating citizenship, just to keep things simple. However, the same processes and concepts apply to persons who have held a green card visa for a significant amount of time–generally eight years, but the counting rules for permanent residents are weird.
In order to terminate your citizenship, you do some paperwork, have an exit interview at an Embassy or Consulate, and receive a Certificate of Loss of Nationality. Unless there is evidence that you do not understand what you are doing, or you are being coerced, you will achieve the desired result. “You’re crazy” or “someone is twisting your arm” (in the judgment of the Consular official) are good reasons to deny you the termination of citizenship that you’re asking for. This makes sense.
What to expect seems to vary from one diplomatic outpost to the next. Some people report enthusiastic questioning by Consular officers; others report that they received matter-of-fact and indeed friendly treatment. Generally, there is nothing to fear. The Department of State forms are poorly designed and sometimes difficult to understand but you will get through the process.
How to deal with the exit tax stuff
Getting the Certificate of Loss of Nationality is not enough, however. You also need to tell the IRS that you are no longer a U.S. citizen, handle the paperwork, and possibly pay some tax. This tax is colloquially referred to by those of us in the tax business as the “exit tax”. You tell the IRS about your loss of citizenship–and settle up on the tax bill–by filing a complicated income tax return for the year in which you terminate your citizenship.
The filing deadline is the same as it always is. For Americans abroad it is June 15 of the next year, and extensions are possible. The tax return is a dual-status tax return (see Chapter 6 of IRS Publication 519) consists of three parts:
- – Form 1040 for January 1 through the day that you terminated your citizenship (usually the day of your exit interview at the Embassy). Report your income normally, as a U.S. taxpayer usually would.
- – Form 1040NR for the day after your exit interview through December 31. Report your income like any other nonresident/noncitizen of the United States on the planet. Generally this means that you only report (and pay U.S. income tax on) income you received from U.S. sources.
- – Form 8854. This is the critical one. This is the form by which you inform the IRS that you have expatriated. You determine whether you must pay an income tax because you expatriated (or not), and do the necessary calculations of the taxable income created by terminating citizenship if you do owe tax.
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).
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’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.
An economist would say that the demand curve predicts that as the cost (broadly defined) of a good increases, demand decreases. A human would say that if something is more expensive, you’ll buy less of it.
Expensive can mean financial cost, of course. But it can also mean non-financial factors. As you get closer to the edge of a cliff, the risk of falling off increases. We would expect people to shy away from the cliff’s edge, with some willing to tolerate more risk than others.
The tax system I described above was enacted in mid-2008. It replaced a system that did not impose an immediate tax on expatriates. In mid-2008 it became immediately more expensive (financially) to expatriate.
Thus, we would expect to see fewer people take this step. Yet we have seen the opposite. The rates of expatriation have increased over those seen before 2008, and since 2008 the number of people expatriating every year has increased.
This is counterintuitive. Why are more people expatriating every year?
Again, looking at the question using economic concepts, the cost of expatriation has increased. But the cost of keeping U.S. citizenship has also increased, primarily in non-financial terms.
Thus, a person’s decision to expatriate is logical: the cost (broadly defined) of keeping U.S. citizenship is more than the cost (broadly defined) of giving it up.
Tax returns are expensive
A U.S. citizen living in the United States has no exposure to the additional burden that an American abroad faces in preparing her income tax return. There are forms and filing requirements unknown to U.S. resident taxpayers, triggered merely by living an ordinary life abroad. Forms 3520, 8891, 8621, 8938 and many others can be required.
These requirements have become more onerous over the last few years. Form 8938 was required starting with 2011 tax returns. It requires reporting of various foreign assets. (Imagine if you, a resident taxpayer, were required to tell the U.S. government what you own and how much it is worth). Form 8621, long-ignored, is now required for any American abroad who buys a mutual fund–equivalent to one from Vanguard or Fidelity–issued by a foreign company. Failing to file certain forms can leave the statute of limitations (the amount of time the IRS has to audit you) open forever, rather than the three year rule that normally applies.
The additional requirements for tax returns mean that the accountants’ fees paid for tax return preparation are higher for Americans abroad. The requirements they face are obscure and technical, with high penalties for error. Americans abroad pay more than resident Americans for their tax return preparation. Someone living outside the United States must think of this when considering expatriation. Indeed this is a primary factor in expatriation cases that our firm handles for normal people. (Your definition of “normal” may be different from mine).
Expensive tax returns, no tax paid
It is important to note that for most Americans abroad, there is no income tax paid annually to the United States. They just prepare complicated tax returns and file them. Two rules, designed to ensure that Americans abroad are taxed fairly, ensure this.
The first of these rules is the foreign earned income exclusion. Look at Form 2555 to see how this works. For 2012, the first $95,100 of earned income is not taxed in the United States. Most people do not earn that much salary, so most Americans abroad pay no income tax in the United States.
The second of these rules is the foreign tax credit. Look at Form 1116 to see this in action. A dollar of income should not be taxed twice. So, an American abroad pays tax in his country of residence, then claims an offset for that tax paid against his U.S. income tax liability. For people living in Europe, New Zealand, Australia, and other high-tax countries, the result is usually a U.S. income tax return with zero income tax payable to the United States. Imagine what it is like to $2,000, $3,000, or more for tax return preparation, with a zero tax bill. It is a pointless an expensive exercise.
Dual citizens abroad who pay income tax
If we exclude people making under $95,100 in salary, and if we exclude people living in high-tax countries who can eliminate U.S. income tax using the foreign tax credit, that leaves only people who live in low-tax countries and have salaries above $95,100 as those who pay income tax. This, I would guess, is a small percentage of all Americans abroad who would be candidates for expatriation.
The income tax on these individuals’ salary, plus income tax on investment income (to the extent not offset by foreign tax credits) will be the major components of Federal income tax collected from Americans abroad. It can’t be a large number, but I have no access to statistics. (I’m on a plane!). My guess is that the revenue is small. But something is better than nothing for the IRS.
This is a relatively small number of people, but for them the U.S. income tax will definitely be a factor in deciding whether to expatriate or not. The appeal of paying nothing rather than something is undeniable.
Expensive tax returns, no tax paid, downside risk
Our would-be expatriate considers paying a lot of money every year to prepare U.S. income tax returns, while paying no U.S. income tax. If there is an error on the tax returns, the potential penalty risk for our would-be expatriate is astronomical. Penalties can be $10,000 for leaving one of your bank accounts off Form TD F 90-22.1.
This problem has been exacerbated in the last few years of the IRS pursuit of undisclosed bank accounts. As the news circulated about the treatment of ordinary taxpayers, fear was created in the hearts of people who were considering expatriation.
The trickle of stories about voluntary disclosure penalties was not helped by the harsh PR from the Internal Revenue Service. The Commissioner announced loudly and repeatedly that Americans with assets abroad were targets for IRS investigation, and prior sins could be repaired only in extremely expensive ways.
In summary, an American considering expatriation sees substantial personal expense, and for what? The possibility of massive IRS penalties for screwing up some paperwork? That sounds unappealing.
Home country tax benefits
The United States has all sorts of tax-deferred accounts for various purposes: accounts for health care benefits, accounts for education savings, and others. Many other countries have similar schemes for their residents, allowing them to save for education, buying a house, or retirement.
A Canadian has a variety of tax-deferred accounts available for saving money–for tuition, for retirement, etc. If that Canadian also holds a U.S. passport, the tax deferral granted by Canada is ignored by the U.S., and the earnings on that account are taxed in the United States. The U.K. has its ISA. Australia has its superannuation.
A dual citizen loses home country tax benefits because of U.S. tax policy.
Even basic banking is becoming a problem
Because of FATCA, foreign banks are identifying their U.S. citizen customers and closing their accounts.
FATCA, for those of you unfamiliar with the law, is a U.S. law which attempts to coerce foreign banks worldwide into reporting all of their U.S. customers to the Internal Revenue Service. To call this an unfunded mandate is an understatement. Rather than pay for this reporting exercise, many foreign banks find it cheaper to shed their U.S. customers.
It is increasingly difficult for Americans abroad to have the regular bank accounts needed to live.
U.S. estate tax
Similarly, the estate tax will be a concern for some. Americans living in countries with a tax on death similar to the U.S. estate tax will likely be indifferent. A tax will be imposed by one country or another when they die.
But for those living in countries with no estate tax, the impact is profound. I have many clients in the Middle East. There it is the norm to have very large family-owned businesses. If two brothers own a business and one is a U.S. citizen, upon the citizen’s death an estate tax will be imposed, essentially causing his share of the business to be sold to the non-citizen’s side of the family. In order to preserve the family business, ownership must be removed from U.S. citizens.
Benefit gap of U.S. citizenship over competing alternatives
Another reason why expatriation increases, I think, is because the alternative isn’t that bad. And it’s getting better all the time. The gap has (for many people) narrowed when considering the benefits of keeping U.S. citizenship compared to holding a different passport. Someone holding a U.K. passport will see little perceived benefit to U.S. citizenship. She can move freely about the planet and live in a first-tier country. Other citizenships are not quite as useful. Iran, at the moment, is under a variety of international sanctions and this makes life more difficult for its citizens. An individual with Iranian and U.S. passports might find it prudent to hold onto the U.S. citizenship.
This benefit gap will continue as more countries aggressively improve their immigration policies to attract desirable immigrants. Also, economic development means that countries will improve and become more desirable to live in.
Finally, people must guess about the future. Political signals from the United States show that expatriation and tax policies are likely to get harsher.
- – There is a fear that the Reed Amendment will be enforced. This is a long-standing and unenforced law that permits the United States to bar re-entry to expatriates.
- – Senator Schumer’s recently-proposed (May, 2012) bill to exact a tax surcharge on expatriates is noticed by people considering this decision. This is a knee-jerk reaction to the Eduardo Saverin expatriation and is unlikely to be passed, but the mere occurrence of these stunts gives the appearance of less stability in U.S. tax policy and encourages expatriation sooner rather than later.
- – The increased tax reporting requirements (Form 8938, FATCA), coupled with Senator Reid’s proposal to give the IRS power to suspend a citizen’s passport if there is a suspected tax liability causes people to fear whether they might be prevented from leaving the United States at some point in the future.
The cost of expatriation now is less than the expected future cost of expatriation. Better to take the medicine now rather than later.
Benefits of retaining U.S. citizenship
A one-sided look at the costs of citizenship is incomplete. There are substantial benefits to being a U.S. citizen.
In theory, if you get in the right kind of trouble the big black helicopters will come to your rescue. On a more practical level, however, it is extremely easy to travel to almost any country you want. There is also the psychological feeling of belonging–you are a citizen of the most powerful nation on this (but not every) planet. It is a sense of belonging to a larger group, a larger culture. Citizenship defines your identity.
And of course if you want to live and in the United States, it is easily done. That your children will also be U.S. citizens is valuable, too.
These are the primary reasons given to me when I talk to people considering citizenship.
We hear frequent accusations that expatriates are unpatriotic or un-American. It is hard to understand the meaning behind the statement. It sounds suspiciously like Disagreement Hierarchy Zero name-calling to me. “U R unpatriotic!” does not engage the facts; it only hurls an epithet.
My experience is that expatriates generally feel no animosity to the United States (regardless of their opinions on U.S. politics and diplomacy), and in fact may have strong positive feelings about the United States and choose to terminate citizenship only reluctantly. However you choose to rank this on your personal patriotism scale is up to you.
More frequently, an accusation is leveled that expatriates do not want to “pay their fair share.” This is a more interesting statement, based in a concrete idea, and is worth considering. Given the financial state of the Federal government, people who pay tax are keenly interested in ensuring that everyone else does, too.
The idea is that all Americans should pay taxes to support the government, because each American receives a benefit from holding U.S. citizenship. The benefit may be large–direct support from the Federal government for health benefits, for instance. Or it may be small–each of us benefits from the Interstate highway system, but the marginal value of one mile of freeway in Wyoming is trifling to me.
I pay my taxes to keep the whole system in good repair, including that mile of Wyoming interstate. Somewhere in Wyoming is someone who could care less about one mile of I-210 Freeway by my house, but who nevertheless pays income tax, too. The system works pretty well.
Americans abroad are paying their “fair share” both in the United States and the country where they live. Someone living in Germany and paying German taxes is contributing to the society in which she lives, and from which she derives substantial benefits. If she is also an American citizen, she is probably contributing nothing to the U.S. Treasury in taxes, but is also not requesting or requiring significant services from the Federal government. Any significant draw on Federal resources would probably be tied to a return to the United States.
My would-be expatriate in Germany will not use the interstate in Wyoming or California, and should not contribute to it. Should she in fact use the freeways, she would be no different than a tourist, and there are plenty of ways a tourist contributes economically to a country she visits.
The “fair share” argument in fact would ask the would-be expatriate to pay more than her fair share (to the United States) because she would be paying taxes for which she will probably never derive any government services.
An American abroad who expatriates was contributing a “fair share” before expatriation–likely contributing little to the Treasury and extracting little in Federal services. Expatriates are not freeloaders.
Visible and hidden cost of expatriation
Creating the conditions for expatriation carries unfortunate costs to the United States. Some are visible and predictable. Some are invisible yet predictable. The Law of Unintended Consequences predicts that there are other results that will follow from expatriation that will have larger effects than the predictable–yet unintended by Congress–results.
The permanent loss of tax revenue and taxpayers is an obvious cost. Someone who terminates U.S. citizenship has permanently exited the U.S. tax system for all purposes. Given the way in which it is done, the person is unlikely to re-enter the United States, at least in any permanent manner.
Future income cannot possibly be taxed in the United States. Future investment preferences will probably favor non-U.S. investments, and of course the possibility of this person returning to the United States to work or start a business is negligible. Their wealth is permanently outside the scope of the U.S. estate and gift tax system. While these taxes bring in a surprisingly small percentage of the Federal government’s annual tax revenue, something is better than nothing. (I would argue that the estate and gift taxes are more convenient as political footballs than as revenue-raisers for the Federal government).
If the expatriates are working outside the United States, creating wealth, businesses, and jobs, this benefits the country where they live and benefits the United States not at all.
This brings up a perplexingly boneheaded aspect of the exit tax laws. Someone who expatriates and is a covered expatriate (too rich, remember?) cannot make a gift to U.S. persons, or leave an inheritance to her U.S. children, without a large tax being imposed on the recipient.
Put another way, the U.S. government actively discourages an expatriate’s capital from coming back to the United States by way of gift or inheritance by her U.S. children. Why should the covered expatriate leave money to her U.S. children if they must pay 35% of the inheritance as tax? Tax policy should not discourage capital inflows.
Expatriation causes a subtle goodwill loss to the United States. I travel extensively, in Asia and the Middle East as well as Europe. There is a great deal of affection for the United States in countries I visit, even places perceived as generally hostile to Americans in the U.S. media.
In no small part I attribute this to the positive effect of several million Americans living abroad. In their day-to-day lives they act as goodwill ambassadors for the United States. Why should tax policies encourage dual citizens to terminate their U.S. citizenship, and take one such goodwill ambassador out of service?
The exit tax rules are discouraging immigrants from making a commitment to the United States, I know (because I hear this from clients and counsel them to follow this path) that the possibility of the exit tax actively discourages promising individuals from seeking green cards.
If a person wants to enter the United States to live and work, I usually recommend looking at visas other than a green card. Someone living in the United States for 10 years on an L-1 visa can leave without an exit tax risk. That same person, holding a green card, would be subjected to the exit tax rules when he leaves. This is a perverse incentive.
In a subtle way, nonresident investors look at the tax climate and the hints of trends in politics and tax. They seem to be far more attuned to abrupt changes in the political climate than we are. Little things like the exit tax cause them to pause briefly when making investment decisions. At the margin I would guess that few people treat this as a definitive factor in making an investment. But it is counterproductive to send a signal to would-be immigrants or investors that causes them to pause and reconsider.
Predict the future
The way to learn is to take a position, explain why, and see the results. So I’m going out on a limb here to predict what will happen with expatriations.
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.
Change the future
There are three ways that tax policy could change to make expatriation less palatable.
Make expatriation more expensive
The first is to make the tax cost of terminating U.S. citizenship so confiscatory that it is out of the question. In its own small way, Carl Shumer is trying to do this by using Eduardo Saverin as an excuse to impose a 30% tax on all expatriates.
But then this makes the United States a financial jail. The word will get around. Money treats taxation as damage and routes around it. If the United States looks like a financial roach motel, capital will go elsewhere.
Another way to fix the system is to replace our current citizenship-based tax system (you are a citizen, so we tax you no matter where you live) with a territorial-based system (we tax you if you live in the United States).
We have the expatriation problem because the United States has an income tax policy based on citizenship: if you are a citizen, you must pay U.S. income tax no matter where you live in the world. And when you die, your assets are subjected to U.S. estate tax, no matter where you live and where your assets are.
The citizenship-based tax system is a system that the United States shares with only one other country–Eritrea..
All other countries have some variation on the territorial system of taxation. If you are citizen living in a country (and thus availing yourself of that country’s services, protection by its Army, etc.) you pay income tax. If you leave the country and live elsewhere, you do not pay income tax–you are no longer using government services.
This is unlikely to happen. It would require a fundamental re-engineering of the philosophy of the Internal Revenue Code by Congress and–more importantly–the boffins the Treasury Department who ultimately make things happen.
Make the cost of U.S. citizenship cheaper
There is a third possibility. A significant factor in the decisions made by people now to expatriate is the impact of the IRS’s pursuit of offshore bank account cases. In the name of treating all taxpayers equally (that’s justice to the IRS), the same penalties were meted out to grandmothers and millionaire tax evaders alike.
The fear factor deliberately cultivated by the IRS Commissioner is in my experience a major driver in people making the decision to expatriate. If the IRS could develop the sensibilities to distinguish between a granny and a tax cheat, and publicize this acquisition of nuance, this might take away the fear of massive penalties and tilt the cost/benefit decision of a would-be expatriate slightly in favor of keeping citizenship.
A calibrated enforcement policy would help. So would a simplification of the paperwork requirements (the $10,000 threshold for reporting foreign bank accounts was created in 1976, when that was Serious Money, or at least more serious than it is now). Actions taken that reduce the financial and perceived risk burden of remaining in the U.S. tax system would reduce the fear that drives people to opt out of U.S. citizenship.
For the would-be expatriate
Finally, for the person considering expatriation, what can I offer as suggestions?
The first comment is a metaphysical one. You are on the planet once. It’s only money. Do not damage your life based on a tax decision. This is truly a “your money or your life” question. If you’re grumpy about the money, re-organize your life so your U.S. income tax are brain-dead simple, do the paperwork, pay the tax, and have an adult beverage.
If you have decided that as a “live long and prosper” matter you want to terminate your U.S. citizenship, do it sooner than later. Do all of your tax paperwork exquisitely correctly, remembering that your primary objective is to completely terminate your status as a U.S. citizen and taxpayer. Do things right.
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.
For those of you who have only one passport–the U.S. one–you will need to acquire a second passport. Select a country that is stable, where your right to citizenship will not blow away after a change in government. Acquire that second citizenship correctly–avoid any hint of gray-zone behavior in the acquisition of citizenship. This would be an easy excuse to terminate your citizenship, leaving you stateless.
See also: Phil Hodgen – “Why people expatriate” – A Comment on his post – What about those who cannot certify 5 years of tax compliance?
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