This is a question I get again and again, because we do so much advising in this area — giving up U.S. citizenship or green cards.
Here is a simple explanation of how it works. If you’re just starting to think about giving up your U.S. citizenship or green card, this is the place to start.
Disclaimer, warning shot, weasel-words, pre-emptive strike
Sorry. Have to do it . . .
– This is not legal advice to you.
– This explanation is like giving me a map of Europe when I ask you to recommend a good Thai restaurant in Zurich. It is extremely simplified. There are exceptions and special rules all over the place.
– In other words, if blog posts were art, this is a doodle on a napkin, not the Mona Lisa.
With that out of the way, here is the explanation.
Two tasks when you expatriate
There are two things you need to accomplish when you give up your U.S. citizenship. You need to convince the Department of State that you are no longer a citizen, and you need to convince the IRS that you are no longer a U.S. taxpayer.
Log out of the citizenship system
The first (and easier) part is to terminate citizenship. You do some paperwork (look for Form DS-4079 on the internet; there is other stuff too that the Embassy will want). You show up at the Embassy or Consulate for an interview.
Your citizenship is terminated effective that day but it typically takes about 4 months to get the confirmation paperwork. I recently had two different clients (on opposite sides of the world) get their paperwork back in a matter of days, however. I blame global warming for that astonishing efficiency.
Log out of the tax system
The harder job is to log out of the tax system.
This job is either paperwork only (if you are “poor”) or it is paperwork plus pay some tax (if you are “rich”).
“Rich” for exit tax purposes
You are “rich” and therefore have to pay tax when you leave if you satisfy one of two financial tests.
The first test is a simple balance sheet test. Is your net worth (assets minus liabilities) $2 million or more?
The second test is based on the amount of Federal income tax paid over five years before you terminate citizenship. Is the average Federal tax liability over those five years $151,000 or more? For someone who terminates citizenship in 2012, that means we look at 2007-2011, and calculate the average based on those years. The $151,000 amount is indexed for inflation so next year it will be higher.
If you satisfy EITHER of these tests, you are “rich” and therefore you will pay tax when you leave the United States. Plus you do the paperwork, of course.
If you satisfy NEITHER of these tests, you only have some paperwork ahead of you but you do not have to pay any tax.
Income calculation for someone who is “rich”
For a rich person who terminates citizenship, there is a “mark-to-market” event in the person’s life. Pretend that all assets are sold on the day before you went to the Embassy to cancel your citizenship, at market prices. The first $651,000 of profit is tax free. Everything above that is taxable, at the normal tax rates that would apply.
There are special rules if you are a beneficiary of a trust, or if you have a pension. There are a few other odds and ends that can cause taxation.
But the most important thing is this “pretend that you sold everything and pay real money taxes on the pretend profits.”
This is done for all assets worldwide.
The exit tax paperwork
The tax paperwork filed is a complex income return for the year you terminate your citizenship. You file it according to the normal filing deadlines. For someone who terminates citizenship in 2012, you will be filing your tax return in 2013.
The tax return has a component that is part-year reporting as a citizen of the United States, another component which is part-year reporting as a nonresident of the United States, and (this is the important one) Form 8854, which is the form the government wants to see to log you out of the tax system.
Prior five years are clean
In order to do this right, your U.S. tax paperwork and tax payments must be up to date for the prior five years. For someone who will terminate citizenship in 2012, that means the 2007-2011 tax returns must be filed, and must be correct.
“Thar be dragons!”
Can I tell you again that there is a lot of other stuff that is important, tax-wise? Get smart before you make that appointment to terminate your citizenship.
We do a lot of this stuff.
We will walk you through the early stages so you can make a well-informed decision: how to do it, how long it takes, what the estimated tax hit (if any) will be, what can be done to reduce or eliminate taxes.
Then if you hire us, we do everything. In our experience the “get out of the citizenship” part is straightforward but the tax stuff is not. We do the pre-expatriation tax planning. We do the exit year tax returns for you and the following year as well because there is usually some strange stuff going on in the year after you leave the United States. It is rare that people can get their financial affairs arranged so that their U.S. finances are completely wrapped up by the time they leave.
I travel frequently (the upcoming trip is Switzerland from 20-27 May, Beirut from 27-30 May, and Dubai from 30 May to 03 June) so we can meet outside the USA. Or we can meet in my office or talk via phone or Skype.