Note from Coleman Wealth: We work with a network of cross border experts, and are fortunate to have connected with the law partners at Hodgson & Russ LLP. Alice Joseffer, a partner at Hodgson & Russ is also the contributor of the post below. Alice offers her clients a full range of tax services and has been practicing for more than 30 years. She focuses her practice on successfully resolving U.S. federal tax controversies and advising U.S. and foreign clients on international tax issues. We thank Alice for allowing us to republish one of her blog posts from February, 2015. The original post can be found at www.smarterwaytocross.com/2015/02/25/expatriations-accidental-us-citizens-tax/
According to Treasury reports, 3,417 U.S. citizens relinquished their U.S. citizenship in 2014, which is more than the number of expatriations reported in prior years. As required by law, the Treasury publishes a quarterly list of names of individuals who have relinquished their U.S. citizenship. Individuals’ reasons for relinquishing citizenship are not published. London Mayor Boris Johnson, a self-described dual citizen ‘as an accident at birth’ has reportedly announced his intent to renounce his U.S. citizenship to prove his commitment to Britain. Perhaps his recent dispute with the IRS over tax on the sale of his home in London factored into his decision. Some accidental U.S. citizens have never entered the United States and simply see no reason to retain U.S. citizenship.
The reason for expatriation may be very significant for U.S. immigration reasons. Under U.S. immigration laws, any former U.S. citizen who officially renounces his or her U.S. citizenship and who is determined to have renounced for the purpose of U.S. tax avoidance may be denied entry into the United States. This provision was included as an amendment (the Reed Amendment) to immigration legislation that was enacted in 1996. There are a variety of other immigration and tax issues that should be considered carefully by an individual before initiating the expatriation process.
How does one become an accidental U.S. citizen? An individual who is born outside of the United States may be a U.S. citizen at birth based on citizenship of a parent. The U.S. laws determining citizenship at birth have varied over the years, so specific facts and applicable law must to be considered for each citizenship determination. But an individual can be a U.S. citizen without taking any affirmative action to become one. In some situations, individuals born in the United States may also consider themselves to be citizens as an accident at birth. Non-U.S. citizen parents may be traveling through the United States when a child is born. Sometimes a baby is born at a U.S. hospital when the baby’s non-U.S. citizen parents live outside the United States but close to a border and, based on medical resources, a U.S. hospital is the place of birth.
Many accidental U.S. citizens are unaware of their U.S. citizenship until an event such as the death of a U.S. citizen parent or an inquiry requires investigation. FATCA, the U.S. regime that requires certain foreign financial institutions to report information about U.S. account holders, has resulted in discovery of U.S. citizenship by some nonresidents.
Why do dual citizens care about their status? Unlike virtually every other country, the United States taxes its citizens on worldwide income. Nonresidents who are not U.S. citizens are required to pay U.S. income tax only on U.S. source income. Although the United States provides certain exemptions and credits for U.S. citizens living outside of the United States, many nonresident dual citizens still pay tax to the United States, including tax on income generated in other countries. Often foreign tax credits do not offset the U.S. tax. London Mayor Johnson was subject to U.S. tax on the sale of his residence. The sale was not subject to tax in the United Kingdom, so there was no foreign tax to credit against the U.S. tax. Further, the 3.8 percent net investment income tax (also known as the unearned income Medicare contribution tax) cannot be offset by foreign tax credits. As a result, nonresident dual citizens who previously owed no U.S. tax because it was offset by foreign tax credits owed tax on their 2013 tax returns, the first year the tax was in effect. Even when no tax is owed, nonresident U.S. citizens have the cost of tax return preparation and record keeping that is different than what is required in their countries of residence.
Some nonresident U.S. citizens who are aware of their status have complied with U.S. tax reporting requirements and also requirements to file annual statements reporting their ‘foreign’ accounts (FBARs). For those individuals, it often seems odd to report, as foreign accounts, ordinary personal checking accounts and retirement savings accounts in the countries where they have always lived and worked. Others, who have not been in compliance, have faced the need to come into compliance and potentially onerous penalties. In some situations, IRS disclosure programs have been helpful, but even when disclosure programs are available, they can be burdensome and costly. But unless a U.S. citizen has been in compliance with U.S. tax reporting requirements for the past five years, the individual can not relinquish citizenship without being subject to an expatriate tax regime.
The expatriation tax regime is potentially onerous. If a U.S. citizen relinquishes his or her U.S. citizenship and meets certain tests, the individual is subject to an exit tax and, potentially, additional tax and reporting requirements. Specifically, if the individual a) has an average annual U.S. income tax liability for the previous five years of $160,000 (the 2015 amount, based on an amount adjusted for inflation) (annual tax liability test), b) has a net worth of at least $2,000,000 on the expatriation date (net worth test), or c) fails to certify compliance with all U.S. federal tax obligations for the previous five years, the person is subject to the expatriation regime.
An important exception to the application of the three-part test applies in certain circumstances. An individual is not treated as meeting the annual tax liability and net worth tests (even if the applicable thresholds have been exceeded) if the individual:
Became at birth a citizen of the United States and a citizen of another country and, as of the expatriation date, continues to be a citizen and is taxed as resident of such other country, and
Has been a resident of the United States for not more than 10 taxable years within the 15-taxable year period ending with the taxable year during which the expatriation occurs.
An exception also applies if the individual relinquishes U.S. citizenship before age 18 ‘ and has been a resident of the United States for not more than 10 years before the date of relinquishment.
Under these exceptions, the annual tax liability test and net worth do not apply to many ‘accidental’ citizens. However, they are required to certify compliance with all U.S. federal tax obligations for the previous five years or be subject to the expatriation tax regime.
The administration’s 2016 budget proposes that an individual will not be subject to tax as a U.S. citizen and will not be subject to the expatriate tax if the individual:
1. Was a dual citizen at birth;
2. Has been a citizen of the other country of citizenship at all times;
3. Has not been a resident of the United States since turning 18 ‘; and
4. Has never held a U.S. passport or only held one for the sole purpose of departing from the United States.
Under the proposal, citizens seeking relief must relinquish citizenship within two years of the later of January 1, 2016, or upon learning of their U.S. citizenship. They must also certify under penalties of perjury that they have complied with all U.S. tax obligations that would have applied during the five years preceding the year of expatriation if the individual had been a nonresident alien during that period (i.e., reporting and paying U.S. income tax on U.S. source income, if any). As such, it appears the proposal would modify existing law primarily by eliminating the requirement for five years of tax compliance reporting worldwide income. Of course, at this time the proposal is simply that and until the law changes there is limited relief for dual citizens.