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Your expatriation tax return when U.S. income is zero

We get questions. Some of them are answered on the weekly Expatriation Only email list (subscribe!). Here the email that went out on Tuesday. And a special thanks to reader R. W. who reminded me to get the email posted here on the blog.


Hi from Phil Hodgen.

You signed up for my “Expatriation Only” email list–every Tuesday you will get an email every week with a real question from a list subscriber and a real answer from me. Maybe there will be other emails, but they will only be from me, and only about expatriation-related topics.

If you want to stop getting these emails, just click on the link at the bottom of the email and you will be instantly unsubscribed.

If you want to ask a question, hit “reply” and send it to me. :-)

This Week

This week’s question asks about dual-status income tax returns.  The email list reader wants to know what the income tax return looks like for the year of expatriation:

I file the 1040 with other forms covering income up to the date of renunciation. Do I still have to file a 1040NR from the date of renunciation to the end of the year when I don’t have any US source income at all for either before or after renouncing?

Unfortunately, the final year income tax return form is a little more complicated than that.  It is semi-hard to figure out whether you file Form 1040NR or Form 1040 as your tax return.  Once you have figured that you, you have to figure out what income to put on the tax return, and what income to leave off.

Here is the short answer. In the year you expatriate, you must file an income tax return with the IRS. You will either file:

  • Form 1040 treating yourself as a resident for the full year;
  • Form 1040NR treating yourself as a nonresident for the full year; or
  • Form 1040NR treating yourself as a part-year resident and a part-year nonresident.

As the question notes, there are a bunch of other forms and schedules that are attached to the tax returns.  Don’t forget those.

If you are filing Form 1040NR, you only tell the IRS about income that is from U.S. sources.  Income you derive from foreign sources is not reported on the Form 1040NR, and is not taxed by the United States.

Now for the details.

Your Tax Year

You, as a human being, will report your income and compute your income tax on a yearly basis.  Almost every human uses the January 1 through December 31 time frame as the year for reporting income and computing income tax for the United States—resident and nonresident alike.  There are a few exceptions to this rule but let’s ignore them.

This means that when the IRS looks for your tax return for the year in which you renounce citizenship (or give up your green card) they will be looking for a tax return that covers the entire year.

It seems counterintuitive.  If you renounce your citizenship, that should cut off your tax filing requirements on that date.  Unfortunately, the answer to that is no.  All humans must use a full 12-month tax year (January 1 through December 31).  The only humans who can use a short year (January 1 through a date earlier than December 31) are dead people.  Their tax years end on the date of death.  

Your Tax Return (If You Must File)

The way to figure out which tax return you must file is partly straightforward and partly not.  You look at yourself on December 31—the last day of your tax year.  What are you on that date?  Well, you are no longer a U.S. citizen, so for income tax purposes you are an “alien”.  

Resident aliens are required to file Form 1040 and pay income tax on their worldwide income.  Nonresident aliens are required to file Form 1040NR, but only if they have income from U.S. sources (and sometimes not even then).

So you will need to figure out whether you are a “resident” or a “nonresident” of the United States for income tax purposes on December 31 of the year in which you expatriate.  This is unrelated to your immigration status as a resident or nonresident.

You will be a resident alien (and file Form 1040) if you spent too many days in the United States over the three year period ending with the year you renounced citizenship.  This is the substantial presence test.  Go look at IRS Publication 519 for more information.  If I write about it here you will receive a small book instead of a short email.  :-)

Note that it might be possible for you to be a resident alien (required to file Form 1040) and then convert yourself to nonresident alien status by making an election under an income tax treaty to be a resident of another country and a nonresident of the United States.  This is a complicated subject but I just want to bring your attention to it.

You will be a nonresident alien (and file Form 1040NR) if you did not spend enough days in the United States to satisfy the substantial presence test.

Not Splitting The Tax Year

If you file Form 1040NR because you make an election under the income tax treaty between the United States and your country of residence, you will be a nonresident of the United States for the entire year, and will compute your income tax as a nonresident of the United States.  

Generally, that means that the United States will only tax income you receive from U.S. sources.  Income you receive from foreign sources will not be taxed in the United States.  You will, however, be required to comply with all of the terrible, horrible, very bad, not good at all paperwork that American taxpayers must suffer through when they have contact with the outside world:  FBARs, Form 5471, Form 8938, and all the rest.

Splitting The Tax Year

If you file Form 1040NR and you do not spend enough time in the United States to be a resident under the substantial presence test, then you will be what the IRS calls a dual-status taxpayer.  For part of the year you were a full-blown U.S. taxpayer (because you held U.S. citizenship or you held a U.S. green card), and part of the year you were a full-blown nonresident alien, (almost) fully out of the U.S. tax system.

For the part of the year that you held the passport or green card, you were taxable on your worldwide income.  This is from January 1 through the day before your renunciation date.

For the part of the year starting with your renunciation date until December 31, you were a nonresident alien.  This means that you were only taxable by the IRS on income you received from U.S. sources.

You can see a discussion of this in IRS Publication 519, Chapter 6.

Answering the Question, Finally

So now I (finally) come to the point where I answer the question.  :-)

The reader had no income from U.S. sources.  At all.  All of her income was from sources outside the United States.  Here is how it works:

From January 1 through the day before renunciation, income received is reportable to and taxed by the U.S.  The fact that the income was from foreign sources is irrelevant.  The power to tax this income is based on the taxpayer’s status as a passport or green card holder.

From the date of renunciation until the end of the year, only income from U.S. sources is reported on Form 1040NR.  Since the reader had no income from U.S. sources—at all—the Form 1040NR will be reporting zero income for that time period.  Essentially, the Form 1040NR is only there as a carrying mechanism to transport the income information to the IRS for the time period of January 1 through the day before renunciation.  See IRS Publication 519 for how that’s done.

The Mechanics of the Dual-Status Tax Return

I will deal with the mechanics of how to fill in the Form 1040NR as a dual status return for another time.  We are busy preparing for the second session of the webinar we are doing for expatriates, and dual status tax returns will be part of this Friday’s session.  There is enough complexity here to make “the preparation of a dual-status income tax return” its own stand-alone webinar.

Disclaimer, Waiver, Warning Shot, Pre-emptive Strike, Etc.

Now of course is a prudent moment to remind you that this is not legal advice. Get competent advice from someone. Especially for dual-status tax return preparation. The IRS is all hand-wavy ‘n stuff about how to do it. Find someone experienced who can look at your situation and tell you exactly how to do it.

Next Week

Next Tuesday there will be another expatriation-related question and answer. Send yours in. Hit “Reply” and start typing. When you’re done, hit “Send”.

Phil.

Section 6039G and the quarterly list of expatriates

A recent comment asked a question that is worth answering here as a full blog post.  In the comment, the reader said:

You mention that “6039G is the infamous rule that triggers the quarterly publication of names of people who renounce U.S. citizenship”.

Aha! So the numbers that are oft-mentioned, such as 1,001 in 2014 Q1, are really only the ***covered expatriates**? Then surely, there must be an even greater number who expatriate by renouncing, but are not covered (such as the dual-citizen foreign-residing teenager entrepreneur), or who are relinquishing.

Is there any report or estimate of the number of people filing Form 8854 each year? Might the true number of people giving up US citizenship be hugely greater than is reported in the quarterly publication, perhaps more than 100,000 per year?

This is a really interesting question. What does Section 6039G really mean? Here is what the law says, at Section 6039G(a):

Notwithstanding any other provision of law, any individual to whom section 877(b) or 877A applies for any taxable year shall provide a statement for such taxable year which includes the information described in subsection (b).

So what does it mean to say you are an individual to whom Section 877A “applies”? Does it mean that Section 877A only applies to you if you must pay the exit tax imposed by Section 877A? If so, then Section 877A only applies to “covered expatriates” and if you are not a “covered expatriate” then we have an interesting possibility: Section 6039G doesn’t apply to you because it is triggered only by Section 877A being applicable to you. I don’t know the answer to that, but I suspect that the U.S. government would strongly argue to the contrary. The IRS eats paper and if they don’t get all the paper in the world they get hungry and grumpy. :-)

But I digress.

The specific information-reporting requirement is found in the flush language at the end of Section 6039G(d):

Notwithstanding any other provision of law, not later than 30 days after the close of each calendar quarter, the Secretary shall publish in the Federal Register the name of each individual losing United States citizenship (within the meaning of section 877 (a) or 877A) with respect to whom the Secretary receives information under the preceding sentence during such quarter.

The “notwithstanding any other provision of law” language is the lazy Congressional staffer’s preferred method of writing laws. “I am too lazy to go and look to see if what I am doing is in conflict with other provisions of the law, so I am just throwing down this card and declaring it to be the ace of trump.” (Interesting question: what happens when two “notwithstanding any other provision of law” sentenced collide? Irresistible force meets immovable object. Let’s leave that for law school professors. How many angels can dance on the head of a pin?)

But I re-digress. Your question can be answered without medieval metaphysics.

The reporting requirement simply says “look at all of the people who lost citizenship as defined in Section 877 and 877A and publish a list of them.” It does not tie this reporting requirement to covered expatriate status.

Presumably this also includes long-term residents who abandon their green cards. I will pull out the lazy blogger card and throw it down, declaring that I am too lazy to follow the logic trail in Section 877A that says “long-term residents giving up green cards are the same as U.S. citizens giving up citizenship.” Yes, I self-declare as lazy. :-)

I too have heard that the list published quarterly is woefully incomplete. Let us say this is true. What is the reason? I am inclined to follow Hanlon’s Razor: “Never attribute to malice that which is adequately explained by stupidity.” Bureaucracy is an exercise in subtractive intelligence. Two heads are not better than one for government work, because the brains involved are pulling in different directions.

The IRS should be following the requirements of Section 6039G(d). It should be publishing an accurate quarterly list of people who relinquish U.S. citizenship or who abandon their long-term resident status.

Invoking Hanlon’s Razor, we can explain possible *ahem* discontinuities in the quarterly expatriate list reporting by the failures of bureaucracy.

Or, invoking Robert Heinlein’s variant — “Never attribute to malice that which can be adequately explained by stupidity, but don’t rule out malice” — we might take a look at the Lois Lerner show. And how the IRS has had stunningly convenient and well-targeted IT system failures to protect itself against claims that the Service has morphed into a political tool rather than the even-handed collector of tax revenue for the Federal Government that it once was.

Valuation date for expatriate’s balance sheet

The Internal Revenue Code contains unnecessary complexity, which — if you are not careful — can trip you up. Here is one such item, triggered by an email from reader G.  My “off the cuff” answer to him was wrong.  Here is the right answer.

The moral of this story is: always look at the law before answering a question. :-)

The problem

When someone renounces U.S. citizenship, the law requires them to (among other things) give the U.S. government a balance sheet showing assets and liabilities. You’re taking a snapshot of your financial situation.  The question is at what moment in time you take that snapshot?

The exit tax rules have two different “moments in time” built into the law. Remembering which moment matters is the problem.

Section 6039G: Useless

The Instructions to Form 8854 tell you that the balance sheet information is required under Internal Revenue Code Section 6039G.  Let’s start there.

Section 6039G is the infamous rule that triggers the quarterly publication of names of people who renounce U.S. citizenship. In addition to requiring the publication of this list, it also specifies information that must be provided by people terminating their U.S. citizenship.

One of those items required? A balance sheet.  Specifically, the taxpayer is required to provide:

information detailing the income, assets, and liabilities of such individual[.]

See Section 6039G(b)(5).

Section 6039G does not specify the effective date for when you should take a snapshot of your income, assets, and liabilities. Let us now go in search of something specific, elsewhere in the Internal Revenue Code.

Balance Sheet: The Day You Renounce

For purposes of filling in the balance sheet on Form 8854, the values of your assets and liabilities must be computed as of the day you renounce your citizenship.

Section 877A(g)(1)(A) says you are a “covered expatriate” if you satisfy one of the tests in Section 877(a)(2).

Section 877(a)(2)(B) is one of the three tests found at Section 877(a)(2).  It is the net worth test.  After you parse through the clumsy cross-referencing from Section 877A to Section 877, it says that someone is a covered expatriate if:

the net worth of the individual as of such date is $2,000,000 or more[.]

In order to figure out what they mean by “such date”, we have to look at the paragraph immediately above Section 877(a)(2)(B).  This is where the Internal Revenue Code defines the net income tax test for expatriation purposes, and the paragraph refers to a time period that ends before a specific date: 

the date of loss of United States citizenship[.]

Since Section 877(a)(2) is written as one giant, clumsy, convoluted sentence broken up into bits and pieces, my 6th Grade grammar says that the reference to “such date” should logically refer to the immediately preceding definition of a date in the long, convoluted sentence.

Therefore I conclude that the the Internal Revenue Code asks you to determine your net worth as of the date that you lose your U.S. citizenship.

This is consistent with the Instructions to Form 8854.  You are told to use values as of your expatriation date:

List in U.S. dollars the fair market value (column (a)) and the U.S. adjusted basis (column (b)) of your assets and liabilities as of . . . [y]our expatriation date if you expatriated on or after June 17, 2008.

Confusion:  Mark to Market Date

The confusion comes in when you look at the “mark-to-market” rules.  These are the rules that apply to covered expatriates. The mark-to-market rules pretend that you sold everything you own on the day before your expatriation date:

All property of a covered expatriate shall be treated as sold on the day before the expatriation date for its fair market value.

There are similar rules for deferred compensation, specified tax deferred accounts, and interests in trusts.  For computing your exit tax, Section 877A pretends that certain events occur on the day before your expatriation date.  This, after all, is the very last day on which you are a full-blown U.S. taxpayer, subject to all of the tax rules.

Not Much Difference

There’s not much difference, really.  The only people who might conceivably care about the difference (“Do I use values on the expatriation date or the day before?”) are those who are really, really close to the $2,000,000 net worth threshold for becoming a covered expatriate, and who own highly volatile assets.

I personally wouldn’t cut things that close.  If your status as a covered expatriate depends on the markets — you’re heavily invested in futures or commodities, for instance — then I think the prudent thing to do is to cash out, expatriate, then re-enter the market.  Why allow outside forces to dictate whether you become a covered expatriate?

Renunciation Interviews Not So Intense

The State Department justifies the new $2,350 user fee for renunciation by saying “Hey, it’s a lotta work. It’s intense. You have to pay me more.” Here is a recent email I received from someone who just went through the process in London. This person was underwhelmed by the State Department’s “intense” interviews:

I had my renunciation interview on 14 August, at which time they took $450 off me. When I applied for this interview no mention was made of the planned increase in charges, which could have meant, should my interview have been delayed by 3 weeks, that the fee would have been five times as much. (Even though I am now retired, and have never earned a salary which attracted tax, I am confident that renunciation would be financially worth while within a few years, even at the higher cost, thanks to the expense of preparing US tax forms and the opportunity cost of foregoing tax efficient investments in the UK.)

Emphasis added. My correspondent understands something that the IRS and State Department have yet to grasp. The email continues:

Also, despite what the State Department says, I did not have “two intensive interviews”, unless two interviews at a window open to view of all waiting in the Passport Section at the London Embassy count. These were to make sure, first, that everything was correct on the (many) forms I had sent in, and, second, that I understood the seriousness of the step I was taking and finally to swear/affirm my renunciation. I thought it was all rather less intensive than it should have been, considering the seriousness with which I had approached it.

Toronto Consulate Wait Times Have Ballooned

An email from Tim S. alerted me to an interesting article by Patrick Cain about getting the difficulty of getting an appointment for expatriation in Canada

Patrick reports that wait times at the Toronto consulate have ballooned.  Here we are in August, 2014.  The earliest date that can be booked in Toronto is January 22, 2015.

Reason #1: FATCA

While the article does not explicitly say so, it appears that expatriation has become more popular since the FATCA agreement between Canada and the United States was implemented on July 1.

The FATCA rules are designed to use foreign banks to rat out U.S. taxpayers to the IRS. Foreign banks face severe penalties if they do not play along with the U.S. government and set in place reporting mechanisms designed to identify their U.S. customers.

This means that sooner or later every U.S. person will get a letter from his or her bank asking the simple question: “are you a U.S. taxpayer?” If the answer is “Yes,” there will be one of two responses from the bank:

  • “Thank you for your answer, and we’re closing your account because we don’t want to spend $10 million upgrading our IT systems just to make a foreign government happy. You’re not a profitable customer; go away.”
  • “Thank you for your answer, and while we’re happy to keep you as a customer, we’re telling the U.S. government about you. (Oh by the way, there may be some increased bank fees in your future.)”

I predict that for Americans abroad their banking choices will become more and more limited. Eventually only the juggernaut multi-national banks will be willing to work with them–the Citibanks, the HSBCs, etc. Smaller banks will simply close their doors to Americans because the compliance costs are too high.

This is something I have seen here in the United States. I recall calling the President of a bank that specializes in banking for mid-sized privately-held businesses only. I have known him for 25 years. I had a foreign client establishing business operations in the United States. He rejected the business because it would require hiring more and new compliance officers. Interesting tidbit: he figured one compliance officer adds $250,000 per year of cost. Thank you Uncle Sam for making everyday life difficult.

Reason #2: Tax Returns Are Expensive

But FATCA is just pushing everyone to wake up to the primary disincentive for holding a U.S. passport: citizenship-based tax rules. If you are a U.S. citizen, you are required to file U.S. income tax returns every year and comply with a (potty-mouth word)-load of bizarre paperwork. This adds enormous complexity and cost to a regular person’s life. Preparing U.S. tax returns is not cheap.  From TFA: 

Until recently, appointments to renounce U.S. citizenship in Toronto could be made within three to six weeks, said Toronto-based cross-border tax accountant Kevyn Nightingale, who specializes in tax advice for people giving up U.S. citizenship.

His clients are driven to divorce Uncle Sam less because of actual U.S. taxes and more because of the costly demands of the tax bureaucracy, he says:

“Almost none of them have to pay any tax – it’s just the hassle and expense of dealing with the paperwork.”

Nightingale says he charges $1,000-$1,500 for “very simple” U.S. returns.

[Note: hyperlink to Kevyn's profile at MNP added by me; it was not in the original article. MNP is a very good cross-border accounting firm.]

What the article doesn’t say: for the Canadians that Kevyn is helping, there is probably a “zero payment due” tax bill from Uncle Sam on that U.S. income tax return.

Think of it. You pay $1,000 – $1,500 for accounting fees and Uncle Sam collects no revenue. Wouldn’t that annoy you just a tiny bit?

Reason #3: The Price of Salvation

The annual upkeep cost of filing U.S. tax paperwork is one thing.

What about those U.S. taxpayers living abroad and faithfully paying tax in their home country who suddenly find out that in some way or another they have run afoul of Uncle Sam’s weird paperwork rules? They face a Pain Factory: massive penalty risks or high professional fees to fix the problem. Or something both.

Yesterday I talked to a guy who had rental income from property outside the United States. He faithfully reported all of the income on his U.S. tax returns, but missed a couple of key pieces of paper that should have been filed. His penalty risks, at my guess, exceed $100,000.

Yes, there are IRS procedures to fix these situations. And yes, he probably–if he files all of the paperwork–will have zero penalties. But the cost of doing so (in professional fees) is likely to be in the $25,000 – $30,000 range.

This is insane.

The article mentions this point as well. Another quote from Kevyn Nightingale in the article:

“If somebody comes to us and says, ‘I’m a U.S. citizen, I’ve never filed tax returns, I’ve got a pretty ordinary life, but I’ve got an RRSP, an RESP, a TFSA and some mutual funds, and can you prepare all my returns and get me ready for expatriation?’, by the time we do all that, it’s not hard to spend $15,000 or $20,000 for a fairly ordinary person.”

This is a fair estimate. The particularly galling part of the expense is driven by mutual funds. It bugs everyone in our office more than anything else.

Buying mutual funds is a normal and recommended way to invest. But foreign mutual funds must be reported on Form 8621 and are taxed as Passive Foreign Investment Companies. The work needed to satisfy these requirements is staggering, driving professional fees through the roof. It’s simply unacceptable for ordinary people living ordinary lives.

The beatings will continue until morale improves.

When we tell people about the tax risks they face because of inadvertent paperwork failures in the past–and the cost to reduce or eliminate the risk–the response is often “How can I get away quickly, quietly, and permanently from this burden?”

The Backlog Solution

Many of you will want to renounce your U.S. citizenship before year-end. You can go anywhere in the world to do it. Start calling Consulates and Embassies to see what the wait time is.

Our experience is that the Caribbean and Central American countries are often good. Southeast Asia seems to be good as well.

Very Interesting: Back to One Appointment?

One of the interesting items in the article–by far the most interesting for me, in fact–is the transition back to a one-appointment expatriation process in Toronto.

When I started doing this work, renunciation required one appointment. Show up, do the paperwork, swear a mighty oath, and you were done.

Then the State Department started requiring two appointments. You had to show up, get lectured about the perils of renunciation, then go away and think for a while. Then you’d go back for a second appointment where they would take care of business. And maybe lecture you a bit more.

Forgive me for the analogy, but it’s almost like the State Department looked at the anti-abortion people who wanted to have a system where if you want an abortion you have to go in for a doctor’s appointment then go away to consider your choice before you can have the procedure. It is psychological warfare to tip the results in your favor.

But Toronto? The article says they are back to a one-appointment process, apparently in self-defense because they have so many expatriation appointments to process.

I hope this rolls out through the rest of the system. The two appointment requirement is silly and counterproductive for the government and the would-be expatriate.