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PostedWhy people expatriate
Phil Hodgen
Attorney, Principal
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[This is a Tomi Ahonen-style missive about expatriation. It is over 5,000 words long, and written on Emirates flight 215 from Dubai to Los Angeles, because it’s 16 hours of flying and what else are you going to do flying over the North Pole but listen to music and write a manifesto? If you’re looking at it in your RSS reader you might just decide to skip it. I wouldn’t blame you. By the way, did you know that it is 8 hours flying time from the North Pole to Los Angeles, almost exactly?]Oh. This post was inspired by a call I received whilst in Dubai from a gent in London. We talked about this topic for about 20 minutes and, well, this post is what happened. Keep the calls and emails coming.
Introduction
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.Terminating citizenship
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: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.
- - 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.
Why?
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.Future legislation
Finally, people must guess about the future. Political signals from the United States show that expatriation and tax policies are likely to get harsher.The cost of expatriation now is less than the expected future cost of expatriation. Better to take the medicine now rather than later.
- - 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.