The Unique Tax Situation of US Citizens
The United States is the only major country that taxes its citizens on their worldwide income, regardless of where they live.
To permanently disconnect from US tax obligations, a US citizen must give up their citizenship, a process called expatriation.
Potential Tax Savings from Expatriation
The income tax savings from expatriation can be significant, especially for wealthy individuals.
- The $1 billion estate of an US citizen dying in 2008 who lived anywhere in the world pays a maximum combined gift and estate tax burden of exceeding $450 million.
- Even a $20 million estate could save over $8 million in taxes by expatriating.
The “Exit Tax” on Expatriates
In 2008, the US government passed a law that imposes an “exit tax” on people who give up their US citizenship.
This tax applies to expatriates with high incomes or high net worth, even if they aren’t considered “rich.”
The exit tax requires expatriates to pay taxes on the gains in their assets, even if they don’t sell them.
Additional Taxes on Expatriates
Expatriates also have to pay up to a 30% tax on distributions from their retirement accounts.
They may also have to pay taxes on gifts or bequests they make to US citizens in the future.
You Don’t Need to be “Rich” to Pay the Exit Tax
It would be one thing if the exit tax only affected billionaires. But, with only a few exceptions for dual nationals and others with strong ties to another country, the law applies to any expatriate that:
- has an average annual net income tax liability for the five preceding years ending before the date of the loss of US citizenship or residency termination that exceeds $139,000, adjusted annually for inflation; or
- has a net worth ofS$2 million or more on such date; or
- fails to certify under penalties of perjury that he or she has complied with all US federal tax obligations for the preceding five years or fails to submit any proof of compliance the IRS demands.
If you qualify under any of these criteria, you may be subject to the exit tax.
The good new is that the first $600,000 of gains is excluded. This exclusion doubles to $1.2 million for a married couple filing jointly, both of whom expatriate. This exclusion will increase by a cost of living adjustment factor after 2008.
Gains will be calculated “mark-to-market”; i.e., the difference between the market value on the date of expatriation and the market value at acquisition. Expatriates who were not born in the United States may elect to value their property at its fair market value on the date they first became US-resident, rather than when they first acquired it.
This phantom gain will presumably be taxed as ordinary income (at rates as high as 35%) or capital gains (at either a 15%, 25%, or 28% rate), as provided under current law.
When you actually sell the assets, no additional US tax is due. But your adopted country might tax the gain a second time, leading to double taxation on the same income.
Beware of Gifting to the US as an Expatriate
You might think the US would encourage wealthy foreigners to make payments to people in the US, as that money would likely be spent on US goods and services.
But if you’re a “covered expatriate” and make a gift or bequest to a US person, the recipient must withhold tax at the highest marginal gift or estate tax rate.
Avoiding the Exit Tax
If your net worth is just over $2 million ($4 million for a married couple), you can try to spend enough to get your net worth under the threshold and avoid the exit tax.
But, if you’ve paid more than an average of $139,000 annually in taxes for the previous five years, this strategy won’t work.
You may be able to defer payment of the exit tax, but you’ll have to pay interest and potentially post a bond.
Additional Options for Non-US Born Expatriates
If you were born with citizenship in both the US and another country, you may be exempt from the exit tax.
- If you were born with citizenship both in the United States and another country, you may not be subject to the exit tax. To qualify for this exemption, when you expatriate, you must also be a citizen of another country (and taxed by another country), and not been a US resident for more than 10 years during the 15-year period prior to your expatriation.
- If you’re a green card holder, you can opt out of the exit tax. To do so, you must become resident for tax purposes in a foreign country that has a tax treaty with the United States. You must also inform the IRS of your intention not to waive the benefits of the tax treaty applicable to that country.
Puerto Rico Tax Incentives: How Much Can You Really Save?
Much has been made of the Puerto Rico Tax Incentives brought in in 2012. But how much tax could you really save? And do you qualify? Find out here: Puerto Rico tax incentives.
The Importance of Getting a Second Citizenship Before You Expatriate
Although it’s not legally required, a second passport from another country is strongly recommended before you give up your US citizenship. This is true no matter if you renounce or relinquish.
Without a second citizenship, the act of expatriating will render you stateless. You won’t have the right to legally live anywhere.
For an entertaining, but romanticized, view of statelessness, watch The Terminal. This movie is based on the true account of Mehran Karimi Nasseri. After being expelled from Iran, he spent 18 years living in a departure lounge of the Charles de Gaulle Airport in Paris until he finally qualified for refugee status in France.
How to Get a Second Passport: 7 Legal Ways
Thinking about a second passport? There are just seven official (legal) ways to get one. Find out which one is the best option for you: How to get a second passport.
Need Help?
We can assist in every phase of giving up your US citizenship or long-term residence. This includes helping you get a second passport before giving up US citizenship.
And if you’re not ready to expatriate, we can help you take advantage of tax breaks in the Tax Code that apply to US citizens and permanent residents living overseas.
Schedule a free no-obligation consultation with a Nestmann Associate to see if expatriation is right for you.
