I did the second webinar today for a limited group of people–all about expatriation. Everyone had a chance to send in questions ahead of time–and I got a lot of them. And there were plenty of questions during the webinar. The show ran for almost three hours: well past the 90 minutes scheduled. Now you know why I limit the number of people in the webinars. 🙂

We will do another webinar on expatriation soon. This one will be scheduled at a time convenient to people in Asia. Contact us if you are interested in getting on the list.

But I digress.

One of the questions that came up today is worth blogging about. (What am I talking about? One question only? No way. I have pages of great questions stored in Evernote as blog fodder. But I digress.)

The Question

Let’s say a husband and wife have a normal investment account of U.S. stocks and bonds at a place like Charles Schwab or Merrill Lynch. They expatriate. What should they do about the investment account–leave it in place or move everything outside the United States?

Let’s assume the brokerage company will allow them to stay on as customers (not necessarily the best assumption in the world) and will allow them to invest freely in all types of assets (definitely not true at all!). What should they do?

The Deciding Factors

The two tax considerations are:

  • U.S. income tax; and
  • U.S. estate tax.

Income Tax Considerations

Let’s keep it simple. The husband and wife keep the same account that they had before. They will each give the brokerage company a Form W-8BEN to notify the company that they are now nonresident aliens for U.S. income tax purposes.

The default U.S. income taxation treatment of their portfolio will be:

  • Dividends are taxed at 30%, unless an income tax treaty allows a lower tax rate;
  • Interest should almost certainly be exempt from Federal income tax;
  • Capital gains will be free of Federal capital gains tax–short term or long term; and
  • There will be no State income tax at all (they aren’t residents of any States).

This sounds pretty good. The full result is hard to determine without knowing where our expatriating couple will live, and what the local income tax rules are in that country. Only by knowing the combined tax hit for the U.S. and their country of residence will we know whether it is better (from an income tax perspective) to leave the assets in the United States or move them to the country of residence. But all in all, the U.S. government more or less keeps its hands out of the pocket of nonresident investors.

Estate Tax Considerations

The problem lies with the U.S. estate tax. When nonresidents own U.S. stocks and bonds, they run the risk of getting hit with the estate tax. These assets are treated as “located” in the United States and if the individual dies, they are going to be subjected to estate tax. The first $60,000 of U.S. assets are not taxed. But above that, expect to pay some tax, and pay for the expense of an estate tax return.

The worst example I saw of this situation was a husband and wife who had $65,000 in a Schwab account. They both died. Schwab froze their account until the IRS issued a letter saying “all of the U.S. tax liabilities for these people have been fully satisfied.” That meant an estate tax return (Form 706NA). It meant over a year of waiting. And it meant a trivial amount of tax collected for the U.S. government–far, far less than the professional fees to get Schwab to loosen its grip on the account and turn over the money to the couple’s daughter.

So, when people expatriate I recommend that they move all of their financial assets out of the United States. Why go through the pain and agony of dealing with the U.S. estate tax system? Invest your money elsewhere.

Many countries do not have an estate tax at all. If you expatriate and live in one of those countries, why would you leave assets in the United States where they will definitely be taxed when you die?

Many countries have an estate tax of their own. It is probable that these countries have a tax credit system–if your heirs had to pay estate tax in the United States, they will allow a credit against your home country estate tax for the U.S. taxes paid. But that doesn’t avoid the cost of dealing with the U.S. tax bureaucracy Borg system. The work involved in preparing and filing a Form 706NA is substantial and costly.

A few countries have estate tax treaties with the United States to soften the blow of the U.S. estate tax. If you live in one of these countries, you might have things a little easier. Perhaps the treaty eliminates the tax entirely. But it will not eliminate the requirement to prepare and file an array of U.S. tax paperwork.

All in all, the U.S. estate tax is an excellent reason to NOT invest in U.S. stocks and bonds.

Note that this holds true if you have a brokerage account in another country. If that brokerage account holds U.S. stocks and bonds, you are at risk of the U.S. estate tax just as much as if you had the assets in a domestic Schwab account.

A Solution: Use a Corporation

There is a solution. It is not for everyone, and it is not cheap. But it works.

The problem is the U.S. estate tax. Here is how we solve it. You form a foreign corporation. This might be formed in your home country, or it might be formed in a tax haven jursidiction. Bahamas. British Virgin Islands. You and your wife are the shareholders. Put your money into that corporation. Then use the corporation to open up a brokerage account at Schwab, Merrill Lynch, or anywhere in the world. The corporation then invests its money in U.S. stocks and bonds.

The same income tax results I described above will apply. Dividends will get taxed by the United States at 30%. (If you use a tax-haven country corporation you will not have any ability to use income tax treaties to reduce that rate). Interest will be tax-free, as will capital gains.

The difference lies with the estate tax. If you and your wife die, the U.S. estate tax system asks the first question: what did they own at the time of death? The answer is that you and your wife owned stock in a foreign (from the U.S. perspective!) corporation. That stock is considered to be located outside the United States. A nonresident owned assets outside the United States. The estate tax cannot apply to those assets, so there is no U.S. estate tax.

This is not necessarily a good idea from the perspective of home country tax systems. Many countries have complex systems in their tax laws that are designed to attack holding companies as I have described. In the U.S. system they are called “controlled foreign corporations” if owned by U.S. persons. There is another set of rules called the “personal holding company” rules that penalize the use of corporations that have too much cash in them. Then of course there is the “passive foreign investment company” rules.

Your country of residence might have similar types of rules. If so, a brilliant strategy from the U.S. tax perspective will make you look like a dunce from your home country’s perspective.

The Simplest Solution

The simplest solution, though, is to close out the U.S. brokerage account and pull the money out of the United States. Then, invest the money anywhere you want, but do not buy U.S. stocks, bonds, or mutual funds.

The world is a very large place, with many opportunities for investment. The U.S. government has yet to learn this simple fact. The U.S. government is fat on hubris and the supposed strength of the U.S. dollar.

Winter is coming.