Expatriates failing the certification test create trouble for themselves
Reader (G)ee posted a comment with follow-up questions on expatriation if you’ve never filed tax returns on my post “The Exit Tax Paperwork for People Who Have Never Filed.” That post was triggered by her question, too. 🙂
Question #1
I want to put her questions in a blog post or two because, well, it will make it easier to find and collect these thoughts rather than just putting an answer in the comment thread.
Thanks for posting my question as a blog. This has brought significant clarity thus far.
However, in regards to your comments regarding leaving “Unnecessary Open Loops”, I have a couple of further questions.
First, doesn’t being subject “to the exit tax” on the basis of “failing to certify” compliance close the loop because the individual is no longer a US citizen because they have both renounced and filled out the 8854 form as a “covererd expatriate” as the law requires?
Why would the option to be a “covered expatriate” be offered to a “failed to certify” dual at birth unaware citizen if it did not adequately deal with the final exiting process? Are they not coming into compliance by being subject to the “exit tax”? In some cases, filing 5 years of 1040’s (with no tax owing) may expose the dual/born abroad to various reporting penalties even if they never owed the US any real tax monies.
Fail Certification Test? You’re a Covered Expatriate
You (not (G)ee but the “you” who is the would-be expatriate trying to figure out what to do) can fail the certification test for two reasons: you don’t certify you’re up to date and paid up on your last five years of income tax, or you DO certify that you’re up to date, but you file the paperwork (Form 8854) late.
That makes you a “covered expatriate.”
That treats you as if you sold all of your stuff on the day before you cancelled the passport. You decanted all of your IRAs. If you have pensions, etc., you have to do whatever Section 877A tells you do to with them. Ditto for beneficial interests in foreign trusts.
You have that status no matter what your net worth. If all you have in the world is a peanut butter and jelly sandwich, the IRS wants it to be marked to market and capital gain calculated.
The Resulting Open Loop: “Hit Me Here. In the Jaw. Hard.”
Your life now has an open loop.
The open loop here is an unsatisfied (and probably uncalculated) tax liability to the U.S. Treasury Department. They know you cancelled your citizenship. They know you are a covered expatriate (you filed Form 8854, remember?). They know you didn’t file tax returns for the prior years.
So what is a government to do? Answer: rain on your parade.
Just filing that exit year tax return and Form 8854 and saying “Sorry, Uncle Sam, in fact I haven’t filed tax returns for the prior five years” will make you technically comply with the exit tax paperwork filing requirements. But it shines a gigantic searchlight on a gaping hole in the rest of your life’s work — filing of annual tax returns going back. In other words, you showed up and said “Guilty, Your Honor.” On paper.
You haven’t filed tax returns. Therefore the statute of limitations is still open for all of the years. The government can pursue you as far and as hard as it chooses. The government will (sooner or later) make up an imaginary number of what they think you had in taxable income, assess a very real tax liability based on their imaginary income number for you, and tell you to pay or die.
You can solve the problem by running away and never coming back to the United States as a tourist or anything else. As long as you live in a place that is not too thrilled to help the U.S. government collect U.S. taxes, you’re probably safe. Or you will solve the problem by going to the IRS and dealing with the mess.
Question #2
A second question: what did you mean by “if you want to re-enter the USA”? Are you referring to whether one would ever want to establish a residency in the US as a now alien or are you referring to just crossing the border?
I mean “crossing the border.” The immigration people at the border are even grumpier than the IRS. Why put your head in the lion’s mouth?
Question #3
A third question: even if the US changes the expatriation process once again, thus changing the rules for the now non US citizen “covered expatriate”, can this be done retroactively, re-exposing a now ex US citizen to future risk?
In general the Constitution is supposed to protect against retroactive application of laws. What you think is legitimate under the Constitution may be very different from what Congress thinks is legitimate, and what the Supreme Court thinks is legitimate.
E.g., under the old expatriation rules, you could give up your passport but until you filed all of your paperwork, the IRS considered you to be a U.S. taxpayer. So if you gave up your passport in 2005 and you never filed Form 8854, as far as the U.S. government is concerned you’d be a U.S. taxpayer out of compliance with everything. Even though you’re not a citizen. Although this is not “apply the law backwards in time” I give you this example to show how the U.S. government cheerfully assumes it owns you.
Proving the contrary would require hundreds of thousands of dollars litigating constitutional issues in Federal Court. If you lose, you risk total financial destruction or imprisonment.
Yesterday, the Senate passed a bill which — if the House agrees and President Obama signs it — will give the government the power to cancel your passport if you owe $50,000 or more in tax.
Own your own life.
I don’t know how harsh the U.S. government intends to be. The trend line looks increasingly authoritarian. My guess is that an overhanging FBAR penalty would create personal risk for anyone re-entering the USA. If this is not true now, it will be in a few years.
Mr. Hodgen,
In your example you discuss someone who has neither paid income taxes nor, (presumably) filed FBARS and renounces.
If someone pays all income taxes and associated interest and penalties but not the FBAR penalty and renounces, would they be in a different position in terms of being able to visit the US?
My understanding is that an FBAR penalty is a debt (but nondischargeable in bankruptcy, similar to a student loan) so failure to pay this would not cause any major problems to someone visiting.
What’s your take on this?
Phil
Trouble is, the sidewalk isn’t that safe either. Start filing tax returns and FBAR’s after 45 years of silence (in order to become tax compliant and therefore pass the 8854 test) and who knows what fines and other unknowns await you.
One’s primary purpose is to terminate citizenship. Why take the hard way there, just to prove a point?
For people where no exit tax will be triggered, I think the default method (Form 8854) should be followed. If presented with two alternative paths — a sidewalk or a dense jungle where you have only a blunt machete — why deliberately choose the more difficult one?
In other words, I agree with you. 🙂
Sorry for the double post.
There are certainly people at Isaac Brock who have relinquished their citizenship and are pinning their hopes on this exception, but I don’t know of anyone who has actually had success in relinquishing, getting a CLN, and avoiding 8854 and the exit tax. As you know, the crux of relinquishing citizenship (as opposed to renouncing) is to have committed an expatriating act and not to have done anything since that time to indicate that you still consider yourself American – including filing tax returns. Why bother to have the relinquishing process on the table at all if, at the end of the road, the result is the exactly the same as renouncing, if not worse.
Mr. Hodgen
I would be so grateful if you could answer this question. I would like to proceed with relinquishment of US citizenship (been in Canada for 58 years, 45 of those years as a Canadian citizen.)
1) In the Notes on 26 USC Sec. 877, there is an exception regarding the exit tax – submitting Form 8854 will not be required ” if the individual establishes to the satisfaction of the Secretary of the Treasury that the individual’s loss of US citizenship occurred before Feb. 6, 1994″. In your opinion, will the IRS accept this and not require submission of form 8854 and/or back tax returns and FBAR’s once an individual has obtained a backdated CLN? A lot of people are depending on this clause, including possibly myself, and I find it worrying because –
2) Nowhere in the instructions for form 8854 is this 1994 date mentioned and if indeed it is valid it would affect a lot of people.
Links are:
http://codes.lp.findlaw.com/uscode/26/A/1/N/II/A/877/notes
Under Effective date of 1996 amendment – (3) special rule (B)
http://www.unclefed.com/Tax-Bulls/1997/Not97-19.pdf
Under Section X, Transition Provision , and
http://www.gpo.gov/fdsys/pkg/USCODE-2010-title26/pdf/USCODE-2010-title26-subtitleA-chap1-subchapN-partII-subpartA-sec877A.pdf
Page 1856 Under Effective date of 1996 amendment 511(g) (3)(B)
Hello Hopelessly,
I don’t have much guidance for you on this that I am willing to talk about publicly. (Blowback on current cases is the reason). I seem to remember that on the Isaac Brock Society site there were a couple of people who had experience with this.
My suggestion is that if you possibly can go out the front door (Form 8854 etc.) you should do it.
Mr. Hodgen
I would be so grateful if you could answer this question. I would like to proceed with relinquishment of US citizenship (been in Canada for 58 years, 45 of those years as a Canadian citizen.)
1) In the Notes on 26 USC Sec. 877, there is an exception regarding the exit tax – submitting Form 8854 will not be required ” if the individual establishes to the satisfaction of the Secretary of the Treasury that the individual’s loss of US citizenship occurred before Feb. 6, 1994″. In your opinion, will the IRS accept this and not require submission of form 8854 and/or back tax returns and FBAR’s once an individual has obtained a backdated CLN? A lot of people are depending on this clause, including possibly myself, and I find it worrying because –
2) Nowhere in the instructions for form 8854 is this 1994 date mentioned and if indeed it is valid it would affect a lot of people.
Links are:
http://codes.lp.findlaw.com/uscode/26/A/1/N/II/A/877/notes
Under Effective date of 1996 amendment – (3) special rule (B)
http://www.unclefed.com/Tax-Bulls/1997/Not97-19.pdf
Under Section X, Transition Provision , and
http://www.gpo.gov/fdsys/pkg/USCODE-2010-title26/pdf/USCODE-2010-title26-subtitleA-chap1-subchapN-partII-subpartA-sec877A.pdf
Page 1856 Under Effective date of 1996 amendment 511(g) (3)(B)
Thanks so much for your time.
Dear Mr. Phil, If a person files past 5 years taxes and goes to US consulate to relinquish his citizenship this week, what is the dead line for filing Form 8854? Must he file with in few weeks?
Wishing you a pleasant stay at Taipei and trip!
Your daughter might be technically tax-compliant. If she had no filing obligation then maybe she is safe.
I have never done that. I always put a pacifier in the baby’s mouth to keep it from crying. Metaphorically speaking.
Meaning: I file “zero” returns whether required or not.
Hello from Taipei. 🙂
Interesting discussion. My daughter, born in Canada to US mother, is 25 and wants to get rid of her US citizenship ASAP. She has worked in Canada and the UK but never made anywhere near the amount above which one is required to submit a 1040. She has spent most of the past 7 years living at home or with family as a student and trying to make a living in a very tenuous career path. She is adamant that she is not going to complete the 1040’s because she doesn’t have to and she can honestly say she has been compliant with all the IRS rules when she renounces, since she has. She has filed FBAR’s for the last 3 years, although I don’t think they are technically “IRS” requirements. She has WAY less then $600.00. Is this going to get her in trouble.
If I become an automatic covered expatriate because I refuse to fill out form 8854, then I guess I won’t leave any of money to anyone in the United States. (Note to self, I have to disinherit my brother who is my sole heir in the United States). What kind of stupid law is that? Don’t they want that money back in the United States? We were discussing a law at Isaac Brock that would make it illegal to use a credit card from a non-FATCA compliant bank to order goods from the United States. Doesn’t the United States want to sell things to people in other countries?
What kind of idiots pass laws that make it so that money doesn’t flow into the United States? That’s cutting off your nose to spite your face.
Thanks Anon. Funny story. My understanding is that very few people get that sailing permit.
That will change.
I’m one of the very few select people on the planet who has an IRS sailing permit. The process was surreal and third-world-ish, involving a whole day, hundred-plus mile round trip in person through two IRS offices.
The first office we visited was empty of all but one other “customer”, but nevertheless made us wait for over an hour. They then claimed no knowledge of sailing permits, despite their web site indicating they could handle them, and sent us to another office some 60 miles distant. The other “customer” in the office was there for the same thing, and was also turned away. One more dissatisfied customer, then.
We arrived prepared with a literal suitcase full of the papers apparently required, but not one was ever requested. Staff seemed broadly confused about the entire process. The day’s high point was when my wife managed to complete the process using the IRS “short cut” of accepting a letter from her employer promising to pay any outstanding tax liability if we didn’t return. She is self employed, and operated as a one-person C corporation!
In the end it was all completely pointless busywork. Our only reason for getting it was i-dotting and t-crossing while moving fast to get out of the US before 877A passed.
I am going to tentatively put Canada down as a yes in terms of allowing a tax credit against US exit tax paid(if for anything just because the political mess this thing is becoming although you might have to fight the CRA bureaucracy all the way up to a ministerial ruling). Canada does have an “exit tax” equivalent and the last amendments to the US Canada treaty back in 2007 supposedly dealt with it however the new US law took effect only in 2008 and I don’t believe there have been any treaty modification to deal with it(The last revision to the US Model Treaty was back in 2006). Also given its punitive intent I don’t get the impression the US is at all interested in helping out its expatriating citizens in the future either on this front(whereas Canada’s exit tax is much more geared toward actual revenue raising purposes and I don’t believe it applies “yet” to treaty partner countries anyways).
CRA has some detailed guidance in terms claiming foreign tax credit against like US State income and franchise tax but much of it again dates back from before 2008.
In terms of everyone else I would say you have a very interesting legal fight in your new/home country if you want to go down this route. Only good part is it probably much cheaper to get a good local non US tax lawyer than to hire a good US tax lawyer in the US.
Yes this is indeed an interesting question. The USA faces the same thing in trying to figure out how to deal with the Canadian exit tax equivalent. I think I remember seeing something floating through Tax Notes Today. I will have to see what it said.
But from the other country’s perspective, no taxable event occurred — no assets were sold “for realz” — so there is no tax liability there. As a result, why should they give a tax credit for the exit tax paid?
Aside: there are a LOT of interesting questions here. Thanks to all of the commenters on the blog who raise the “What about this, what about that?” questions. They’re fun to think about and puzzle through to some kind of answer.
Another very interesting and technical question is(and this way beyond any of us including I suspect Phil to answer at this moment in time)if you do have any exit tax liability as a covered expatriate how to do other countries(where the ex US citizen resides) treat that in terms of being able to claim a foreign tax credit(The US exit tax being the “foreign” tax)and the ability to carry forward that foreign tax credit across multiple years. I suspect if other countries start seeing foreign tax credit submissions based on US exit tax liability they may start having interesting conversations with the US Treasury over US tax policy.
Again this is not at all a question I expect to be answered any time soon although I will try research at least Canada, Australia, and New Zealand. I will also stick to Phil’s advice against open loops in such as it is probably best to not be a covered expatriate even if you can claim a local tax credit against US tax paid.
The reason I was asking about the sailing permit issue is because I read an old report from 2002/2003 indicating that only 50 percent of people who were supposed to file form 8854 were doing so but only 10 to 20 percent of departing resident aliens were filing the sailing permit forms which given the high number of Canadian citizens who were some point resident aliens in the US means a lot of Canadians could be effected by the sailing permit issue too.
@Broken Man,
You are right. The first $651,000 of “mark-to-market” income is exempt from taxation. You get the exemption when you put it on paper.
So yeah. The peanut butter and jelly sandwich (lovingly made by Picasso) may not generate much mark-to-market income. In that case, our hypothetical expatriate would mollify a grumpy IRS by filing the appropriate paperwork and being safe from income tax.
The hypothetical expatriate would not be able to make gifts or leave inheritances to a U.S. person, without tax consequences.
And more to the point, (G)ee was asking about a nonfiler who expatriates and deliberately says “No, I wasn’t compliant for the prior five years.” Those years continue to stay open for business.
Yes, another government might tell the IRS to go stick its nose in a dead bear’s bum. The CRA seems to be a likely candidate for taking such a position. 🙂 But I’d rather control my own destiny rather than rely on what I think a government might or might not do. Because governments change. And anyway, as that great BBC show “Yes, Minister” demonstrates, the politicians aren’t in charge anyway.
Correct me if I’m wrong, and I hate to ruin your peanut butter and jelly image, but I thought that covered expatriates were exempt from tax below $600K or something in personal assets.
*Potentially* this creates a loophole where a dual born abroad with a limited connection to the US and assets below the cutoff can avoid the hassle of filing five years of returns by renouncing, failing the certification test, stating the true value of their assets and getting on with life. At least in Canada, the CRA won’t collect IRS penalties (as opposed to taxes), which you would think would make Canadians a less attractive target for the more abusive penalties.
What are the liabilities in this scenario?
I never remember whether it is W8-BEN or W-8BEN. Sorry. 🙂
@Tim,
From a perspective of the immigration system, you are an ex-citizen on that magic day at the Embassy.
From the IRS perspective, you ceased being a U.S. person on that day, too. You’re a nonresident alien. They demand that you file the paperwork to follow-up on that event (dual status return plus Form 8854) but you’re a nonresident alien.
The only question is whether you need to do W-8BEN or W-8CE in a particular instance.
As for the sailing permit question. . . .
Interesting question. 🙂 I’m leaving on a trip tomorrow night (Indonesia, Dubai; meet me in Dubai March 26-29) so I don’t have time to deal with it in depth but it is definitely on my list of blog post ideas.
Question for you Phil on a somewhat related subject? Given it is now taking up a year for people’s CLN’s what is your tax status in the time between renouncing and your CLN arriving. Are you still a US Person. Is it okay for example to use form W8-EN instead of W9 during this time period. Also it might interesting to talk about filing the so called sailing permit for resident aliens at the end of their stay in the US. Are the consequences for not filing the sailing permit the same for not filing form 8854.