Deliberately Choosing Covered Expatriate Status
I received a question from a reader that is worth discussing. Lightly edited to protect the innocent here is the question:
Describing an anonymous third-party friend here of course. [Of course. ] Dual US-Canadian citizen from birth, born in the US, lived a few years in the US in the 90s, filed tax returns those years only, then moved back to Canada. Recently discovered the whole tax and FBAR thing, far too stubborn to comply at this point.
To the question. If the net gain on all your assets was less than $650k (or whatever the limit is), could or should you renounce US citizenship, indicate that you were not tax compliant on form 8854, and enter the exit tax regime as a covered expatriate? Then you’d just have to do the exit declaration, at which you show net gains under the limit for taxation, rather than fuss about with five years of 1040s and FBARs and all that.
Or would this just piss off the powers-that-be? Fines aren’t collectible in Canada, so the risk is more travel inconvenience than financial penalty.
The Question is Really . . .
What the reader is asking is whether pursuing a strategy of deliberately declaring status as a covered expatriate will work.
Sheep and Goats
When you give up your U.S. citizenship the IRS categorizes you as a sheep or a goat.
You are a goat and condemned to hell if you are are rich (the definition is irrelevant for this question) or if you have not been faithful with your U.S. tax obligations (paperwork and payment of tax). The IRS is too polite to call you a goat, so they call you a “covered expatriate.”
If you are poor (again, we don’t care about what this means for the purpose of this blog post) and you have been faithfully filing tax returns and paying your U.S. taxes, then you are, to the IRS, a sheep. You are a mere “expatriate”.
“I Want to be a Goat”
In the scenario described above, the dual citizen is presumably does not meet the financial tests to become a covered expatriate. This means when he gives up his U.S. citizenship his status as “sheep or goat” (meaning “expatriate” or “covered expatriate”) turns on whether his U.S. tax paperwork and tax payments are up to date. Or not.
And here we are exploring a deliberate choice of NOT bringing all of the paperwork up to date, and NOT paying any U.S. income tax that is due.
If you want to see where this happens, look at page 1 of Form 8854, near the bottom, where the person signing the statement says under penalty of perjury that all of the tax obligations for the last five years (Title 26 is the part of the United States Code having to do with taxes) are up to date and paid.
This person will deliberately not file tax returns for the prior five years, and of course will not pay the taxes due. Or the penalties for late filing various forms — whatever they are. He will, however, presumably file excruciatingly correct U.S. tax returns for the year of expatriation.
Consequences of Covered Expatriate Status
The consequences of being a
goat covered expatriate are:
- Gift. If you make a gift to a U.S. person, the recipient has a potential tax to pay. See 26 USC Section 2801. Presumably our hypothetical dual U.S./Canadian individual will never give a penny to a U.S. person.
- Bequest. If you die and leave an inheritance to a U.S. person, the recipient has a potential tax to pay. Again, see 26 USC Section 2801. Again, I assume this is not going to happen, so our hypothetical dual citizen won’t care about this.
- Lorena Bobbit. The IRS could go on a binge of jilted-lover vengeance and attempt to tag our hypothetical dual citizen with U.S. tax liabilities and penalties for past sins. This is a risk if the Canadian tax authorities are playing footsie under the table with our IRS Overlords. If the Canadians have half a spine and tell the U.S. government to go bite tires, then there is no risk — unless our would-be goat decides to travel to the United States. I suspect there is no extraordinary rendition of Canadians to the United States for taxes owed to the USA. Yet.
- “Hello, Lion. May I inspect your teeth?”. If our deliberate goat decides to travel to the United States, the consequences are unknown to me. If there is a criminal indictment, there would be the possibility of arrest. If it is a mere civil tax debt to the U.S. government, well, I thought we abolished debtor’s prisons a while ago. But don’t quote me on this–it’s a Brave New World we’re living in. So the better answer is to stay out of the United States for the rest of your life.
In short, I think you could be a covered expatriate, and you keep yourself and your money out of the United States for the rest of your life, then you can be a happy goat.
This is not my advice to my expatriation clients. I keep telling them over and over again — your primary purpose is to exit the United States cleanly and permanently. It is worth doing some extra paperwork and possibly paying some tax to be absolutely bulletproof. Don’t let grumpiness cloud your judgment.
When to file Form 8854
We get questions from our handy-dandy Contact page. Some of them are important questions that apply to a lot of people.
One such question came in this morning. Someone expatriated yesterday (i.e., in 2013). He knows he must file Form 8854. But when does he file Form 8854? Today? Next year? That’s worth a blog post.
You file Form 8854 as an attachment to the income tax return you file for the year in which you relinquish citizenship. You file your income tax return for the year in which you relinquish citizenship according to the standard deadlines that apply to nonresident aliens.
Look at the Instructions to Form 8854 (PDF), Page 3 under the heading of “When to File”.
“If you expatriated after June 16, 2008, attach Form 8854 to your income tax return (Form 1040 or Form 1040NR) for the year that includes your expatriation date, and file your return by the due date of your tax return (including extensions).”
The filing deadline possibilities are April 15 or June 15. Figure out which one applies to you. The filing deadline for your tax return (and Form 8854) is extended if you apply for a filing extension in a timely manner. That can take you until October 15, and in some cases until December 15 for your filing deadline.
For someone who terminates citizenship in 2013, this means that the earliest filing deadline possible is April 15, 2014, and the conceivably latest filing deadline for Form 8854 (attached to the 2013 tax returns) is December 15, 2014 (assuming you get the right extension requests filed on time).
Lots of people get tripped up by this. There is another “When to File” heading on Page 2 of the Instructions to Form 8854 that tells you to file Form 8854 “as soon as possible” after expatriating. If you relinquished your U.S. citizenship in 2013, don’t worry about that stuff on Page 2. It applies to people who terminated citizenship under the old rules. Your filing instructions are on Page 3.
I’m quoted about expatriation
I had a moment of glory in the sun today, talking about expatriation with Lynnley Browning, a reporter for CNNMoney/Fortune. I was asked why there are more and more people giving up U.S. citizenship.
“It’s the cumulative effect of the I.R.S. ‘jihad’ against foreign bank accounts,” said Phil Hodgen, an international tax lawyer in Pasadena, Calif. He said growing numbers of Middle Eastern investors were ordering their dual-citizen children to dump their U.S. passports if they wanted to inherit family-owned companies without onerous U.S. estate taxes.
There you go. Me mouthing off as usual.
Seriously, though. The United States is shooting itself in the foot with its tax policies. The ACA continues to advocate for residence-based taxation. This is the solution.
Expatriation if you never lived in the USA
I received a question from a reader and it is worth a blog post.
I have been reading the expatriation blog. I have a question regarding expatriation of dual nationals never having lived in the US. If they file the 5 years back + current year 2012 IRS and Treasury Dept. forms and then renounce a couple of months after, how soon can they send in the final papers? Is there any advantage to for example file the back years in November, renounce in December and then send the final forms at the beginning of 2014? I suppose this could also be done via the Streamlined program?
This is all about dual-citizens (USA plus some other country) where the individual has never lived in the USA. Indeed, in my experience these people may not even have a Social Security Number.
They’ve never filed U.S. tax returns because–except for an accidental event in their lives that caused them to be U.S. citizens–they have no contact with the United States.
What They Want
Sadly, U.S. citizenship is no longer the valuable asset that it once was. Increasingly it is a liability. These dual citizens want to renounce their U.S. citizenship.
The Tax Problem
The reason they want to give up U.S. citizenship is (in my observation) driven entirely by U.S. tax considerations. The tax considerations appear to be ranked, from most important to least important:
- The estate tax. You have lived your entire life outside the United States. You built up a business from nothing that is now worth $100,000,000. You die and leave the business to your children who are not U.S. citizens. The United States wants to impose its estate tax the value of that business. Your response? “NFW.”
- The paperwork/penalty environment. The U.S. tax system has a well-deserved reputation for obscure paperwork requirements and harsh penalties and taxation for people who screw things up. I’m looking at you, Mr. File-Form-5471-one-day-late-and-pay-$10,000. I’m looking at you, too, Mr. Guess-What-You-Own-A-PFIC-Ha-Ha-The-Joke’s-On-You. And I’m looking at a busload of your ilk. Peh.
- Income tax. They’ve made their lives entirely outside the USA and are making income. If they live in a country with an income tax, they’re paying tax there. They’ve never asked the USA for anything, and never will. “Black helicopters will come and save you” is BS and all you have to do is look at the recent fun ‘n games in Egypt to see how diligent the U.S. government was there.
So they want out.
But They’ve Never Filed
As usual, I digress.
These people have never filed U.S. income tax returns. They didn’t know they had to, they thought they didn’t need to. Yet in order to renounce their U.S. citizenship they need to log out of the U.S. tax system properly. That means filing Form 8854. And that, in turn, means that you tie up loose ends for the prior years.
Which brings us back to the question I received this morning.
Here’s what I think you have to do. I’m not talking about whether you are a covered expatriate or not, or anything like that. I’m talking about the tax filing strategy that allows you to achieve your primary objective. Your primary objective is to get Uncle Sam’s tax monkey off your back. Never forget that. Do all of your tax paperwork to achieve that objective. Do not give the U.S. government any excuse to come after you in the future.
What to File
With absolute certainty, you need to file a U.S. income tax return for the year in which you renounce citizenship. Do Form 8854, and do everything else that is required.
Do the prior five years of tax returns, too. On Form 8854 they ask about the five years prior to the expatriation year. I cannot imagine renouncing citizenship if you don’t do that. Just do it. You don’t need legal advice for this. Just do it.
For the years before THAT, you need to look at your financial affairs carefully and your risk exposure. This is where the problems lurk. The U.S. government has no time limits to pursue you for tax obligations if you never file the tax return. You have to file the tax return to get the clock ticking. Ordinarily the clock imposes a three year time limit. After three years, you are safe forever. In some situations, the time clock ticks longer–six year, maybe forever. So the short answer for the ancient years is “Get some advice.”
Phil’s Pacifier Principle
If you don’t file, the clock doesn’t tick. You want the government to be closed off from chasing you, according to its own rules.
This is where you need advice. How do you close the door forever on the government, using its own rules? (Hint: the legal jargon for this is “statute of limitations”.)
My tax return filing philosophy can be summed up as “The Pacifier Principle.” If you are a parent, you know how loud an infant can be. You also know the magic of a pacifier. Pop one of those things in a baby’s mouth and it is instant quiet. There is no nutrition being delivered, but the baby is happy.
It’s the same thing with tax returns. I believe that filing tax returns–even if you are not necessarily required to do so–is a good thing. Let’s say you had zero income in a particular year. File tax returns with zero reported all over it, and zero tax due. Now you have the clock starting to tick. After three years, you are safe.
Let’s say that 10 years from now the U.S. government becomes keenly interested in you, after you expatriated. They say to you, “Aha! You didn’t file tax returns for 2012. We have you now!” Now you have to shovel snow uphill in Hell in the summertime to prove that your live in 2012 consisted of zero income and therefore zero income tax liability. Where are your 10-year old bank records? How can you prove that you had zero income?
In contrast, let’s say that 10 years from now some friendly representative of the U.S. government comes knocking and asking about your U.S. income tax returns for 2012. You say “Check your own database!” and they discover you filed, and the statute of limitations ran. It is a much harder job for the government to wreak havoc at this point.
If you’re filing a bunch of tax returns late, just file them. Yes, sometimes there is a timing strategy for when to file. This is something you figure out based on each person’s situation. Sometimes it is a good idea to wait. But more often the sensible thing is “Just get it filed.” There is no clear rule in my mind for this.
If you are asking “When should I file this tax return?” I think you are forgetting your Primary Objective: to log out of the United States, cleanly and permanently. Spend all of your time making sure your tax filings are clean and bulletproof. After that, and when everything is neatly printed and sitting on the table ready to sign and send, THEN decide whether to send them in now or wait a while.
To get specific on this person’s question, yes you could wait until November to file a bunch of stuff. And you could just file it right now. In the bigger scheme of things, remember the Primary Objective and don’t try to be too clever.
Look at the Streamlined Procedure for U.S. citizens abroad. The way I read the rules, it will work very well for left-handed people who are taller than 2 meters except when they’re not, and who can whistle, but only certain tunes, and only if they file in a month that has a K in it. (Translation: the rules are imprecise, and by entering the Streamlined Procedure you have put your head in the mouth of the lion and you’re hoping the lion tells the truth when he says he won’t bite.)
I know that reasonable minds differ. Michael Miller is a great tax lawyer in New York and he thinks it works. I’m kinda cranky about all of this stuff the IRS is doing penalty-wise for U.S. citizens abroad. The IRS’s ideas sound really good until you get up and walk out of your cubicle and into the real world. Von Clauswitz had some cogent advice about this. /rant
As usual, I am not your lawyer, and this is not legal advice. You’d be a damn fool to make important decisions based on the ravings of a random dude (that would be me) on the internet. Go hire someone with skills, pay for advice, and follow it.
Note to Concerned Immigrant
A reader who nicknamed himself/herself “Concerned Immigrant” left me a message from the Contact page of this site.
Hi Concerned Immigrant. I sent you am email in response. It bounced because you gave an obviously fake email address.
Perhaps you just wanted to vent your anger at the FBAR stuff your parents face.
Anyway. Here is the gist of the response I tried to send you.
(1) Do everything correctly for 2012. Don’t miss this deadline.
(2) Get some competent advice about how to handle the past years. If the advice is OVDI, then stand up and walk away, swearing the mightiest oaths that a drunken sailor could swear.
(3) And yes. The IRS and its Streamlined Procedure. It is a steaming pile of . . . . Ahem. I digress. The Streamlined Procedure is useless. I will stop there. I’m heavily jet lagged and might ^H^H^H^H^H would probably lapse into ill-advised profanity if I continue.
Greetings from Heathrow Terminal 5, BA’s lounge. Monday morning, after leaving Riyadh on a 12:40 am BA departure. I got off the plane singing Willie Nelson’s “Bloody Mary Morning” (YouTube) to myself.
It is an orange juice morning morning for me. I will see my own Mary later today. I’m happy about that.