The New Tax Law and Expatriation: New Reasons to RenounceMarch 13, 2018 - Phil HodgenExpatriation
Our trusted servants in Washington DC blessed us with a new tax law, effective December 22, 2017. The new law–the Tax Cuts and Jobs Act of 20171 –did not change the expatriation tax rules, but it did make expatriation more attractive to a certain group of Americans abroad.
Tax Cuts and Jobs Act of 2017
The Tax Cuts and Jobs Act2 changed many, many parts of the Internal Revenue Code. The international tax rules, in particular, have been massively changed.
But Congress did not touch Sections 877A or 2801 of the Internal Revenue Code. Those are the two special-purpose statutes that impose tax on people who renounce US citizenship or abandon their green cards.
Therefore, someone who expatriates in 2018 will face the same tax laws that applied to someone expatriating in 2017, 2016, or before.
The basic tax rules for expatriation are unchanged. But for a certain group of Americans (mostly living abroad), the new tax law radically increased the cost of keeping US citizenship. The economic incentives for renouncing citizenship–or abandoning a green card–have tilted further in favor expatriation. It is now more expensive for these people to retain US citizenship.
Incentives matter. “If you have dumb incentive systems you get dumb outcomes.” That’s a quote from Charlie Munger in the linked YouTube video, and I highly recommend watching the whole 9 minute video.
Congress has created tax disincentives for a certain group of Americans. We should not be surprised if we see these Americans reacting in predictable ways to those disincentives.
The people who will want to rethink their citizenship will be Americans, mostly abroad, who own or invest in foreign businesses. These are entrepreneurs, business owners, venture capitals, private equity investors. These are people who create jobs and build wealth.
A dual-citizen physician in Canada who operates her practice through a professional corporation might be an example. A start-up tech entrepreneur based in Singapore might be another. A private equity investor, buying and selling companies in Europe, might be a third example.
In short, all you need is a human with a US passport (or green card) and a business outside the United States.
The New (Dis)Incentives
This group of people–entrepreneurs, investors–are the people we work with day in and day out. They face two new (dis)incentives, courtesy of the Tax Cuts and Jobs Act of 2017:
- Tax. Corporate profit that previously would not be taxed in the United States might now be taxed in the United States; and
- Professional Fees. The new tax laws add complexity and uncertainty. Navigation and countermeasures will mean massive legal and accounting fees.
How the Incentives Work
Consider a simple example. A US citizen lives abroad, and owns 100% of a foreign corporation. The foreign corporation has a normal type of business: anything from retail sales to professional service.
Before: No US Tax on Corporate Profits
In the days of old, the US citizen could reasonably expect that corporate profits would be taxable in the foreign country, but not in the United States.3 The US citizen would only pay US income tax on salary and dividends received.4
Now: Likely US Tax on Corporate Profits
The new laws create new methods by which the United States can tax a US shareholder on profits earned by a foreign corporation.
At a meta level, the new tax laws created potential tax breaks for foreign corporations owned by US corporations. In many instances (and only after lighting a few brain cells on fire trying to figure out answers to questions using the gratuitously over-complex new tax rules) foreign profits flow upstream to the US parent corporation without further US tax. Tax-free foreign profits. What’s not to like? (If you name happens to be Apple).
These tax breaks do not apply to foreign corporations owned by US individuals. If the gratuitously complex new tax rules force profits upstream to be (potentially) taxed in the hands of the US shareholders, the tax breaks available to US corporations are prohibited for US persons.
In short: US corporations good, US humans bad.
This creates a tax risk for American entrepreneurs abroad. They can handle this risk in one of four ways:
- Create a new US parent corporation for their foreign corporation. Instead of owning that simple corporation in Singapore as a human, you create a Delaware corporation that owns the stock of that Singaporean corporation, and you own the stock of the Delaware corporation.
- Do not make changes to the business structure, pay more US tax and pay more for US legal and accounting advice.
- Stop being a business owner. Get a job working for someone else.
Either Way, Legal and Accounting Fees
But any way you cut it, there will be heavy legal and accounting fees for the American entrepreneur abroad to navigate the new tax laws–even if nothing can be done to avoid the new law’s impact.
Furthermore, legal and accounting fees will be more expensive in the future. Form 5471 is now going to be more complicated than before, and that means more money to prepare that tax form.
The Wakeup Call
American business owners abroad are waking up to a rude tax bill that will be presented to them on their 2017 tax return. The new tax law (“Section 965” if you want to ask Mr. Google about it) says, in simple terms, “take all of the retained earnings for your foreign corporation, do some math, and report this as taxable income in 2017”.
I have talked to Americans who own foreign businesses and have been operating for 20 years. They might have $3 million of retained earnings in their corporations.
After doing the complex math in the new tax law, they face a US tax liability of hundreds of thousands of dollars, payable over eight years, starting with their 2017 tax return.
This wakeup call has been heard. We receive calls and emails from these people, asking about expatriation. They have had enough.
It’s predictable. If you want less of something, tax it more. If you want fewer American entrepreneurs abroad, make the tax rules worse.
What To Do
For those of you who own businesses abroad (even if you are a minority shareholder), here’s what you need to do:
- Ask your tax advisor about Internal Revenue Code Section 965. The best advice we are giving right now is to make a guess at an estimated tax payment and pay it before April 15, 2018.
- File for an extension of time to file your income tax return. Use Form 4868. No one knows the rules right now (especially the IRS), so give yourself until October 15, 2018 to gain some clarity.
- Hire someone to give you tax advice for how to structure or restructure your business operations abroad for 2018 and future years. Look at US taxation of corporate profits. Do you like what you see? If not, either restructure your business to make the result less bad, submit to the Borg and be assimilated, or . . .
- Make plans for expatriation.
In Other News
Beginning with the next Expatriation Only post, Debra Rudd, CPA, will be taking over as the author. She has provided tax advice for would-be expatriates, and prepared hundreds of expatriation tax returns. Debra will provide a fresh perspective on the complex tax issues facing those who decide to renunciate their US citizenship. You can expect to see practical and easy to understand advice from a seasoned tax preparer who has been in the trenches and made it out again.
- This is a link to the Wikipedia article about the new law. There is much love for Paul Krugman in the article: he is cited as authority for three different assertions. Read the article and you might be able to discern the political bias of the Wikipedia hive mind. ↩
- This is a link to the actual legislation. If you want to understand what Congress did–and if you want to sleep–download the Conference Report PDF. ↩
- This statement is full of assumptions. I am thinking here of an incorporated business that provides goods or services to the general public, and has very little or no passive income (dividends, rent, etc.). ↩
- There are some other ways that the US citizen/shareholder could get tagged with taxable income, but these rules were (and are, because these rules still exist) weaselly little traps built to prevent tax games by multinationals. ↩