This Week’s Question
This week’s question comes up fairly frequently, particularly from “accidental” American citizens. The typical example is a person who was born in the United States while his parents were attending school, but who left and returned to his home country at a very early age–never to return to the United States.
I have no Social Security Number and I have never filed a tax return. I want to renounce my citizenship. Should I get a Social Security Number and file five years of tax returns before I do that?
And when I say “fairly frequently” I mean twice today. 🙂
I usually tell people to exit cleanly from the United States: get all of your tax returns into the system, then renounce your citizenship. Sometimes people actually do this. Heh.
You can renounce your citizenship successfully even if you have never filed an income tax return in the United States. All this means is that you have some unfinished business with the Internal Revenue Service:
- You have created a potential tax bill for yourself in the expatriation year because you failed the “certification test”; and
- You have told the IRS (on Form 8854) that you have some tax messes in your past, and you know it, and now they know it too.
But the real risk is uncertainty and fear.
Failing the Certification Test
Someone who renounces citizenship (or cancels a green card) is either a “covered expatriate” or not – for tax purposes. One way to become a covered expatriate is to have a failure with filing tax returns or paying tax in the five years before your expatriation year.
If you have never filed a tax return and you renounce your citizenship? Classic. You are a covered expatriate. You fail the certification test.
Consequence: Exit Tax
If you fail the certification test, you are treated as if you sold all of your asset on the day before you renounced your citizenship (or gave up your green card). After applying an exemption, all of your capital gain becomes taxable immediately. Pensions are (unless you take some proactive steps) treated as if you received a giant lump sum distribution. Other bad stuff happens. It can get expensive.
Or it might cost you nothing. Do your calculations. If you are not wealthy and you do not have retirement plans, it is entirely possible that the exit tax is a toothless dog – it can’t hurt you.
Consequence: Inheritance Tax
A second consequence of failing the certification test: if your children are U.S. citizens, they will pay a giant tax when they inherit assets from you (or when you give them a gift). If your children are not U.S. citizens, this is no problem to you.
You Know, and Now They Know
Accidental Americans who have been living abroad their entire lives are off the radar as far as the U.S. government is concerned. There is no reason that you should ever show up in the IRS database of taxpayers: you do not have an identification number, and you have never filed any tax returns in the United States.
When you show up at an Embassy and renounce your citizenship, however, you are extremely visible.
And you know that you have never filed a tax return, even though you were required to do so. Now, the U.S. government knows about you, and (potentially) can figure out that you never filed a tax return.
What Are Your Choices?
If this is you, there are three choices:
- Renounce your citizenship and do not file a tax return with the IRS. Ever.
- Renounce your citizenship, then file a tax return for the year in which you renounce citizenship, but nothing else.
- File five years of tax returns, renounce your citizenship, then file a tax return for the year in which you renounce citizenship.
Choice 1: Renounce and Never File Anything
Can you go into an Embassy, renounce your citizenship, walk out, and never file a tax return? Sure. But what is the risk?
The risk is that the U.S. government, at some point in the future, decides you are interesting and decides that you are interesting.
Is it possible that the IRS will never care about you for the rest of your life? If you never visit the United States again and never invest in the United States, the likelihood is low. The world is a Very Big World. Your bet is that you are a very small fish in a very large ocean. You are willing to treat the United States and its economy as radioactive and never go near it.
Benefit: zero cost solution. Price paid: the psychic tax of uncertainty, possible financial risk.
Choice 2: Renounce, Don’t Clean Up the Past, But File Your
Exit Year Return
What if you go to the Embassy to renounce your citizenship, but never clean up your prior years of tax returns? Instead, you file all of the tax returns for your expatriation year. You concede that you are a covered expatriate and deal with the consequences.
This strategy is risky. You reveal your existence to the IRS by filing the tax return for the year of expatriation. Worse yet, you have just painted a giant bullseye on yourself. On Form 8854, Part IV(A), Line 6 you have checked a box that says tells the IRS clearly that you have some tax messes in your past:
Do you certify under penalties of perjury that you have complied with all of your tax obligations for the 5 preceding tax years (see instructions)?
If you tell the truth, you have invited the IRS to send you a letter and open an audit.
You can either ignore the letter or deal with it.
If you ignore the letter, your life strategy will be to never travel to the United States and never invest in the United States. The government knows about you, knows that you have unspecified tax problems (in fact, they can see that you never filed a tax return), and is hungry for money.
If you deal with the audit at that point, you will be filing several years of income tax returns. You will be paying penalties. You will be paying interest. Expect no mercy. This will be an expensive audit.
In other words, you are either in the first camp (stay away from Radioactive America for the rest of your life) or you are looking at the strategy I recommend (clean up your messes) but with a much more expensive outcome.
Will the IRS come after you? Yes they can, but will they? If you are a low income, low net worth person, there is no incentive for the government to allocate personnel and money to chasing you. The government holds all of the cards. Your liability for taxes never goes away (it only goes away three years after you file a tax return and you haven’t filed anything for those old years). The government can just sit back and wait. If you put yourself in harm’s way, you are easy pickings.
If you are a high income, high net worth person, there is a bigger incentive for the government to pursue you. In addition, there are probably more reasons why your life or your investments will touch the United States sometime before you die. Even if you do not get the audit letter, gravity is working in the government’s favor. The IRS just lies in wait.
Benefit: save the cost of five years of tax returns. Price paid: the psychic tax of uncertainty, after having made yourself visible and vulnerable to attack.
Choice 3: Do It the Hard Way; Your Future Self Will Thank You
My consistent advice to people, when asked, is that the best strategy is to do things right. First, file those five years of tax returns. Then, renounce your citizenship. Finally, file that last U.S. income tax return and Form 8854.
The price of this strategy? Time and money. Time because it will probably take a couple of months to get those five years of tax returns prepared and filed (more if you have to apply for a Social Security Number first). Money because it costs money to get the tax work done.
The benefit? You can move freely around the planet without fear. You can do business and invest in the United States without fear.
I figure that there are some universal laws. Paying the price is one of them, and in the long run everyone pays the price. I would rather not pay the mental price of fear or uncertainty.
But only you can be you. I will leave you with Bill Murray’s response to the question “What’s it like to be you?” from 7 Steps to Living a Bill Murray Life, by Bill Murray
I think if I’m gonna answer that question, because it is a hard question, I’d like to suggest that we all answer that question right now, while I’m talking. I’ll continue. Believe me, I won’t shut up. I have a microphone. But let’s all ask ourselves that question right now. What does it feel like to be you? What does it feel like to be you? Yeah. It feels good to be you, doesn’t it? It feels good, because there’s one thing that you are — you’re the only one that’s you, right?. So you’re the only one that’s you, and we get confused sometimes — or I do, I think everyone does — you try to compete. You think, Dammit, someone else is trying to be me. Someone else is trying to be me. But I don’t have to armor myself against those people; I don’t have to armor myself against that idea if I can really just relax and feel content in this way and this regard. If I can just feel, just think now: How much do you weigh? This is a thing I like to do with myself when I get lost and I get feeling funny. How much do you weigh? Think about how much each person here weighs and try to feel that weight in your seat right now, in your bottom right now. Parts in your feet and parts in your bum. Just try to feel your own weight, in your own seat, in your own feet. Okay? So if you can feel that weight in your body, if you can come back into the most personal identification, a very personal identification, which is: I am. This is me now. Here I am, right now. This is me now. Then you don’t feel like you have to leave, and be over there, or look over there. You don’t feel like you have to rush off and be somewhere. There’s just a wonderful sense of well-being that begins to circulate up and down, from your top to your bottom. Up and down from your top to your spine. And you feel something that makes you almost want to smile, that makes you want to feel good, that makes you want to feel like you could embrace yourself.
Happy Tuesday, my friend.
I am not a guru and I am not Bill Murray. This is not legal advice and before you take the plunge, think long and hard and get professional advice. Choose to do something that your future self will thank you for.