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Tax Consequences Of Expatriation

During last month’s Olympic Games, skier Eileen Gu made headlines not only because of her considerable skill but also because she has potentially joined the ranks of Americans who have renounced their citizenship.

At this writing, Gu has not addressed her citizenship status, repeatedly refocusing public questions about it toward her athletic career. These questions arose because the American-born Gu chose to compete for China in the 2022 Games. The International Olympic Committee allows dual citizens to compete as long as they hold a passport for the country they represent. While the United States allows dual citizenship, China does not. Some observers, however, suspect China has selectively chosen not to enforce that rule in cases like Gu’s.

Whatever Gu’s particular arrangement, the speculation brought attention to a growing number of U.S. citizens choosing to cut ties with the country. Some may be fed up with the country’s hyperpartisan political climate, while others who have long lived or worked abroad may want to gain citizenship in a country that won’t let them do so while keeping their U.S. passport.

A small but notable group are “accidental Americans.” This category includes people whose noncitizen parents happened to be in the United States for education or work when their child was born, since anyone born in the U.S. is a citizen (except children of foreign diplomats). The same is true of anyone born in a recognized U.S. territory such as Puerto Rico. The “accidental American” category can also include children born to U.S. citizens overseas in certain circumstances.

This scenario raises a question. If accidental Americans live in countries that allow dual citizenship, why not enjoy the privileges that come with their double nationality? Many people worldwide would love the right to visit, live in or work in the United States. The answer is often the same as the one that contributes to many other decisions to renounce U.S. citizenship: taxes.

The United States is nearly unique in taxing its citizens on their income regardless of their residency. This means that even if an individual has never set foot in the United States, he or she may owe taxes here. In cases where a treaty or other circumstances prevent citizens from owing taxes, they are still saddled with the hassle and expense of preparing tax filings and disclosure forms for the Internal Revenue Service.

Accidental Americans who don’t realize how the U.S. tax regime works – a frequent situation, especially if they are born to non-American parents – can face serious penalties for years of noncompliance. United Kingdom Prime Minister Boris Johnson was reportedly once outraged to discover that he owed tax to the U.S. authorities after recognizing a gain on the sale of his London home. Johnson, who was born in New York to British parents and left the country at age five, subsequently renounced his American citizenship in 2016.

The United States’ worldwide approach to taxes can be burdensome, but expatriation is not a decision to make lightly. If tax considerations are your main motivation, read on to find out how the IRS will do its best to make your departure as painful as it can.

The Expatriation Process

There are a variety of ways for Americans to lose their U.S. citizenship. These can potentially include running for public office in another country, joining another country’s armed forces, or a conviction for treason. But in the vast majority of cases, losing U.S. citizenship is a result of formally renouncing it.

Renouncing status as an American citizen usually happens in two parts. One process involves the State Department, and the other involves the IRS.

As far as the State Department is concerned, the American must visit a U.S. consulate or embassy and announce his or her intentions to a diplomatic or consular officer. The renunciation process involves attending an exit interview, signing a formal oath of renunciation and paying a nonnegotiable fee of $2,350. Renunciations by mail, verbal statement, electronic means or a third party acting on a citizen’s behalf are not valid. Expatriation is not final until the department issues a certificate ratifying the process.

In order to renounce citizenship, U.S. citizens also must be current on their income tax returns, as well as any other required tax filings, for the year of expatriation and the five previous years. This will generally involve filing a final year income tax return. In addition, the individual must submit IRS Form 8854. This form includes a personal balance sheet and income statement, as well as a variety of measures that will determine whether the individual is subject to an exit tax upon renunciation. Failing to file Form 8854 can lead to a $10,000 penalty, even if you do not owe exit tax.

The exit tax, also known as an expatriation tax, is among the United States’ means of discouraging citizens from renouncing citizenship just to avoid global taxation. Americans renouncing their citizenship after June 17, 2008 owe the tax if they meet one of three criteria:

  1. The individual’s annual net income tax for the previous five years exceeds a specified amount ($172,000 for tax year 2021; this amount is indexed for inflation)
  2. The individual has a net worth of $2 million or more on the date of his or her expatriation
  3. The individual fails to certify on Form 8854 that he or she has complied with all U.S. tax obligations for the five years preceding expatriation.

If a U.S. citizen meets one of the aforementioned criteria, the IRS considers the U.S. citizen a “covered expatriate.” Certain dual citizens and minors are exempt from covered expatriate status, regardless of income tax or net worth.

Covered expatriates are deemed to have sold their worldwide assets for fair market value on the day before expatriation takes effect. You may hear this called a “mark-to-market” regime in some contexts. The proceeds of the hypothetical sale are subject to U.S. capital gains tax, at either short- or long-term capital gain rates as appropriate. The law does exempt a portion of the gains from tax; for tax year 2021, the first $744,000 of hypothetical gains were excluded.

In addition, tax-deferred accounts such as individual retirement accounts and Section 529 investment accounts are treated as though the owner received a complete distribution of all the accounts’ assets on the day before expatriation. In general, though, there is some leniency when it comes to certain penalties that would normally apply. For example, expatriates under the age of 59 1/2 are not subject to the 10% penalty for early withdrawals from an IRA.

Two exceptions to the exit tax are for individuals with deferred compensation arrangements and beneficiaries of nongrantor trusts. For the purposes of this tax, deferred compensation may be eligible or ineligible. In general, eligible deferred compensation arrangements are offered by a U.S. company or other U.S. payor. The expatriate does not need to pay taxes on eligible deferred compensation until they start to receive payments, but the income must be subject to withholding and the taxpayer must irrevocably waive any treaty benefits that would otherwise reduce the applicable withholding. Ineligible deferred compensation, typically from a foreign entity, does not offer these same options. The taxpayer is assumed to have received the net present value of the accrued benefits of the plan as of the date of expatriation. They must report this income on their final income tax return.

Interests in nongrantor trusts are also partially sheltered from the expatriation tax. A covered expatriate with an interest in a nongrantor trust is subject to tax withholding on future distributions. By default, covered expatriates are treated as if they waived any applicable treaty benefits in relation to the trust. The individual may choose instead to seek a ruling from the IRS that will treat the individual as receiving a full distribution of their interest in the trust upon expatriation. This will mean an upfront tax payment, but no future withholding.

Some expatriates may find paying the expatriation tax a burden, especially since the tax is imposed regardless of whether the individual actually sells the property subject to the tax. The IRS does allow individuals to defer paying the tax if they make an election on Form 8854. The deferred tax is due to the U.S. once the taxpayer disposes of the property, or upon his or her death. This election applies on a property-by-property basis. The taxpayer must provide adequate security for the unpaid taxes and waive any treaty benefits that would inhibit the U.S. from collecting taxes. Deferring the tax does come at a cost, since interest will accrue on the unpaid tax during the deferral period.

Some citizens who intend to renounce their citizenship but who would face an exit tax only because they are not current with their U.S. tax obligations now have options for relief. This relief is meant for citizens who made a good-faith mistake about their citizenship status. The IRS has instituted provisions for citizens who have a net worth below $2 million and who do not meet the average annual income thresholds that apply to covered expatriates. Candidates must have an aggregate tax liability of $25,000 or less for the taxable year of expatriation and the five prior years. This option is not open to individuals with a tax filing history as a U.S. citizen or resident, though it is available to individuals who filed nonresident returns (Form 1040NR) under the belief they were not a citizen. The provisions are intended for those who failed to file and pay taxes due to negligence or mistake, not those who willfully avoided taxation.

If individuals meet these requirements and navigate the procedure laid out by the IRS, they may be able to avoid liability for unpaid taxes and penalties. They can also avoid falling into the third category of covered expatriate, or citizens subject to the exit tax upon expatriation. This relief is especially welcome for accidental Americans who were genuinely unaware of their tax obligations to a country they left decades before, or never visited at all.

While You Wait for a Decision

Given the seriousness of expatriation, you should consult with an attorney, a tax expert or both before you proceed. Even once you have made the decision to expatriate, however, know that you may not be able to control the timing of the process.

You are officially no longer a U.S. citizen on the earliest of four possible dates. The first is the day you renounce your nationality before a diplomatic or consular officer, as long as the State Department subsequently approves your renunciation. The second is the date you submit a signed voluntary relinquishment to the State Department, assuming the relinquishment is later approved. The third is the date the State Department issues a certificate of loss of nationality, and the fourth is the date the U.S. court cancels a naturalized citizen’s certificate of naturalization. The process may involve more than one of these events, but the earliest is the one that counts for tax and other legal purposes.

At this writing, many aspiring expatriates find themselves in a holding pattern waiting for any of these events. This is mainly because of the requirement to renounce citizenship in person. Since March 2020, many U.S. consular missions have suspended expatriation services as a result of the COVID-19 pandemic. Even when services resume, embassies and consulates are likely to face a significant backlog. The Guardian reported that, as of December 2021, an estimated 30,000 Americans living abroad wanted to begin the renunciation process but could not.

American citizens stuck in limbo should remember to stay current with their U.S. tax obligations in order meet the process’s requirements when they get the opportunity. Bear in mind that even in cases where treaties or other factors mean you owe no U.S. tax, you must still file an income tax return and any other relevant reporting documents.

You should also take special care to avoid becoming stateless while handling the delayed renunciation process. Stateless individuals, or those without citizenship in any country, face difficulties in travel, owning or renting property, securing the right to work, receiving medical care and a variety of other areas. If at all possible, you should fully secure citizenship in your new country before renouncing your U.S. citizenship.

COVID-19 delays can sometimes create complications, especially in countries that do not allow for dual citizenship. Without a clear sense of how long expatriation will take, it can be nerve-wracking to balance competing requirements. This is a situation in which a knowledgeable professional will be invaluable.

After You Renounce U.S. Citizenship

Once you navigate the expatriation process, be aware that you may not be done with the U.S. tax authorities.

After you file your final-year income tax return and Form 8854, the IRS legally has three years to audit your final paperwork. This window expands if the authorities have reason to suspect fraud. Be sure to keep all your records organized and accessible, even after you have surrendered your passport. In addition, you will need to file Form 8854 annually if you choose to defer payment of the exit tax, maintain outstanding eligible deferred compensation arrangements, or are a beneficiary of a nongrantor trust.

If you have income sourced to the United States, you will still owe tax, even as a noncitizen. If you have income tied to the U.S., you may be required to file Form 1040NR annually, just as someone who was never a citizen would. “Effectively connected income” is income connected with a U.S. trade or business, and is taxed at graduated rates that former citizens will find familiar.

In addition, any other U.S. source income is considered “FDAP” income – fixed, determinable, annual or periodical – and therefore taxable, unless it falls into a few main categories of exception. These include income connected with a U.S. trade or business (covered under “effectively connected income”); gains from the sale of personal or real property; or income that the IRS would typically exclude from gross income. FDAP income is typically taxed at a flat 30% unless a treaty with your country of citizenship applies. Unlike effectively connected income, you generally cannot use deductions or credits to lower your FDAP tax obligations. If you are in the United States physically for more than 183 days during a calendar year, your capital gains will also be taxed at 30%, unless a treaty stating otherwise applies.

If you have family who remains in the United States, you may face complications from the federal gift and estate tax. American citizens who receive gifts or bequests from a covered expatriate larger than the annual gift tax exclusion may incur tax liability. The annual exclusion is adjusted for inflation; in tax year 2022, it is $16,000. Larger gifts can trigger transfer tax at the highest applicable rate. If an expatriate makes a gift to a U.S. trust, likewise, the trust will owe transfer tax. Gifts to a foreign trust can trigger tax if they distribute assets to a U.S. citizen or resident, though the initial gift to the trust is not a U.S. tax event. Based on proposed rules announced in 2015, American recipients should report these gifts to the IRS on Form 708, but the IRS has yet to issue the form at this writing.

In addition to these reporting requirements, American citizens must disclose gifts of $100,000 or more they receive from a noncitizen or foreign estate to the IRS on Form 3520. Failure to file this form can lead to an initial penalty of $10,000 or 35% of the value of the transfer, whichever is greater. Additional penalties can apply for continued noncompliance after the IRS notifies the taxpayer.

You should also take special care as an expatriate parent. If your minor children are U.S. citizens, you cannot renounce their citizenships for them. Note that even if your children were born abroad, they could still be citizens, depending on the circumstances; for their sake as well as yours, it pays to consult the applicable rules. In general, your children cannot renounce their own citizenship until they are 18, though some limited exceptions do exist for children between the ages of 16 and 18. Regardless of what your children plan to do about their own citizenship as adults, be aware that you may face some tax filing requirements on their behalf in the meantime. It is best to consult a knowledgeable tax professional to be sure you are aware of these potential scenarios.

Beyond the effects on your tax planning, remember that renouncing U.S. citizenship has profound consequences. Depending on your new country of citizenship, you may need a visa to get back into the United States to visit or to work, and there is no guarantee that you will obtain one. If the United States Attorney General finds that you expatriated exclusively to avoid taxation, you may be indefinitely excluded from visiting the U.S. under the Immigration and Nationality Act. In nearly all cases, renouncing your citizenship is irreversible. To become a U.S. citizen again, you would have to pursue the same road to citizenship as any other noncitizen, and current immigration policy means that approach is not an easy one for most people.

Expatriation is not the first strategy to consider if your aim is simply to lower your overall tax burden. In fact, it should likely be the last option on your list, considering the difficulty, the drawbacks, and the extent to which the U.S. tax authorities are likely to maintain a presence in your financial life even after you leave. That said, there are circumstances when expatriation is the right choice. If you are sure you are ready to say goodbye, make sure the IRS gets its due on your way out – and after.

Senior Client Service Manager ReKeithen Miller, who is based in our Atlanta office, is the co-author of Chapter 14, “State Income Taxes” in our firm’s recently updated book, Looking Ahead: Life, Family, Wealth and Business After 55. He also contributed to the firm’s book The High Achiever’s Guide To Wealth.