America, love it or leave it! Tax consequences of citizenship renunciation

The Unites States are known for their tax treatment of American citizens regardless of their place of residence or domicile. As such, US nationals have to file annual tax returns mentioning their worldwide income and are often taxed by the United States regardless of the fact that they have barely a connection with the country. For many, the concerns about their financial futures due to the heavy tax burden are too much. This especially applies to those “accidental Americans” who are born to American parents living abroad that have never even once visited the US.

The situation has even become more stringent with the introduction of the FATCA regulations. In either instance, whether with citizens worried about their financial futures or whether with the Accidental Americans, there is an exit strategy available that would fully or at least partially eliminate this tax shortfall. This strategy is the renunciation of US citizenship.

In the following article, Ms. Alicea Castellanos, partner at "Global taxes LLC", talks about the renunciation of US citizenship and the tax consequences thereof.

During the tumultuous protests against the Vietnam War in the late 60’s and 70’s, many pro-war activists decried the slogan “America, love it or Leave It!”. The meaning behind the slogan is that there is no middle road when proclaiming allegiance and loyalty to the US. That is, you are either supportive of your country and the decisions made by its government, or if not, you have the choice to leave and live elsewhere. It is a highly emotional proclamation reminiscent of a time in this country when people were deeply divided on very serious life and death issues. Fast forward 40 years to the present and you will note the landscape of the US very much resembles that of the late 60’s and 70’s. America is encountering deep division once more. Coupling that situation with a deadly pandemic and you have citizens who are second guessing whether their future remains in the US.

However, there are US citizens who will not second guess their future in the US due to political reasons. Rather, these people are more concerned about their financial futures due to the heavy tax burden required of American citizens. Further, there are the so-called “accidental Americans” who are born to American parents living abroad that have never even once visited the US. Technically, people who fall into this category are required to report income and file tax returns in the US. With the passage of the Foreign Account Tax Compliance Act known as FATCA, financial institutions over the world are now required to determine the citizenship status of their account holders and report the findings to the Internal Revenue Service (IRS). This scenario leaves accidental Americans in a precarious position such that they will now be subject to double taxation. In either instance, whether with citizens worried about their financial futures or whether with the Accidental Americans, there is an exit strategy available that would fully or at least partially eliminate this tax shortfall. This strategy is the renunciation of US citizenship. The laws of relinquishing citizenship are detailed in the Immigration and Nationality Act. The US Department of State has the authority over this process. Dubbed the label of an “expatriating act”, it requires forethought and intent to complete the process. The process is accomplished by taking an oath in person to that affect with a consular or diplomatic officer. There is a mandatory fee of $2,350 assessed at the time of renunciation. However, there is no requirement to become income tax compliant nor to obtain a Social Security number.

Nonetheless, giving up a US passport or long-term green card is a serious undertaking. The IRS will review the matter to determine the tax results of such an act of expatriation. There is an IRS tax upon exit from the US, which is like an estate tax on the gain in all of one’s assets even if nothing is being sold. The tax is computed as if you sold all of your assets on the day before renunciation. With a capital gains tax rate that could be as high as 23.8% and a potential levy of the associated net income tax, the want to be ex-American citizen will find himself with a hefty bill to pay to the IRS. Regardless, many have determined that that is a small price to pay in order to no longer be bound by the US tax filing and reporting requirements, of which are imposed against worldwide assets and income. With the exception of Eritrea, the US is the only other country in the world that taxes it citizens on worldwide assets and income.

There are three triggers for the Exit Tax and any one of them will make you a covered expatriate. First, if the aggregate value of your net worldwide assets is over $2 million, or for a married couple $4 million, you will be assessed the tax. Another trigger is if your average annual net income tax for the 5 years ending before the date of expatriation or termination of residency is more than a specified amount that is adjusted for inflation ($160,000 for 2015, $161,000 for 2016, $162,000 for 2017, $165,000 for 2018, and $168,000 for 2019). Take note that this figure is not your taxable income, but the tax liability on the income. The last trigger is if you fail to certify on Form 8854, Initial and Annual Expatriation Information Statement, that you have complied with all U.S. federal tax obligations for the 5 years preceding the date of your expatriation or termination of residency.

A tax professional can assist you with some planning techniques that may effectively avoid the exit tax. For example, in gifting assets to each other, spouses can bring their respective net worths under $2 million. This strategy is effective when both spouses are US citizens since the gifting will avoid gift taxation due to the unlimited marital deduction for gifts and bequests. However, if one of the spouses is not a US citizen, the gifts may be subject to tax. In 2020, the annual exclusion for such a gift is $157,000. If the US citizen spouse needs to transfer more than that to bring net worth under $2 million, you would need to rely on the unified tax credit or make transfers over multiple years before the year of expatriation.

A married couple can effectively avoid the scenario of an exit tax as far as the second trigger of the annual income tax liability is concerned by filing separate income tax returns. Since the trigger is based on the average annual tax liability for the five year prior to expatriation, it is possible to circumvent this trigger by filing separately for several years. This is because you are otherwise required to use your net income tax liability on joint returns even if only one of the spouses is expatriating.

Even with careful planning, it is still possible that expatriation will trip one of the three triggers and necessitate the payment of an exit tax. A covered expatriate will be shielded from tax on the first $725,000 of gain in 2020. To claim the exclusion, a Form 8854 is filed with the IRS. Married couples expatriating would each file their own Form 8854 to have a combined $1.45 million of gain excluded. The exit tax on certain assets such as in those held in a 401(k) plan can be deferred. This means the exit tax would only be paid upon taking distributions from the plan. However, since at that stage you would no longer be a citizen, your income tax rates would b 30% and there would be no treaty benefit to reduce the tax. For other assets, there is a possibility to make an irrevocable election to defer the payment of the exit tax. However, with such an election, the IRS would require a bond or adequate security for any deferred tax. Such an election also does not toll the accrual of interest on the amount owed.

Assuming the de facto gain on assets is less than the threshold, there are still negative consequences to being a covered expatriate namely when it comes to estate and gift taxation. Section 2801 of the Code imposes a tax on US citizens or residents who receive gifts or bequests from covered expatriates. The gift received is taxed at the highest estate tax rate in effect on the date of receipt and is paid by the recipient. Further, a current non-US, but former US citizen, with properties remaining in the US would only have those assets shielded from the estate tax on the first $60,000 of value. This is a far cry from the 2020 lifetime exemption of $11.58 million per US citizen donor. Planning, however, can eliminate this exposure if all US assets are liquidated and the expatriate holds only non-US assets at death.

The decision whether to love or leave America is not so clear cut when it comes to the area of taxation. An American can love his country while at the same time feel the need to leave because of being overwhelmed by the complexity of the US tax code and taxpayer obligations. It does not go unnoticed that the US is one of only two countries in the world that taxes on worldwide assets and income. Even with various tax credits and deductions available to US citizens to defray the heavy price of double taxation, some may justifiably feel that such measures are insufficient. Further, there are people living overseas falling into the category of accidental Americans who are faced with the same daunting tax obligations as American citizens who reside in the US. This could be the case even if such accidental Americans have never visited the States. It is a futile exercise bordering on anachronism and irrelevancy to invoke those emotional slogans of the 1960’s and 1970’s and direct them at these expatriates and accidental Americans. The motivations of these people to avoid a heavy tax burden has less to do with sovereign allegiances and loyalties and more to do with the protection of assets.

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