Before Taking Flight: Expatriation Tax Considerations
Anticipated or not, Americans increasingly seem to be questioning the value of their U.S. citizenship or long-term residence for personal, professional and financial reasons. Nearly 500 Americans expatriated during first-quarter 2011, a nearly 30% increase from the quarterly average in 2010 and a more than 168% jump from the quarterly average in 2009.
Perhaps it’s a desire to return to your ancestral home after living or working in the U.S. Maybe during years of global travel, you’ve found the ideal locale for permanent residency outside of the United States. Or perhaps it’s simply time for a change.
If taxes are a factor in the decision, it’s crucial to note that officially declaring you are renouncing your citizenship for tax reasons could prohibit reentry to the U.S., as outlined in the Reed Amendment to federal immigration laws passed in 1996. However, the U.S. Department of Homeland Security has not published implementing regulations, so no procedures to implement this law currently are in effect, according to the Department of State.
Regardless of the reason, it takes a considerable amount of foresight and preparation. “You want as few surprises as possible if you choose the path of expatriation,” says Suzanne Shier, tax strategist for Personal Financial Services at Northern Trust. “So it’s important that you get the right advisors in the United States and overseas who understand the complexities and can look at these circumstances from both ends of the telescope.”
U.S. Tax Considerations
For individuals whose average annual net income tax during the past five years has averaged less than $151,000 (in 2012), have a net worth of less than $2 million and have certified their tax compliance for the past five years, expatriation is relatively simple. But those with greater-than-average tax liabilities or a larger net worth are referred to as “covered” expatriates, a designation defined in the Heroes Earnings Assistance and Relief Tax (HEART) Act of 2008.
Such individuals face an all-encompassing tax bill on their existing assets based on the assumption that they liquidated everything – regardless of whether they actually did – on the day before they expatriated. Assets are marked-to-market, and covered expatriates are taxed on all but $651,000 of the assumed gains. Deferred compensation, specified tax deferred accounts and non-grantor trusts are not subject to this deemed sale treatment, but are either treated as taxable on the day before expatriation or subject to withholding tax when actually paid or distributed.
For example, a person who renounces his U.S. citizenship on April 30 must file a Form 8854 to account for the tax due – the so-called Expatriation Tax – as if the assets were liquidated on April 29. The tax may be deferred, but interest is charged and the tax is imposed when the assets are disposed of.
“Where the calculations get complicated are situations involving hard-to-value assets such as real estate in remote locations, portions of family-owned businesses and non-qualified bonus plans paid out in different countries,” says Phil Hodgen, an international tax lawyer based in Pasadena, Calif. “For example, what is the value of 500 hectares in Malaysia? The options are to get an appraisal – which the IRS might contest, and can be difficult and expensive – or get rid of the assets that are troublesome.”
To avoid potential penalties and interest charges from the Internal Revenue Service (IRS), Hodgen recommends making an estimated federal tax payment of slightly more than the amount due on Form 8854 in the quarter in which the renunciation happened.
The Decision to Expatriate
For many, the largest impediment to moving permanently abroad is the large bill associated with the Expatriation Tax. Sticker shock is likely, but Hodgen reasons that a U.S. taxpayer may pay that much as he or she disposes of the assets over time, should he or she remain a citizen.
A harder-to-swallow potential downside is the future tax burden on U.S. citizen or U.S. resident beneficiaries of expatriates. Should an expatriate make gifts or bequests back to U.S. beneficiaries, the IRS will assess the full gift and estate tax at the highest marginal rate and will not allow for any exemption other than the annual $13,000 gift tax exclusion (unless there is a separate treaty-based limitation that applies).
Further, Shier says U.S. recipients of such gifts or bequests are responsible for all related tax liabilities. Conversely, where expatriation is not involved, U.S. gift and estate taxes generally are paid by the donor or the decedent’s estate, not the donee.
But as unappealing as the tax consequences can be, the opportunity to sever ties with the United States may be beneficial for some, since U.S. citizens and residents annually pay U.S. income taxes on any income earned worldwide. In such cases, Shier says the clean slate may be a benefit.
Hodgen adds that expatriation has helped many multi-national families resolve issues stemming from the long reach of U.S. tax laws, which can impede business investments in other countries and complicate estate planning for families primarily rooted elsewhere.
As for those who simply wish to start a new life in a different land, Shier says although the taxes could be significant, it’s a one-time hit. And if an individual weighing the pros and cons of moving abroad knows a sizeable windfall is looming, he or she may prefer to get settled outside the United States before the fortune materializes.
Options for Landing
While taxes may be a factor in any large decision such as this, many other elements must be considered.
“Be realistic, as it’s difficult to find the quality of lifestyle you’ll find in the United States, with medical facilities and support systems, but with no taxes,” says Ken Vacovec, a Newton, Mass.-based lawyer who specializes in international taxation.
Ultimately, every locale will have its own tax idiosyncrasies, which should be discussed and analyzed with local tax experts. For example, western European countries such as the United Kingdom, France and Germany have high income tax rates and differing tax rules around estates, inheritances and capital gains. Meanwhile, some Caribbean nations known as tax havens for offshore income assess considerable taxes on their residents.
On the other side of the world, Singapore assesses modest income taxes, does not charge capital gains taxes and abolished estate taxes in 2008. China, on the other hand, employs a progressive income tax and taxes capital gains, yet does not tax inheritances.
More broadly, Shier suggests delving into a country’s legal infrastructure. Countries such as the United Kingdom, Singapore and Hong Kong adhere to a common law system, which is compatible with U.S.-style trusts. Countries such as Germany, France and China, however, are based on civil laws systems, which do not necessarily recognize U.S.-established trusts.
Shier says due diligence on tax treaties between the United States and another country can help avoid an unpleasant surprise stemming from double-taxation down the road. For example, while the tax treaty between the United States and United Kingdom mostly aligns the income and estate tax regimes, the treaty between the United States and France does not clearly address the European country’s wealth tax, which has no U.S. equivalent.
The bottom line: Anyone considering renouncing their U.S. citizenship or long-term residence should only do so with proper and comprehensive research and planning.