Analyzing your Tax Situation if You Expatriate
We've put together some general considerations that can help you analyze your situation. Everyone's situation is clearly different, but these are what we'd consider useful starting points. Some are obvious, others not so.
You can jump straight to a section by clicking on a link below, or just scroll down through the page to read them one after another.
- Hoping the system will change isn't the answer. Neither is dropping off the radar.
- Do you need a tax professional?
- How much time you can spend in the U.S. after expatriation and still be taxed as a non-resident
- Figuring if the U.S. burden increases your total tax on earned income
- Investment income
- Future changes in your life
- Retirement, savings, and tax
- Changes in tax codes
- Inheritance issues: spouse and/or heir(s) not U.S. citizen(s)
- Inheritance issues: spouse and/or heir(s) U.S. citizen(s)
- Inheritance issues: receiving an inheritance from a U.S. citizen
- Considering the "deemed sale" of the exit tax
Hoping the system will change isn't the answer. Neither is dropping off the radar.
Despite the hopes of many people who find themselves forced to consider expatriating, the reality is that U.S. citizenship-based taxation is not going to change. If anything, the tax burden for overseas citizens will most likely only increase, along with the reporting requirements, restrictions, and regulations.
There is no reason for Congress to ever surrender the tax revenue from citizens abroad. Overseas citizens are an extremely convenient target: they have little political power, they generally don't vote (and even when they do, their votes are not aggregated in one district/state but are instead scattered around the country), and they can be easily caricatured as rich tycoons sipping piña-coladas on the beach.
Simply ignoring their U.S. tax obligation has worked for many people until now, but international information-sharing, more effective tracking systems and massively increasing IRS resources devoted to overseas compliance are combining to make it much more difficult to successfully "disappear off the radar".
For us, the bottom line is: if you want to keep your citizenship, then you have to pay taxes and comply with all the regulations. If not, you should renounce.
Do you need a tax professional?
If you navigated to this site and are reading this, then we'd bet that you have the ability to understand all the tax issues. Good summaries and explanations about expatriation are hard to find on the internet, but the codes and laws themselves are available online. Finding the information can be difficult at times, but the list of resources we put together here will help you get started and save you enormous amounts of time.
Also, it's important to realize that you're probably affected by only a limited number of tax regulations. Tax codes in many countries - and especially in the U.S. - are huge, but fortunately the parts relevant to any one person are fairly manageable. Each person has their individual items that need to be researched, but very few people have such a wide variety of income and assets that they need to deal with so many different issues.
We feel that by investigating and understanding all the tax regulations yourself, you'll do yourself a favor in the long run. No one knows your situation better than you, and no one cares about it more than you, so if you learn the information yourself, you'll be the one who can do the best job for yourself.
On the other hand, learning about tax means you have to spend enormous amounts of time to research all the details, all the most-recent changes, all the subtleties of the ways different tax regulations interact with each other. And your time is important; it could be a lot more valuable to spend that time doing something else more productive or enjoyable.
Also, when dealing with renunciation tax law specifically, and international tax law in general, there are lots of gray areas that are not clear. Issues that we've come across that are especially confusing when considering U.S. expatriation are: inheritance/estate tax, particularly if you have property in U.S. at the time of death; tax on trusts; tax on a business you own with operations in several countries.
And the interaction of U.S. tax law with the tax law of your country of residence could be particularly tricky. No tax law addresses every situation, and even the best explanations from the tax agencies cannot answer every specific situation that you could find yourself in. It can be helpful to have the guidance of someone who has been through it before; he won't be smarter than you or have greater ability, but his previous experience could save you time and (possibly) money. And if your tax issues are particularly varied or unusual, he might be able to draw for help on the specialized knowledge of a network of colleagues.
So if you don't want to make the huge time investment to run through the scenarios, or you don't feel comfortable navigating through murky international tax regulations on your own, then work with a tax professional. Depending where you live, you might need to work with more than one pereson, because you'll be dealing with the tax code of the U.S. plus your country(ies). In most major countries, though, there are tax pros who specialize in U.S. expatriate's tax, so one pro might be enough.
If you decide to work with a tax pro, our recommendation is to learn as much as you can on your own before meeting.
Your knowledge will help you make better use of the tax pro's skills and experience. The advantage of working with a professional is the previous experience and knowledge that he brings to your case, so your research will also help you to test him on it beforehand to see what he knows. The reality is that the field of expatriate tax seems to attract a lot of under-qualified types, and it's silly to pay him if he's learning on the job and on your time. Prepare a list of detailed questions about the tax law of the U.S. and your country of residence, about the existing tax treaties, and about the tax effects of U.S. expatriation on both your U.S. taxes and your non-U.S. taxes. The tax information on this site is fairly basic but should give you a good starting point for your questions. Any tax professional should know significantly more about these issues than what's on this site; if he doesn't, our opinion is that he's not worth your time or money.
How much time you can spend in the U.S. after expatriation and still be taxed as a non-resident
Regarding U.S. taxes, you will be treated as any other citizen of your country in almost all respects. Assuming you live outside the U.S. and don't have a green card, you will be taxed as a non-resident non-citizen on any U.S. source earnings, allowing you to benefit from no taxes on interest and capital gains.
However, you will be treated as resident for tax purposes if you spend enough time in the U.S. (including U.S. territorial waters) to meet the "substantial physical presence" test, defined as spending:
- At least 31 days in the current year
- At least 183 days during the 3 year period that includes the current year and the previous 2 years, where you count all of the days you spend in the U.S. in the current year, 1/3 of the days you spent in the previous year, and 1/6 of the days you spent in the second year before the current year.
In essence, under the the "substantial physical presence test", you can spend an average of up to 4 months each year in the U.S. and not be resident for tax purposes.
Note that because of the different weights used to count days in each year, there are several permutations of time spent in the U.S. that are possible. For example, you could spend 180 days in year 1, 120 days in year 2, and 110 days in year 3, and still not be considered resident in any of those years.
Figuring if the U.S. burden increases your total tax on earned income
As a U.S. citizen, you're subject to taxes on your foreign earnings, but you're allowed to take a credit for (most) taxes paid to a foreign government. Assuming you live outside the U.S., you're also allowed to exclude the first $92,900 (as of 2011) in earned income from U.S. taxes.
So the total tax you pay to all countries on earned income (i.e., income from work as opposed to income from investments) will depend on how much you make and what tax rate your country of residence imposes. How the total tax on your earnings would be affected by renunciation of U.S. citizenship will depend on this combination.
In considering how renunciation will affect the total tax you pay on earnings, you have to evaluate both the tax rates in your country of residence relative to U.S. rates, and your earned income relative to the U.S. foreign earned income exclusion.
So what's this mean in practice? The devil is in the details, but we can make some generalizations:
If you live in a country with higher tax rates than the U.S., your total taxes are probably not higher because of the U.S. tax burden.
And even if your country of residence has lower taxes than the U.S. but your income is lower than $92,900, then the total taxes on your earned income probably aren't higher due to the U.S. obligation.
But if you live in a country with lower taxes than the U.S. and your earnings income is above the $92,900 limit, the total tax on your earned income is probably higher because of the U.S. tax burden.
Note that these are very big generalizations, and the details can sometimes dramatically change the conclusion. For example, definitions of income categories and types of taxes often do not match between the U.S. and other countries. In these situations, you could end up paying the higher of both rates in all situations AND be double-taxed in situations where the U.S. does not consider the foreign tax you pay to be creditable. We've seen some pretty unappealing results in specific cases, so it's definitely worth looking into the details of the interaction of U.S. tax law with that of your country of residence.
The way you earn your income is also important to consider when analyzing renunciation:
If capital investment is an important part of producing your income, no more than 30% of your income can be counted as earned income and benefit from the exclusion. The rest is treated as investment income and fully taxed by the U.S.
This can have a dramatic effect for many individuals who are self-employed, invest their own money professionally, own and operate a business in which they invested money, have stakes in partnerships, etc. In essence, 70% of the income you earn from these activities is considered investment income and cannot be excluded, regardless of how much time you spend doing your activity. Many U.S. citizens working overseas are trapped by this and are subject to full taxation by both their country of residence and by the U.S.
Renunciation in these situations will very likely reduce your total tax burden.
Depending on your situation, this can have a significant effect on your total tax burden. Take the example of a retired man living in a country that does not tax investment income. With no wage earnings, he doesn't qualify for the foreign earned income exclusion, and he is fully taxed by the U.S. for all his earnings. If he were to renounce U.S. citizenship, his total tax burden would be zero.
Another consideration is whether you make numerous investments in the U.S. In particular, whether you will in the future make numerous investments in the U.S. As we discussed here, the U.S. is a tax haven for non-resident non-citizen investors: most interest and capital gains are not taxed. If you expatriate, you will enjoy these tax-free investments as well.
[Remember that depending on your situation, you might have to pay the mark-to-market exit tax on the unrealized gain on all your assets at renunciation. But you have to meet the economic threshold tests, and even if you do, you still have an exclusion of $627,000 (as of 2010), so it's possible that you might have to pay nothing. See here for details.]
Future changes in your life
Renunciation is not just for a year or two; it's a final, irrevocable lifetime decision. So as you consider the tax impact of renunciation, you have to think about the future of both your financial situation and the tax codes of different countries.
Think about your income. How will your earnings change? How will the ratio between your wage earnings and investment earnings change? When will you retire, and how will that affect your financial profile? All these issues could affect the tax impact of renunciation.
Think about where you'll live. If you plan to live and work in only one country for the rest of your life, then you only have to consider that country's tax system relative to the U.S. But if you move often between countries, or if you think you might ever move countries, then it's worth considering both the current and possible future rates in different places. Tax codes vary enormously and countries compete with their rates, so you can always find countries with systems which are more advantageous for you, but few people make their decision of where to live based solely on tax. Planning far into the future is difficult, but even your best guess can help guide you in your analysis.
Retirement, savings, and tax
Imagine that after retirement, you live primarily on the income from your investments, savings and pension/retirement receipts. As you will not be able to exclude any of this income from your U.S. taxes, you will be fully taxed by the U.S. on all your income. If you will retire in a country that has similar or higher tax rates than the U.S., it might make little difference. But if you plan to retire in a country with lower or no taxes, then your annual taxes would be significantly lower if you expatriate.
On the other hand, if you qualify as a "deemed expatriate" under the exit tax rules, and you have more than $627,000 (as of 2010) in unrealized profits, then you will have to pay the mark-to-market expatriation tax and any savings from lower future annual taxes might be negated. It all depends on your individual circumstances.
It's also important to consider that even many high-tax countries do not tax investment income, earnings from savings or capital gains. Belgium and New Zealand, for example, have marginal tax rates for earned income that are generally higher than the U.S., but have no capital gains taxes at all. If you live in such a country, and capital appreciation is or will be a a major source of your income, then expatriation could significantly lower your taxes.
The interplay of different tax regimes on retirement distributions could also affect your decision about renunciation.
Payments from any private pension funds or retirement plans are fully taxed by the U.S.: they're considered investment income and can't be shielded with the foreign earned income exclusion.
An additional complication is that any benefits you may be entitled to from U.S. Social Security will be reduced by any payments you get from a foreign public retirement plan. Renunciation of citizenship would eliminate the U.S. tax obligation and reduce your taxes in most of these cases.
Additionally, although foreign taxes you pay on your pension receipts can often be used as a credit in calculating your U.S. taxes, there are still quite a few taxes you might have to pay in your country of residence which are not creditable. The result is guaranteed double taxation. There have proposals to correct this situation, but reducing revenue in order to benefit retired Americans overseas has not been a Congressional priority. Renunciation of citizenship in these cases would eliminate the double taxation.
Another issue to consider is where you invest. Many countries have high taxes on domestic investments, but do not tax investments abroad. As it's increasingly common to live in one country and invest in others, this can have a big impact on your after-tax income. As an example, if you live in such a country but all your investments are made in other countries, then you would not have to pay any tax where you reside. Nonetheless, as a U.S. citizen, you would be liable for U.S. taxes on your income despite the favorable tax laws of your country of residence. In this case, expatriation could significantly lower your taxes.
Finally, it's important to note that while residing overseas, you will not benefit from Medicare, regardless of how much you have contributed to it in the past.
Medicare benefits, the federal health insurance program for people 65 and over or disabled, are limited to the U.S. Note that this is regardless of whether you have or do not have U.S. citizenship.
Citizens overseas generally receive no benefits outside the U.S. from the program. Part A coverage is free but services can only be provided within the U.S. For Part B coverage, you have to pay a monthly premium, but even if you're paying the premium, the services are limited to within the U.S. Part D coverage, the prescription-drug benefit, is also limited to within the U.S. Groups representing retired Americans overseas have lobbied extensively for years to allow Medicare benefits for citizens abroad, but to date Congress has never acted.
Note that renunciation does not affect your eligibility for Social Security and Medicare. You are still eligible for full benefits of both after your renunciation. [As noted above, Medicare does not cover outside the U.S., so you'd have to travel to the U.S. to receive Medicare services, but this is the same for a citizen as for someone who's renounced].
Changes in tax codes
Regarding the U.S. tax system, it's worth considering that benefits for U.S.-citizens abroad are constantly being eroded.
A large change in 2006 already hurt overseas taxpayers, and the trend seems to be even for even reduced benefits. Despite the hopes of Americans overseas groups, it appears very unlikely that the foreign earned income exclusion will be made unlimited, i.e. allow you to exclude all income earned overseas from your U.S. taxes. A bill was introduced by Senator DeMint (Rep., S.C.) and Rep. Meeks (Dem., N.Y.) to this effect in 2007, but got no support and died; the same legistlation was introduced in 2009 (only by Rep. Meeks this time), and has similarly gotten nowhere.
On the other hand, the calls in Congress to reduce or even eliminate the foreign earned income exclusion are particularly noteworthy. In 2003, legislation to eliminate the exclusion - and thereby subject all income earned overseas to U.S. tax - was not only proposed, but actually was passed by the U.S. House as a way to partially fund an unrelated tax cut bill. Last minute maneuvering removed the elimination of the exclusion from the bill that was sent to the White House and which became law. Although the many lawmakers opposed to any exclusion for foreign income did not succeed in eliminating it, they did later manage to add to the TIPRA law (passed in 2005, effective in 2006) provisions which significantly reduced the tax benefits received by U.S. overseas citizens (see here for full discussion of how it worsened for overseas citizens).
We think it quite likely that the trend will continue: tax benefits given to U.S. citizens overseas will continue to be reduced or eliminated outright.
What tax law changes do you think are likely in the U.S.?
Another very obvious change that could impact many U.S.-citizens living outside the U.S. is the burden of ever-increasing reporting requirements. Reports of foreign accounts, calculations of paper profits from foreign exchange gains, tax years that do not match, etc: if you do taxes for the U.S. and another country, you know what a time-consuming and expensive hassle all the paperwork already can be.
The reporting burden of U.S.-citizens overseas has already increased over the last few years, and all signs from the U.S. government are that it will significantly increase even more over the next 2-3 years.
This is a real cost. We know of several families who own small businesses for whom the administrative burden of dealing with the IRS in addition to the tax authorities of where they reside was one of the factors which contributed to their renunciation.
In addition to changes in U.S. tax law, you also have to consider where you live. What changes are likely in your country(ies) of residence?
Inheritance issues: spouse and/or heir(s) not U.S. citizen(s)
In fact, this is one of the bigger reasons behind several expatriations which we know of. As a U.S. citizen, you cannot transfer property tax-free to your non-U.S. spouse. There have been numerous complaints about this made by affected individuals, but we see no chance that this rule will ever change. Transfers to a citizen-spouse are allowed tax-free because the U.S. considers that it will eventually get a chance to tax the assets (presumably, when the citizen-spouse sells the assets or dies). But transfers to a non-citizen spouse effectively put the assets permanently out of the reach of U.S. taxation, so the U.S. wants to tax them before they "escape".
In contrast, as a non-U.S. citizen, your assets outside the U.S. will not be subject to U.S. estate taxes, and your spouse will not face any gift taxes. Note that this advantage doesn't depend on what your non-U.S. nationality is or where you live; as far as we know, there is no permutation of possible residency and citizenships worldwide where it would be better to have not renounced U.S. citizenship in this situation (if anyone does know of an example, please let us know).
For the same reasons, it's also similarly advantageous to have expatriated if your heir(s) is/are non-U.S. citizens.
Inheritance issues: spouse and/or heir(s) U.S. citizen(s)
If you are a U.S. citizen, you may transfer unlimited property to your U.S.-citizen spouse upon your death free of U.S. taxes.
If you renounce citizenship, then as a non-resident non-U.S. citizen, you should still be able to transfer property free of U.S. estate taxes upon death to your U.S.-citizen spouse. However, due to the 2008 exit tax law, your spouse will have to pay a 35% tax on everything received from you above the gift exemption limit (currently $13,000) because you renounced U.S. citizenship.
If you and your spouse were to both renounce U.S. citizenship, then you would be able to pass him/her unlimited non-U.S. assets at any time free of all U.S. taxes.
U.S.-based assets, including U.S. stocks and U.S. real estate, are a different story.
The U.S. assets of non-resident non-citizens are subject to the U.S. estate tax and only the first $60,000 (as of 2009) is exempt. If you have renounced and then pass these U.S. assets to a U.S.-citizen spouse, you avoid the estate tax because you're allowed unlimited transfers to your U.S.-citizen spouse. However, your spouse will presumably have to pay the tax dictated by the gift-tax provision of the exit tax. (This issue is still murky, and no IRS guidelines have clearly said what happens in this situation. We assume the worst; as in most things related to tax, it's the safest bet).
If you give your U.S.-assets to anyone other than a U.S.-citizen spouse, then he/she will face the U.S. estate tax (although if the recipient is a U.S. citizen, he/she is exempted from paying the gift tax due to the fact that your estate already has paid an estate tax). Many expatriates aren't affected by this provision because they have few assets in the U.S., but if you do, we recommend investigating in detail because the issue is still unclear and could vary significantly based on your individual circumstances.
Be sure to confirm your residency status, because U.S. residency status for estate tax is figured differently than for income tax. For example, you could be a resident alien for income tax, but a non-resident for estate tax.
Inheritance issues: receiving an inheritance from a U.S. citizenThere's a different point to consider if you are a U.S. citizen and expecting an inheritance from another U.S. citizen. Under current U.S. law, inherited assets will step up their basis; in other words, the market price of the assets when you receive them in the inheritance will be considered to be your cost.
Thus, if you are considering expatriation, you have incentive to wait until immediately after receiving the inheritance to renounce citizenship. The estate will be taxed at the estate tax rate, but will benefit from the $5 million (as of 2011) exemption. At your expatriation, your net gain will be zero and you will pay no tax under the deemed sale. Note that the status of this step up in basis is tied to estate tax rules which could potentially expire and change based on the U.S. political situation at the end of 2012.
Considering the "deemed sale" of the exit tax
If your net worth is under $2 million and your average tax liability for the 5 years prior to your expatriation is under $145,000, then the exit tax doesn't apply to you and you can simply ignore it. Your tax obligations end on the day you expatriate. [To be precise, you still have to file Form 8854 to the IRS, but only to certify that the tax does not apply to you].
Or if you received dual citizenship of the U.S. and some other country at birth, if you continue to have the citizenship of that country, if you are taxed as a resident of that country, AND if you have been a resident of the U.S. for no more than 10 of the 15 years prior to renouncing U.S. citizenship, then you're also exempted from the exit tax, regardless of your net worth or level of income tax payments.
(Full details on who is covered by the exit tax here).
But if the exit tax applies to you, it could significantly affect your analysis. Some issues to consider:
The timing of your expatriation can be very important. Your assets will be valued as if they were sold on the day before your renunciation, so the prices on that day will determine the tax you pay.
For very illiquid assets, the exact day might make little difference. But for liquid assets such as stocks or commodity holdings or even certain real estate, there's enough daily volatility that your valuation - and thereby, the tax - might vary by several percent from one week to the next.
A major point to also consider if you have assets denominated in non-dollar currencies is the exchange rate. Your U.S. taxes will be based on the unrealized dollar gain. Given the dollar weakness over the last few years (last decade, actually), it's quite common that assets you own haven't appreciated much in value in the local currency, but show a gain of 20-50% when calculated in U.S. dollars.
You will be liable for tax on the dollar gain, even if the asset value hasn't moved in local currency.
In practice, this means you have to use both the exchange rate now and the exchange rate at the time of purchase in your calculations. You convert the purchase price into dollars at the then-prevailing exchange rate, convert the "deemed sale" price into dollars at the exchange rate of the day before your expatriation, then compare the difference to get your net gain or loss.
It can be a ridiculously complex task, particularly if you have many non-dollar assets purchased at different times. And given the steady weakness in the dollar over the last few years, the effect of this tax-code provision is quite likely to create phantom gains on which you will have to pay what are, unfortunately, very real taxes. As illogical as it is, this rule has been firmly settled for over a decade since a taxpayer challenged it up to the Court of Appeals and lost decisively. Even the Court acknowledged as "fair and reasonable" the taxpayer's argument that he had not realized any profit from dollar weakness, but ruled that a U.S. citizen must nonetheless use the U.S. dollar as his "functional currency" for all tax calculations (Quijano vs. United States, 1996). [If you used a local-currency mortgage to pay for a home, you could be particularly hard hit, as the taxpayer in that case was, by currencies moves in both directions: dollar weakness creates phantom dollar-gains on your house, which are taxable as capital gains, while dollar strength creates phantom dollar-gains on your mortgage, which are taxable as ordinary income].
For more discussion of taxes on these phantom gains you never receive and whether the absurdity will ever stop, see our discussion here.
[Note that it's possible that tax planning far enough in advance to create a qualified business unit (QBU) could partially mitigate this effect, but it can be difficult to meet the requirements. Moreover, it's very unclear if and how the exit tax would interact with the QBU. As of this writing, we have to assume that there would be no benefit].
Note that all these rules apply to any U.S. citizen: all citizens have to calculate their gains in dollars and pay taxes on the dollar income, even if it's a phantom gain that gave you no benefit. The only difference caused by renunciation is that as a covered expatriate, you must actually calculate and pay taxes as if you sold all your assets the day before renunciation. As a citizen, you pay the taxes when you actually do sell the assets.
If you are not covered by the exit tax (i.e., you're not a "covered expatriate", as described here), then renunciation effectively frees you from the tax burden caused by these foreign currency problems.
It's important to note that just as timing matters in the price of the asset, timing also matters in the exchange rate. You'll use the exchange rate on the day before your expatriation to calculate the dollar value of your assets. Exchange rates moves of 5-10% within a month are not unusual in the last few years for even the major currencies; this has a direct 1-to-1 impact on the valuation of your assets in dollars.
An obvious point is that you can't predict the movement of exchange rates, stocks, etc, so any day is as good as the next. This is clearly true. However, certain periods can be particularly advantageous. For example, we know several people who took advantage of the combination of low stock prices and rapid dollar appreciation in January-March 2009 to expatriate. Although they didn't know at the time how prices would move in the future, they did know that the unrealized dollar gains on their assets had dropped substantially when compared to just several months prior. In one case we know, the individual's unrealized gains in September 2008 would have been $1 million. Because of stock and dollar moves, his gains were slightly less than half that when calculated at his expatriation in March, 2009. The reduced net worth calculation put him under the $626,000 exemption and left him free from tax liability.
A different option to consider regarding the exit tax is the use of gifts before your expatriate to reduce your net worth. Under the December 2010 tax agreement between the President and Congress, each individual has a $5 million lifetime gift exemption. With proper planning, you can take advantage of gifting to reduce your exit tax liability, and possibly even lower your net worth below the threshold so that the exit tax no longer applies to you. [Note that both the estate/gift tax as well as the expatriation tax are highly politically contentious issues in the U.S. and could change at any time, so you should definitely confirm that the law which would apply to you is currently as we describe here].