Citizenship-Based Tax and Expatriation for Americans Abroad
Here at Hoxton, we have an experienced team specialising in helping American clients living outside of the United States. Such clients must navigate the complex world of citizenship-based taxation and expatriation. To help you gain a greater understanding, we will cover the below:
- What expatriation is?
- The tests and exceptions for being a covered expat
- Computing the exit tax for covered expats
- Transfer taxes on gifts and bequests from “covered expats”
- Pre-expatriation analysis and planning
- Investment strategies before, during, and after expatriation
- The economic considerations of expatriation
What is Expatriation?
Expatriation refers to giving up one’s U.S. citizenship or permanent resident status. This can be a difficult decision, but for some people, it is necessary to reduce their tax burden or simplify their financial affairs.
- It is important to note that expatriation should not be done lightly or without proper planning.
Being a Covered Expat: Tests and Exceptions
If you are a U.S. citizen or permanent resident considering expatriation, it is essential to understand the tests and exceptions for being a covered expat. A covered expat is someone who meets one or more of the following tests:
- The net worth tests: If your net worth is $2 million or more on the day before you expatriate, you are a covered expat.
- The tax liability test: If your average annual net income tax liability for the five years before expatriation is more than $190,000, you are a covered expat.
- The certification test: If you fail to certify that you have complied with all U.S. tax obligations for the five years before expatriation, you are a covered expat.
There is an exception to being a covered expat if you are a dual national at birth and continue to be a citizen of the other country at the time of expatriation. You must have been a resident of the United States for not more than ten of the fifteen taxable years ending with the taxable year during which the expatriation occurs.
Exceptions for Dual Nationals
For dual nationals, there is an exception to the net worth test. The threshold for dual nationals is $165,000, and the threshold is adjusted for inflation. If your net worth is below this threshold, you will not be considered a covered expat, even if you meet the other tests.
Calculating the Exit Tax for Covered Expats
If you are a covered expat, you will be subject to an exit tax on your worldwide assets. The exit tax is a tax on the unrealised gain in your assets as if you had sold them on the day before expatriation. The tax is calculated based on the fair market value of your assets on that day.
The tax rate is currently 30% on the net unrealised gain. There is a $821,000 exclusion amount, meaning the first $821,000 of gain is excluded from the tax. The exclusion amount is adjusted for inflation.
Exit Tax on Deferred Compensation Plans
If you have deferred compensation plans, such as a 401(k) or IRA, you will also be subject to an exit tax. The tax is based on the present value of the deferred compensation plans as of the day before expatriation. The tax rate is currently 30%.
Scope of Worldwide Property for Net Worth Test and Exit Tax
When computing the net worth test and the exit tax, worldwide property’s scope includes all tangible or intangible assets wherever located. This includes:
- Real estate
- Bank accounts
- Intellectual property
It is important to consider this when deciding whether to expatriate.
Transfer Taxes on Gifts/Bequests from “Covered Expats”
If you are a covered expat, your gifts and bequests to U.S. persons will be subject to transfer taxes, including gift tax and estate tax. The transfer taxes are imposed on the fair market value of the gift or bequest, and the tax rates are up to 40%. There are some exceptions and exclusions to the transfer taxes, so it is important to consult a tax professional for guidance.
Gift and Estate Tax on Covered Expats
If you are a covered expat, you will be subject to gift and estate tax on your U.S. situs assets, regardless of where you live. U.S. situs assets include:
- Real estate located in the United States
- Tangible private property located in the United States
- Certain stocks and securities of U.S. companies
The tax rates are up to 40%.
Pre-Expatriation Analysis and Planning
Before deciding to expatriate, conducting a pre-expatriation analysis and planning is important. This includes:
- Assessing your net worth
- Tax liability
- Compliance with U.S. tax obligations
You should also consider the potential impact on your estate plan and the transfer taxes on gifts and bequests.
Investment Strategies Before, During and After Expatriation
Before expatriation, reviewing your investment strategies and considering any potential tax implications is important. During and after expatriation, you may consider investing in tax-efficient investments, such as exchange-traded funds (ETFs) or tax-managed mutual funds. It is also important to consider the potential impact of currency fluctuations on your investments.
Expatriation Done Right is a Measured Decision
Expatriation is a serious decision that should not be taken lightly. It is important to consider all the potential tax implications and seek the guidance of a qualified tax professional. A measured approach can help ensure that you are making an informed decision in your best interest.
While the decision to expatriate should not be based solely on tax considerations, it is important to understand the potential economic benefits and drawbacks. Expatriation can provide greater financial flexibility and lower tax burdens, but it can also result in the loss of certain benefits, such as Social Security or Medicare. It is important to weigh these factors carefully and seek the advice of a qualified financial professional.
What to do
In conclusion, citizenship-based taxation and expatriation for U.S. citizens can be a complex and challenging topic. It is important to understand the tests and exceptions for being a covered expat, the exit tax, transfer taxes on gifts and bequests, and the potential economic considerations. It is also important to seek the guidance of qualified professionals, including tax and financial advisers, to ensure you make informed decisions in your best interest.
If you would like to reach out to our team of experts to get more clarity on your situation regarding taxation – please use the contact form, and a team member will be in touch rapidly.