Heads, Big Brother wins. Tails, you lose.
That’s the no-win dilemma US citizens who live overseas face when it comes to using a US passport as their main travel and identification document.
Actually, it’s a seven-times lose dilemma, as I’ll describe in a moment. And it’s likely why Americans are giving up their citizenship faster than ever before – 2,909 in the first three months of 2020 alone.
If you’re a US citizen and thus eligible for a passport, Uncle Sam could refuse to issue or renew it for a variety of reasons, including having a “seriously delinquent tax debt” to the IRS of $53,000 or more (including interest and penalties).
Bam, you lose.
If you’re a US citizen living abroad, your passport is essential to your everyday existence. Indeed, any residence visa requires possession of a valid passport.
Thus, if your US passport is revoked, unless you already have a second passport, you’ll have to come back to the US and leave your family, your property, and business relationships behind.
You lose again.
Yet Uncle Sam also makes it uniquely difficult for US citizens living abroad, with the country’s policy of citizenship-based taxation. The US is one of only two nations that impose income tax on its citizens’ worldwide income, even if they live in another country. (Eritrea, a totalitarian dictatorship, is the other one.)
Complying with US tax rules is hard enough if you live in the US. But if you’re residing in another country, you must file two sets of tax forms each year.
Plus, 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.
FATCA, for instance, forces foreign financial institutions (FFIs) to follow US tax and reporting rules with respect to their US clients. If they don’t, or can’t, they face a 30% withholding tax on many types of US-source income and other capital transfers.
FATCA’s intention is to root out all that money Americans supposedly stash away in tax havens to ensure that Uncle Sam gets his share. Even though the claim that the Treasury loses $100 billion annually from offshore tax evasion turned out to be a lie.
FFIs also must enforce US money laundering, anti-terrorism, and securities regulations. 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 lose a third time.
And that’s only the beginning.
Let’s say you live in a country with a higher tax rate than the US – in no way considered a tax haven – and sign up for a pension plan there.
You innocently assume the income generated within the plan is tax-deferred until you retire, as the country you live in and pay taxes to provides for this advantage.
Not so fast, says the IRS.
Simply by following the example of your friends, families, and co-workers, you’ve unintentionally enmeshed yourself in one of the most complex sections of the Internal Revenue Code — those dealing with foreign trusts.
In some cases, you’ll need to pay US tax on the income from the pension as it accumulates. And you might not be able to take a credit against the tax you paid in the US on your income tax liability to your home country. When you start receiving pension payments, that country will tax it again.
You lose a fourth time.
What’s more, if you’re a participant in a foreign retirement scheme, you’re generally supposed to start filing two US tax forms you’ve probably never heard of: Form 3520 and Form 3520-A. Some foreign pensions are exempt from filing these forms, but many aren’t.
Here’s an excerpt from the first paragraph from the instructions to Form 3520-A:
A foreign trust with a U.S. owner must file Form 3520-A in order for the U.S. owner to satisfy its annual information reporting requirements under section 6048(b). Each U.S. person treated as an owner of any portion of a foreign trust under the grantor trust rules (sections 671 through 679) is responsible for ensuring that the foreign trust files Form 3520-A and furnishes the required annual statements to its U.S. owners and U.S. beneficiaries.
Got that, campers?
And yes, very heavy penalties apply if you don’t file these forms – especially Form 3520, where the IRS can impose a 35% penalty for unreported transfers to or from the foreign trust.
If you can prove you didn’t realize you had to file this form, the IRS might let you escape without penalties. Also, the IRS recently issued new rules which are somewhat less onerous than the old ones. But you’ll still need to hire an expensive international tax specialist to lead you through the labyrinth.
You lose a fifth time.
And if you didn’t file Form 3520, and failed to qualify for a penalty exemption, you might have a “seriously delinquent tax debt” that leads to revocation of your US passport.
You lose a sixth time.
Understanding this background, you might be surprised to learn that only 2,909 Americans gave up their citizenship and passport in the first quarter of 2020, opting out of this corrosive system permanently.
Yes, it’s the highest quarterly total ever. But the number pales in comparison to the estimated nine million Americans currently living abroad full-time or almost full-time.
One reason expatriation – giving up US citizenship and passport – is likely so rare is that it’s a touchy topic. After all, it stops the clock on all future IRS obligations to report or pay tax on non-US income, although you’re still obligated to pay previous taxes, interest, and penalties.
Thus, Congressman Sam Gibbons (D-FL) spoke of “the despicable act of renouncing allegiance to the United States.” Rep. Neil Abercrombie (D-HI), described expatriates as “Benedict Arnolds who would sell out their citizenship, sell out their country in order to maintain their wealth.”
The ferocity with which US politicians have seized upon this issue has made sanctions against expatriates increasingly more severe. Congress first enacted anti-expatriation tax rules in 1966. The laws were tightened in 1996, 2004, and most recently in 2008.
The 2008 law imposes an “exit tax” on unrealized gains held in the worldwide estates of US citizens or long-term residents who expatriate. And once again, there’s no assurance that the country you live in won’t impose tax a second time on the same gains when you sell appreciated assets after expatriation. There are numerous other tax booby traps that can apply as well. And while it’s possible to mitigate these results, avoiding the traps again requires expert (and expensive) advice.
Do I hear “seven”?
What’s more, if Senators Bob Casey (D-PA) and Chuck Schumer (D-NY) have their way, wealthy expatriates would be banned from ever returning to the US.
Expatriates don't get a lot of sympathy on Capitol Hill – or on Main Street, USA. Naturally, the media emphasizes the tax aspect of expatriation when it trains its focus on high-profile expatriates like Facebook co-founder Eduardo Saverin or pop singer Tina Turner.
But almost all individuals who give up US citizenship or permanent residence pay at least some tax in their adopted country. In popular expat destinations like Canada and the UK, they typically pay more.
Is expatriation for you? The decision to give up US citizenship is a serious one. It requires that you acquire a second passport if you don’t already have one. You must also live permanently outside the US if you don’t already.
But expatriation is the only way that US citizens living abroad can legally and permanently eliminate US tax and reporting obligations on their non-US income, wherever they live. It's a tax avoidance option that Congress may eventually make even more onerous.