Complying with US tax rules is hard enough even when you live in the United States.
But with rare exceptions, if you’re one of the four million or so US citizens living in another country, you must file two sets of tax forms each year – one in the country where you live, and a second in the United States.
This is an almost unique burden. The only other country that taxes its non-resident citizens is the totalitarian dictatorship of Eritrea.
What’s more, Americans living abroad also have extensive reporting obligations that they often know nothing about. For instance, the bank account they hold at what they consider a “local” bank is, in the eyes of the IRS, a “foreign account” that must be reported.
The life insurance policies they’ve purchased, and the pension plans they’re enrolled in are likewise foreign accounts. Plus, any tax deferral they receive for the growth in value in a life insurance policy or a pension plan often isn’t recognized by the IRS.
That means they’ll pay tax twice on the same income – once to Uncle Sam on the unrealized gain inside the insurance policy or pension plan and a second time to their country of residence when they actually receive it.
What’s more, laws like the infamous Foreign Account Tax Compliance Act (FATCA) have made it nearly impossible for Americans living abroad to carry on the most basic financial and business relationships in their adopted countries.
Among other odious provisions, FATCA, forces foreign financial institutions (FFIs) to enforce US tax and reporting rules with respect to their US clients. If the FFIs don’t, or can’t, they face a 30% withholding tax on many types of their US-source income.
It’s no wonder that most overseas financial institutions have fired their US clients – including those living in the country where they hold their accounts.
You might wonder why Uncle Sam seems to detest Americans living abroad. The logical answer would be that the IRS is convinced they’re paying little or no tax in the countries where they live. And the agency wants what it believes is its fair share.
But the vast majority of US citizens living outside the United States reside in countries where the tax burden is higher than it would be in the United States.
Take Canada, for instance, where around one million US citizens live (perhaps more). Canada’s top federal income tax bracket is 33%. That might seem relatively mild, but all Canadian provinces also impose an income tax, which tops out at 25.75% in Quebec.
What that means is that when an American living in say, Quebec, files their US tax return, in most cases, they won’t owe any tax. Indeed, the only significant revenue Uncle Sam generates from a typical US citizen living in another country is if they slip up and forget to file a form.
For instance, a few years ago, we had a Canadian client who purchased a cash-value life insurance policy in that country. The investments in the policy included several Canadian mutual funds.
The growth in the policy’s cash value was tax-deferred in Canada. But not in the United States. So, our client had to pay US tax (along with late payment penalties) on the gain in the policy’s value each year she held it.
And since the Canadian insurance policy didn’t meet the US Tax Code’s definition of “life insurance” (and why would it?), our client needed to file additional reporting forms for each “foreign” mutual fund held within the policy. That resulted in more late filing penalties along with a draconian tax framework for something called “PFIC excess distributions.”
As you might think, citizenship-based taxation isn’t popular among Americans living overseas. Over the years, they’ve lobbied Congress, formed advocacy groups, and spent a fortune on complying with the US tax obligations.
Some have expatriated – given up their US citizenship and passport – to legally and permanently end their tax and reporting obligations on their non-US income and assets. Others take advantage of a handful of tax breaks Congress has extended to Americans living abroad – most importantly, the foreign earned income exclusion (FEIE).
Some – especially those who by circumstances of birth or parentage are US citizens – try to hide that fact from both FFIs and Uncle Sam. But the Treasury Department is cracking down hard on such “accidentals” and threatening to penalize FFIs that offer them financial services.
It doesn’t need to be this way. In 2022, American Citizens Abroad (ACA), an advocacy group for US citizens living overseas, released an economic analysis of residence-based taxation (RBT) – the system of taxation every country other than the United States and Eritrea follows.
It concluded that a transition from CBT to RBT would largely be revenue neutral and would perhaps even generate a small surplus over the next decade. But the response from the powers-that-be in Washington, D.C. since then has been non-existent.
There simply isn’t any good way that an American living in another country can carry on basic financial and business relationships. And currently, the only way out is expatriation – admittedly, a radical step, but one that an increasing number of former US citizens have chosen. In 2022, a total of 3,429 Americans expatriated.
In order to expatriate, though, you need a second citizenship and passport. Otherwise, upon giving up US citizenship, you would be stateless – a person without a country and not legally entitled to live or work anywhere.
The decision to give up US citizenship is a serious one. It requires that you live permanently outside the United States. And if you have a net worth over $2 million or meet other criteria, you may need to pay an “exit tax” when you end your US citizen status.
If you’re considering expatriation, we can help. Over the last two decades, we’ve helped hundreds of clients obtain second citizenship in the Commonwealth of Dominica and the Federation of St. Kitts & Nevis. And we’ve assisted many of them in expatriation – divorcing Uncle Sam for good. Contact us at service@nestman.com for more information.
