US tax pitfalls for a US person living abroad
The US is unique among developed nations in applying its full tax code both extraterritorially and permanently to US persons who do not live in the US. This creates significant investing problems, expenses, barriers, obstructions, and increased tax burdens for these individuals.
US tax pitfalls for a US person living abroad lists and describes the major investing difficulties faced by US persons living outside the US. US persons are US citizens and US permanent residents (also known as green card holders). Even if their physical green card has expired, US permanent residents remain fully taxable by the US until their permanent resident status is officially abandoned or rescinded.
The information in this article describes the situation for current US citizens and green card holders. It is also a list of considerations and planning points for people who are not yet US citizens but are contemplating becoming one in future, and who do not plan to live in the US for the rest of their lives, and for US citizens living abroad who do not plan to return to the US to live, and who are considering renouncing their US citizenship to simplify their financial lives.
The US taxes citizens and green card holders who do not live in the US, but these people are also within the tax jurisdiction of the country in which they live. Unless they live in a country with no income tax, this means they are subject to at least two overlapping tax regimes. And potentially more that two, where local and state taxes also apply.
The Foreign Earned Income Exclusion (FEIE) and Foreign Tax Credit (FTC) mitigate some of the most obvious cases where double-tax could occur, and there is a commonly held belief that together these eliminate US tax for US persons living abroad.
This belief is false. The FEIE and the FTC are both limited and inadequate, and they do not fully protect from double-tax or from US tax except in the simplest of circumstances. The FEIE is limited to only earned income, and while unused foreign tax credits can be carried over in years when they are not used, the requirement for them to be characterised may mean that excess credits in one category cannot be used to offset tax from income that is in a different category.
The US has signed tax treaties with a reasonable number of countries, but it uses the treaty saving clause to ensure that US persons can only use treaties in very limited circumstances. A treaty often fails to protect a US person from US tax.
The sections below describe cases where you will, as a US person living abroad, face double-tax or added US tax on top of your local tax liabilities, and where there is no protection from the FEIE, FTC, or any tax treaties. Some of these may be avoidable with foresight and planning, and some can be sidestepped but only with difficulty or perhaps by giving up an element of financial gain, but some are unavoidable.
Earnings and salary
Specifically for employment earnings, as a US person living abroad, you can shelter up to a limited amount each year from US tax using the FEIE. Beyond this level though, you have to rely on foreign tax credits to mitigate US tax on foreign earnings.
Because of the stacking rule, the FEIE is less valuable than other deductions and exclusions. This rule requires you to calculate tax so that income above the FEIE is taxed as if no exclusion applied. In other words, it pushes income above the FEIE into higher tax brackets. It is therefore just a credit for the US tax that would have been due on the foreign income.
In addition, note that you must have a tax home in a country other than the US, and that the US does not recognise certain locations as foreign (for example, Antarctica). The FEIE can only be claimed on a timely filed tax return. If you are a green card holder, you are unable to use the FEIE if you are not a citizen of or a national of a country with which the US has an income tax treaty.
Where you earn above the FEIE, a foreign tax credit only helps if there is any local tax for you to credit against US tax. If you work in a country with low or no income taxes, you may have insufficient foreign taxes available for credit. In this case, you will pay tax to the US, and your own overall tax bill will be higher than non-US citizens who are otherwise in the same position as you.
- Warning: Earned income and salary is the only type of income that is protected by the FEIE or the foreign housing exclusion. For everything else, listed below, you can only use foreign tax credits, and then only where there is an actual foreign tax liability for which the US allows a credit.
Pensions, investment income, dividends and interest
You are liable to US tax on pensions, annuities, interest, dividends, capital gains, rent, royalties, and any other type of unearned or passive income that you receive as a US person abroad, no matter where that unearned or passive income is sourced. You can use foreign tax credits to reduce this US tax, but this will be no benefit where your local tax liability on this income is zero.[note 1]
Some countries have no income taxes at all.[note 2] And of those that do, some do not tax investment income.[note 3] Or if they do, they tax it more lightly than other types of income, perhaps relying on sales taxes rather than income taxes for their tax revenue.
In addition, you are required to categorise your foreign tax credits, so that you can only claim credits against US tax where you paid local tax on the same category of income. This means that you may pay local tax on one type of non-employment income, US tax on a different type of non-employment income, and with no means of obtaining a credit for either. Worse, although you can carry unused foreign tax credits forwards, if not used they expire after ten years. Additionally, there are flaws in the US foreign tax credit rules that may discriminate against some taxpayers; specifically, taxpayers with a reduced rate on some classes of non-US source income, and whose marginal US tax rate is below the highest US tax bracket.
Where your US tax liability on passive income exceeds any local tax liability on the same category of income, you are left with a US tax bill to pay. You cannot claim a foreign tax credit for non-US sales taxes.
Locally tax-free savings and investment accounts
A common case where US persons living abroad can face tax liabilities in excess of those payable by citizens of other countries is where your country of residence generally taxes investment income, but offers limited tax-free or tax-advantaged local savings accounts and investment wrapper accounts.
Examples include UK Individual Savings Accounts (ISA), Canadian Tax-Free Savings Accounts (TFSA), Japanese NISA accounts, and French Assurance-vie and Plan d'Épargne en Actions accounts. For all of these, all capital gains, dividends and interest occurring inside the wrapper are locally tax free. However, the US does not recognise these wrappers as a tax shelter, and so will tax all of the income occurring inside them annually, as if they were normal unwrapped savings or investment accounts.
The result is that you will again pay higher tax than any non-US citizen in comparable circumstances.
Net investment income tax
The Net Investment Income Tax (NIIT) is a tax surcharge of 3.8% on investment income, and is triggered if your total gross income exceeds certain levels. The IRS has explicitly disallowed applying foreign tax credits to reduce the NIIT. As a result, if subject to the NIIT you are likely to face double-tax.
If this investment income is not local-source, it is possible that your residence country may allow a tax credit for US NIIT paid. Otherwise, the result is pure double-tax on this portion of your investment income.
Alternative minimum tax
You also need to prepare -- or pay to have prepared for you -- two versions of each foreign tax credit form, one for regular tax and the other for AMT.
Capital gains give rise to several of the most vexing US tax problems for US citizens living abroad. Many countries either do not tax capital gains at all, or if they do then it is either lightly or with a sizeable exemption.
In contrast, the US fully taxes capital gains, and also differentiates between short-term and long-term holdings, so that short-term gains are treated as income and taxed more heavily. It also computes the capital gain for foreign assets based on the exchange rates in effect at the dates of purchase and of sale.
As a result of mismatches between the way the US and many other countries tax capital gains, it is easy for a US person living abroad to find themselves with a US capital gains tax liability that cannot be reduced or offset by any local tax liability.
Phantom currency gains
The US requires you to compute capital gains on foreign assets in USD only, using the exchange rate in effect when the asset was bought to arrive at the basis, and the rate in effect when the asset was sold to give the sale proceeds. This can result in a taxable USD gain, even where there is no local currency gain. And worse, the US taxes foreign currency gains at income tax rates.
For example, suppose you buy a rental property for €200,000 when the exchange rate is €1 = $1, and sell it later for, again, €200,000, but when the exchange rate has become €1 = $1.25. In EUR, your local currency, you have no gain. However, because the EUR/USD exchange rate changed while you owned that asset, you have a USD gain of $50,000. And you now owe US income tax on that $50,000. Because you have no local gain and so no local tax liability, you cannot reduce this US tax liability using foreign tax credits.
It is quite possible to make a local currency loss that nevertheless generates a US taxable gain. Suppose above you had sold the rental property for €180,000. This is a EUR loss to you locally of €20,000, but a taxable USD gain of $25,000.
In the examples above, you are in a worse tax position than a similarly situated non-US citizen.
Sale of primary residence
In most countries, any gains you make on selling your primary home are generally free of tax. However, the US limits tax-free gains on your primary residence to $250,000 ($500,000 if married filing jointly), and also requires you to have lived in the house for two of the past five years before allowing any capital gains tax exemption.
Where you sell your local home and fall outside of these US tax exclusions, you face a US tax liability for the gain on your home's value that again cannot be offset or mitigated by using foreign tax credits.[note 4] This US tax liability erodes your ability to buy another property, relative to other non-US citizens.
Paying down a foreign loan or mortgage
If you have a non-US loan, repaying it may create a US taxable event. This is a particular issue where the loan is a mortgage. Even superficially entirely normal actions such as remortgaging, changing mortgage provider, and making capital repayments can all lead to a US tax liability.
A mortgage for £100,000 is taken out when the exchange rate is £1 to $1.50. A capital payment of £100,000 or the remortgage occurs when the exchange rate is £1 to $1.20. This would result in a $30,000 exchange rate gain.
The IRS view is that the individual took out a debt of $150,000 (£100,000 x $1.50) but only had to repay $120,000 (£100,000 x $1.20). The $30,000 of debt no longer owed is regarded as gain and is taxed as ordinary income. If we reverse the situation, i.e. assume the individual took out a mortgage for £100,000 and the exchange rate is £1 to $1.20 on the date it was taken out, and at the time of redemption or capital repayment the exchange rate is £1 to $1.50, the result is a US dollar loss of $30,000. Unfortunately, this loss is a “personal” loss and personal losses are not deductible.
— US Tax & Financial Services
This can leave you significantly worse off, relative to non-US citizens who take identical actions.
Pensions are another treacherous area for US citizens living abroad. Some countries' tax treaties with the US cover pensions, at least partly, so in these countries the results might be less bad than in others, but grey areas in the treaty mean that poor tax outcomes are still likely.
The default case, where a non-US pension is not covered by treaty, is for the US to treat it as an ordinary unwrapped investment account, or potentially as a non-US trust.[note 5] This can lead directly to double-tax, where contributions and gains within the plan are subject to US tax annually, and withdrawals are subject to local tax when taken. Also, full compliance with US tax reporting rules may be impossible, because of lack of information from the pension scheme itself.
Even if you live in a country where there is a treaty covering pensions (and the US does not disallow the pension articles using its saving clause), you may still face problems.
For example, the US/UK treaty covers some UK pensions reasonably well, particularly employer pensions, but it limits your contributions to only what you would have been able to contribute to a similar plan, a 401k or IRA say, if you were employed in the US. US annual retirement savings limits are generally lower than UK ones, so you cannot save as much for retirement as your non-US citizen peers and colleagues can. You must also watch out for the US highly compensated employee (HCE) rule, something that non-US citizens can of course ignore entirely.
The situation in Australia is particularly poor. Australian superannuation plans are partly compulsory, but are not covered by the US/Australia tax treaty. If you live in Australia, you may have to declare your superannuation plan as a foreign grantor trust, with extreme and onerous US tax and reporting outcomes. One expert explains:
The second theory, used by the majority of US tax professionals, is that Superannuation is a non-qualified retirement plan under the US tax code. This can generate a number of different results depending on the nature of the superannuation fund receiving the contributions and its connection to the employer.
For funds that meet the qualifications of an employee’s trust under 26 USC 402(b) the likely outcome is that contributions to the fund are taxable in the US as they go in, earnings inside the fund are tax-deferred, and withdrawals are taxable as they come out with a deduction for an allocation of any contributions previously taxed. However, there are special fund eligibility requirements for highly compensated individuals, which will cause many higher income individuals to be required to include not only contributions in their current US taxable income, but also the earnings inside their superannuation fund.
Furthermore, if personal contributions exceed employer contributions, then the entire balance is treated as a foreign grantor-trust – requiring all income to be taxed currently on the US return in addition to several extra information returns, each of which carry a minimum penalty of USD10,000 for failure to file. Self-managed super funds (SMSFs) are particularly dangerous for US taxpayers as they are almost always seen as a foreign grantor-trust.
Finally, since superannuation is not a qualified US retirement plan, any movement of super balances between funds is treated as a taxable distribution. This includes consolidation of fund balances or rollovers when changing employment, all of which are tax free transactions under Australian tax law.
Any US tax paid on superannuation contributions, earnings, or rollovers will not be offset by a tax credit for Australian tax paid because these are tax-free transactions in Australia. Similarly, any US tax due on distribution to a retiree over the age of 60 will not have an offsetting credit for Australian tax paid.
— Let's Fix the Australia/US Tax Treaty!
Treaties may offer some protection, so in the best cases you will only be subject to additional rules and restrictions on local retirement savings plans. In the worst cases though, you will face double-tax on your retirement savings, once by the US and then later on by your home country.
Prizes, lottery and gambling winnings
In many countries, prizes and winnings are tax-free. The US however, treats all gambling winnings, prizes, lottery wins, and any other competition wins as taxable income. This would encompass everything, from winning €100 million in the EuroMillions lottery through to winning a cake at the local village fair.
So if you live in the UK and win £1 million in UK premium bonds, you might face paying close to $350,000 in US income tax on this prize, and with no foreign tax credit offset. In contrast, a non-US citizen would pay nothing.
Receipt of gifts and bequests
As a general rule, US persons do not need to report receipt of gifts and bequests to the IRS. However, there is an exception for receipts of gifts and bequests from non-US persons in excess of $100,000 in a year. These need to be reported on Form 3520, under threat of penalties of $10,000 for late filing or noncompliance.
Tax on gift and bequest receipts
US persons do not pay tax on gifts or bequests received, but with one important exception. Gifts and bequests from a covered expatriate (under the US expatriation tax rules) are subject to a 40% transfer tax on receipt, payable by the recipient. The US introduced section 2801 tax in 2008, but as of 2021 the IRS has still not created a route to compliance with this law. This is an impressively long delay, even by the standards of the IRS.
When the IRS does finally get round to implementing section 2801 tax, if you receive a gift or bequest from a covered expatriate you will be much worse off that a non-US person receiving the same gift or bequest. Until then, this tax is officially deferred, meaning that you do not -- in fact, cannot -- pay it now, but you nevertheless need to set aside money from your gift or bequest to allow for it becoming collectable in future.
Controlled foreign corporations
If you are an officer, director, or substantial shareholder in a company registered in your home country, the US may treat that company as a controlled foreign corporation (CFC). This generates extremely onerous US tax reporting requirements, with penalties of up to $60,000 for noncompliance or late filing.
The Subpart F tax rule is particularly unpleasant. Buzzacott explains:
In general, should you own greater than 50% of the shares of the limited company, you may be subject to Subpart F rules. This could apply if the limited company received the following types of income: dividends, interest, rent and royalties, to name a few. It could also apply to income from personal service contracts where the corporation does not designate who performs the services. The Internal Revenue Service (IRS) would tax the US person on their proportional share of the Subpart F income earned by the CFC, regardless whether this has been distributed to them.
As the owner of a company that the US views as a CFC, you can face a much higher tax burden than a non-US citizen with the same level of ownership.
Partnerships with non-US persons
The controlled foreign corporation (CFC) rules outlined above can also make it difficult for you as a US citizen to enter into partnerships with other non-US citizens. Your participation will embroil the non-US corporation in a lot of US tax reporting that most non-US persons and companies are keen to avoid.
Anecdotally, US citizens are now finding it hard to enter into partnerships outside the US, and may find that they are being passed over for senior roles in existing companies.
Extensive and intrusive reporting requirements
As a US person living abroad, you will have to deal with many more, and complex, IRS forms. These are forms that people living in the US will rarely encounter, if ever. These forms are difficult and time-consuming to complete, and costly if you find that you are forced to used a paid preparer. They are also intrusive, since they require you to list not just your taxable and non-taxable income, but also the full details of all your non-US accounts -- income, account number, highest balance during the calendar year, name of non-US financial institution, and so on.
Typical forms you will encounter, above and beyond the normal Form 1040 and all of its associated schedules and extra forms, are:
- Form 2555, for claiming the Foreign Earned Income Exclusion.
- Form 1116, to claim a Foreign Tax Credit. You might need to complete several of these.
- Form 8938, Statement of Foreign Assets. Here you list the details, income and balances of all your non-US accounts. Essentially duplicative with FinCEN form 114, but often both must be filed.
- Form 8833, Treaty-Based Return Position Disclosure. Used to claim tax treaty benefits.
- Form 5471, Information Return of US Persons With Respect to Certain Foreign Corporation. Used for controlled foreign corporations (CFC).
- Form 8865, Return of US Persons with Respect to Certain Foreign Partnerships. As above, just more of the same.
- Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company (PFIC). Extremely time-consuming, but required if you hold any non-US domiciled funds or ETFs. The IRS's estimated time to complete this form is over 48 hours.
- Form 3520, Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts. For any activity involving non-US trusts, and also for gifts and bequests from non-US sources above $100,000.
- Form 3520-A, Annual Information Return of Foreign Trust with a US Owner. Required if you own a local trust. Another extremely time-consuming and complex form.
- FinCEN Form 114, Foreign Bank Account Reporting (FBAR). Filed annually with the Financial Crimes Enforcement Center. This form can only be filed electronically. The threshold for filing is very low, just $10,000 in non-US accounts. Essentially duplicative with form 8938, but often both must be filed.
Disadvantageous tax filing status options
If you are married, you have the choice of filing US tax as Married Filing Jointly (MFJ) or Married Filing Separately (MFS). If your spouse is not a US person though, choosing MFJ will subject them to the full extent of difficult and unpleasant US tax laws on all of their own non-US income and financial affairs.
Most non-US spouses (sensibly) wish to keep the IRS entirely out of their personal financial affairs. This means that unless you can use Head of Household status, you will be obliged to use MFS when you file your US taxes. This is generally less advantageous than filing jointly with a spouse, and often also less advantageous than filing Single. In other words, you are pushed into the US tax filing category that has the highest tax rates and the lowest allowances of all the available options.
This usually has the effect of leaving you in a worse tax position than a similarly situated US citizen living in the US.
Expensive tax filings
Unless your finances are extremely simple, using a paid preparer to complete your US tax return will be extremely costly. Typical fees to complete forms such as 3520 and 5471 alone run to between $200 to $600 for each copy needed, in addition to the base cost of completing the 1040 and its associated schedules.
US expats with finances that are entirely regular and vanilla in local terms regularly complain of US tax preparation fees in excess of $2,000 to $3,000 annually. This is an out-of-pocket expense that your non-US citizen peers do not have to pay.
Extreme penalties for noncompliance
The penalties for noncompliance of US reporting rules are draconian, often two orders of magnitude or more above the penalty that would be imposed on a US resident for similar noncompliance or late form filing.
For example, the penalty for a late-filed form 3520 begins at $10,000. Moreover, the IRS has begun aggressively enforcing this penalty. The penalty for non-filing of form 8938 starts at $10,000 and rises to $60,000. And the penalty for non-filing of form 8865 follows the same pattern.
The most extreme penalty of all -- and one that may arguably be in violation of the US constitution's eighth amendment excessive fines clause -- is the civil penalty for not filing FinCEN form 114 (also known as FBAR). This is $12,921 if non-wilful, and the higher of $129,210 or 50% of the highest account balance for the year, if wilful.[note 6] Penalties may apply per year, in the case of multiple year violations, so that in the worst cases the penalties for non-filing may exceed the account balance.
As a US person residing abroad, you have to learn to live with the perpetual risk of these oppressive penalties for simple form errors. Many US expats find that this alone creates considerable emotional and mental stress, quite apart from the bureaucratic nuisance and tax expense of the US's citizenship-based taxation regime.
Extended or no statute of limitations
Normally, the IRS has three years from a tax return due date in which to assess tax. This rises to six years for "substantial understatement" of income.
However, for certain forms relating to non-US assets, such as the 8938, the statute of limitations does not begin to run at all if you are required to file this form but do not. If you omit a 5471 from your return, your entire tax return remains open for audit indefinitely, leaving no cover whatsoever from a statute of limitations.
Revocation or denial of US passport
If you find yourself in the position of having what the IRS terms a "seriously delinquent tax debt", the IRS can inform the State Department, which may then revoke your US passport, or refuse to issue a new one if your current one has expired.
For this to occur, you have to reach a given level of US tax debt. However, this debt is inclusive of any interest or penalties, meaning that the large penalties for non-filing forms such as 3520 make this level more easily reachable than might be imagined. Notably however, FBAR non-filing penalties are not included in the definition of debt for this purpose.
For some people, typically those with another citizenship besides US, denial of a US passport may pose few if any problems. For others though, perhaps where residency in their current country is based on their US passport, it could create serious problems.
FATCA, PFIC and PRIIPs
One of the effects of the Foreign Account Tax Compliance Act (FATCA) is that non-US banks and financial institutions are now forced to search their customer bases for 'US indicia' such as a US phone number, US address, or US place of birth, and then report any customers that they suspect of being US persons either to the IRS directly, or indirectly through their own country's tax authority where that country has signed a FATCA Intergovernmental Agreement (IGA) with the US.[note 7] The threat from the US for noncompliance is a withholding tax of 30% on all payments from the US to that non-US bank or financial institution.
Because this is both a major costly administrative burden and a significant compliance penalty risk, a number of non-US banks and financial institutions have taken the commercial decision to no longer offer services to US persons. This includes those living in the same country as the bank, and who may also be full citizens of that country as well as being US citizens. As further fallout, some US financial institutions now also refuse service to US persons who are not living in the US.
A US tax law, Passive foreign investment company (PFIC), applies unpalatable tax rules to US persons who own non-US domiciled funds or ETFs.[note 8] Conversely, if you hold US domiciled funds or ETFs, you might run into difficult or punitive local tax rules for holding 'offshore' funds, leaving you in a no-win situation.
And in 2018, an EU regulation known as PRIIPs became operational. It requires funds and ETFs sold to EU residents to provide a Key Investor Information Document (KID, or KIID) in a particular format. As of 2020, no US domiciled fund or ETF produces a KID. The UK left the EU in January 2020, but created its own 'UK PRIIPs' regime that is fully aligned with the EU PRIIPs, so PRIIPs restrictions continue to apply in the UK.
This means that your situation is especially problematic if you live in the EU or the UK. Here, these three tax rules combine in a way that can make it practically impossible for you to own any index funds or ETFs. The only simple viable route is through a US based account with US based broker. Opening one may involve convincing them that you are a US resident, even though not. Otherwise, you run into problems opening a local brokerage account due to FATCA. And if you can find and open one, you will not be able to buy US domiciled funds or ETFs because of PRIIPs,[note 9] and will run into the US PFIC tax rules if you use non-US domiciled ones.
Your non-US citizen peers, friends, and family can invest freely through local brokerages, using non-US domiciled index funds and ETFs, without any of these tax drawbacks and limitations.
US states that have income taxes vary in the way they treat individuals who move outside the US. It is possible, then, that you have a state income tax filing requirement, and perhaps actual tax liability, as well as US federal tax requirements. Details are too diffuse and complicated to go into here, and you will need to investigate your situation with whichever state or states might claim you as a taxpayer.
Not all US states recognise US tax treaties, and so if you are relying on a treaty to protect you from US tax, this treaty may not protect you from any US state tax liability you may have.
As always, non-US citizens in the same situation as you will have none of these difficulties with US state taxes. A non-US citizen who is not living in the US cannot be considered as still resident or domiciled in any US state.
As well as the direct difficulties caused by your US citizenship, there can also be indirect ones. Two have already been mentioned. They are inability to open accounts at many non-US banks and brokerages, and also at some US brokerages, due to FATCA, and possible inability to enter into foreign partnerships.
A less obvious restriction on your employment prospects comes from the requirement to file FinCEN form 114 (also known as FBAR). This form requires you to report
... a financial interest in or signature or other authority over at least one financial account located outside the United States.
— IRS, Report of Foreign Bank and Financial Accounts
As a result of this, you can be rejected for, or otherwise unable to take on, certain roles within non-US corporations, particularly any in finance or accounting. These roles will instead be filled by your non-US citizen colleagues.
You may be excluded from non-US trusts. Foreign trusts with a US person owner or a US person beneficiary acquire certain added reporting requirements, either to the IRS or to you, that most will be keen to avoid. The easiest way for them to avoid these reporting requirements is to exclude you from the trust.
When considering employees for foreign assignments, companies look closely at the costs of the assignment. The US's citizenship based taxation makes US citizens more expensive for these assignments, either because salary must be adjusted upwards or because they will need to provide you with 'tax equalisation' as part of the relocation package.
This makes you more expensive to employ than non-US citizens, and so less competitive in the global jobs marketplace. It is a particular problem where relocation will be to a country with low or no income taxes.
Additionally, any 'tax equalisation' package will only cover salary. It will not cover you for any of the other US tax problems you will face, such as double-tax on investment income or tax on phantom currency gains. An employer might cover the cost of your (expensive) US tax filings, but this will itself be a taxable benefit.
The US has an expatriation tax that applies to US citizens who renounce their US citizenship. It passed into law in 2008, as part of the mostly unrelated HEART act, and is administered by the following form:
- Form 8854, Initial and Annual Expatriation Statement. Used to certify compliance with tax obligations. Requires a list and valuation of all worldwide assets.
The tax is triggered if you have total assets above $2 million, not indexed for inflation, or if you exceed a given annual federal tax liability over the preceding five years. It also applies to long-term green card holders who formally abandon their US permanent resident status, if they have held a green card in eight years or more.[note 10] There is an exemption for individuals who are dual citizens from birth, and who have no recent history of being US resident.[note 11] Individuals subject to the expatriation tax are known as covered expatriates.
There are three main provisions to the US expatriation tax, also commonly known as the 'exit tax'. The first can often be mitigated, but the other two are repressive, and at least in one case, usually unavoidable. Because it overrides the provisions of tax treaties the US has signed with other countries, the US expatriation tax potentially violates the Vienna Convention on the Law of Treaties.
If you are planning to renounce your US citizenship or give up long term US resident status, the usual advice such as saving the maximum into local pensions or US IRAs and 401ks, or using health savings accounts (HSA), may not apply. In this case you might instead prefer investments that are easily liquidated, sit outside the expatriation tax deemed disposition rules for retirement accounts, do not come with US or other political risk, and will not be problematic in your home country.
The US "deems" your assets to have been sold on the date of expatriation. This is a pretend sale of assets, but if these assets have unrealised built-in capital gains then the tax on them has to be paid immediately with real money. There is an sizeable exemption before any tax becomes due. You cannot use the $250,000 ($500,000 if married and filing jointly) primary residence capital gains tax exclusion in a year in which you are "subject to expatriate tax".
There are several ways in which you can reduce or counter this tax. Simplest is to give away assets to bring you below the $2 million asset test for the tax. This may involve you filing US gift tax returns and using up some of your lifetime US gift and bequest allowance, but consuming that is not an issue as you will no longer be a US citizen after renouncing, and so free and clear of future US estate taxes, at least provided you organise your assets correctly once you become a US nonresident alien. Because the US estate tax can look back up to three years on gifts,[note 12] you may need to start planning expatriation several years in advance.
You might also consider selling and repurchasing liquid assets, to eliminate unrealised capital gains. This will be harder with illiquid assets though, for example your home or other real estate. This can be particularly important where assets will be liable to your home country's capital gains tax later. In this case, the result will be double-tax, because countries do not give tax credits for taxes paid years or decades earlier on "deemed" -- that is, pretend -- asset sales.
Immediate tax on retirement accounts balances
This is an extremely unpleasant expatriation tax provision. The tax "deems" your retirement savings accounts and other deferred compensation to have been distributed fully on the date of expatriation, so that they become taxable as income all in a single year. The exemption mentioned above for the "deemed" distribution of other assets does not apply to this provision. Immediate tax on your entire retirement savings balance will drive up your tax to extreme levels, and could easily destroy your retirement prospects entirely.
The exception to this is a 401k. To avoid a "deemed" distribution, the expatriate must voluntarily waive tax treaty rights on reduced withholding on this income, and so pay a flat 30% US withholding tax on all withdrawals. This may be reclaimable under the appropriate treaties.
Where your home country taxes withdrawals from a 401k or IRA, these can lead to double-tax on retirement savings. For IRAs in particular, countries are unlikely to allow you credit for any "deemed" US tax paid perhaps years or decades earlier.
One possible way to defuse some of the problem here could be to use a Roth 401k or a Roth IRA. The contribution and conversion elements of these will not be taxable, leaving only the earnings and gains to generate a tax liability. However, other countries rarely recognise the tax-free nature of a US Roth account,[note 13] so you will need to be sure of your local tax position on these.
Tax on future gifts and bequests to US persons
The worst expatriation tax provision of all. Section 2801 taxes gifts and bequests to a US person from a covered expatriate at a rate of 40%. For more, see Tax on gift and bequest receipts, above.
This captures money made perhaps long after renouncing US citizenship. It also leads to double-tax, and perhaps even to triple-tax. For example, money that has already been taxed by the US under the expatriation tax or normal income or capital gains tax rules is then taxed a second time when received by a US person from a covered expatriate. If that money also faces local country tax so that it is double-taxed due to another US tax provision, the result is triple-tax.
This expatriation tax provision encourages covered expatriates to exclude US persons for gifts and bequests. It also motivates entire families to expatriate together.
The Reed Amendment attempts to create a permanent entry ban on covered expatriates ever returning to the US, even for a short visit.
Since its passage in 1996, the Reed amendment has so far proven to be mostly unenforceable. There have been multiple attempts over the years to shore it up so that it can be enforced, but so far none has achieved much success.
However, this does not mean that it will not be enforced in future, and potentially retroactively. As a US person living abroad, if you are considering renouncing your US citizenship to free yourself from the difficulties caused by US taxes, you will need to bear this in mind.
Retroactive US tax laws
The US expatriation tax, passed in 2008, is arguably a retroactive tax provision. It adversely alters the taxation of retirement savings made years or decades earlier, based on characteristics (such as holding a green card) that might not have been entered into had the law existed at the time. It may capture gains that accrued long before a covered expatriate became a US person. And also, under section 2801, gains that accrue long after ceasing to be a US person. It results in double-tax that would not have occurred before.
A more recent example is the Global intangible low-taxed income tax (GILTI), passed in the Tax Cuts and Jobs Act (TCJA) in 2017. This tax was marketed as being aimed at global multinational corporates, but as written it also applies to individual CFCs being managed by US person entrepreneurs abroad. Its "deemed" repatriation tax provision looks back 31 years, and taxes earnings and profits retained in CFCs and accumulated from 1986 to 2017, even if there is no actual flow of funds back to the shareholder. Because these profits will be taxable locally when actually distributed or taken, the likely result is double-tax.
The US both enacts retroactive tax laws and uses "deeming" as a fictive way of creating a tax liability in the absence of any actual taxable event or income. As a US citizen abroad, you will need to be on constant lookout for these types of laws, and be ready to reorganise your assets, or perhaps your entire life, to avoid being financially damaged by them.
Unknown future US tax laws
Nobody knows what new taxes the US will create that cause further problems for US persons living abroad. If the past is a guide though, the direction of travel does not appear promising. And there are two areas where attempts to worsen tax laws further for US persons abroad can already be seen.
As a reaction to Eduardo Saverin renouncing US citizenship, in 2012 an attempt was made to pass the Ex-PATRIOT Act. The main effect of this act would have been to impose a permanent US entry ban on specified expatriates (essentially, the same people who are covered expatriates under the US expatriation tax). In other words, banishment for renouncing citizenship if you have a certain level of assets or wealth.
Crucially, the Ex-PATRIOT act includes the following text:
For purposes of subparagraph (A), the term ‘specified expatriate’ means, with respect to any taxable year, any covered expatriate (as defined in section 877A(g)(1)) whose expatriation date (as defined in section 877A(g)(3)) occurs after the date which is 10 years prior to the date of the enactment of this subparagraph.
— Ex-PATRIOT Act
This is overtly retroactive. Ex-PATRIOT did not pass in 2012, but there have been attempts since to try to pass it again. So far none has succeeded, but this is not to say that it will never pass.
Repeal of the FEIE
The foreign earned income exclusion is a regular target for repeal or abolition in congressional bills. For the moment, it is still in place, but it may be a matter of time before you are left with only imperfect foreign tax credits to protect you from US tax on your non-US earnings and salary.
Effects on other family members
Your US citizenship can have tax effects on other members of your family. Some are avoidable, but others are not.
Entangling a non-US spouse in US tax laws
If you hold any joint accounts with your spouse, these need to be reported on both Form 8938 and FinCEN form 114. Understandably, most non-US persons are unhappy with having details of their personal finances sent annually to the IRS and to FinCEN.
This occurs independently of which US tax filing status you use. It may be unwise for you as a US citizen to maintain any joint accounts with a non-US spouse.
Entangling children in US tax laws
If you meet the necessary US residency and marital status requirements, any children you have that are born abroad will nevertheless automatically become US citizens. This means that they immediately acquire all of the tax problems described in this article.[note 14]
You cannot renounce your children's US citizenship on their behalf. Only they can do this, and generally not earlier than age 18. Because of the cruel way this law operates, it is impossible for individuals with "developmental or intellectual disabilities" to ever renounce US citizenship, leaving them trapped for life.
- You can also lose out to foreign tax credits in the other direction. For example, if you hold US municipal bonds that are US tax-free, your local country will probably still tax income from them. In this case, you cannot claim a foreign tax credit against local tax, because you have no US tax liability. Unlike the reverse case though, this is not a problem that is unique to US citizens, but would apply to any resident of your country holding these same investments.
- For example, Bermuda, the UAE, Saudi Arabia and Oman.
- For example, Singapore.
- For a high-profile case of US tax on a foreign home, and one that led to renunciation of US citizenship, see: "Boris Johnson Renounces US Citizenship Over Tax Dispute". Observer. Retrieved November 2, 2019.
- In March 2020, the IRS released Revenue Procedure 2020-17 that provides an exemption from foreign trust reporting for "certain" non-US retirement savings plans. Unfortunately, the definition of plans that are exempt from reporting adopts a predictably US-centric view and is narrowly drawn, so that many and perhaps most other countries' retirement saving plans will fall outside of it. For more, see: "Tax experts critical of, and/or baffled by, new IRS effort to exempt some foreign trusts from info reporting". American Expat Finance. Retrieved July 25, 2020.. Also: Hale E. Sheppard (March–April 2020). "Foreign Retirement and Savings Plans, Waiver of Forms 3520 and Forms 3520-A, and Limits of Rev. Proc. 2020-17" (PDF). Retrieved February 7, 2021.
- In 2015, congress mandated the IRS to revise the FBAR penalty amounts upwards from $10,000 and $100,000, citing "inflation" as the reason for the increases. Notably however, the threshold non-US account balance for filing this form has remained at $10,000 since the FBAR was first introduced in 1970. Unlike the penalties for non-filing, the threshold has never been increased for inflation. For more, see: "US Taxpayers' Nightmare Continues: FBAR Penalty Inflation Adjustment". Sherayzen Law. Retrieved November 3, 2019.
- Under the FATCA IGAs, some common local country account types may be excluded from FATCA reporting by the non-US bank or financial institution to the IRS, for example UK ISAs. However, these accounts are not exempt from reporting by individuals, and so you would still need to include them on any form 8938 and FinCEN form 114 that you file annually with the IRS.
- Practically every non-US domiciled fund and ETF will be a US PFIC. As a quick way to tell, if it has 'UCITS' somewhere in its name, it is European domiciled and so a PFIC. Aside from reading its prospectus, KID, or fund documents, the other unambiguous way to tell is to find its ISIN. If the first two letters are not 'US', it is almost certainly a US PFIC for tax purposes. Most UCITS funds are domiciled in either Ireland, with ISIN code 'IE', or Luxembourg, with ISIN code 'LU'.
- Forum member "finrod_2002" provides details of how an investor might use options trades to work around PRIIPs restrictions, in Bogleheads® forum post: . 17 Feb 2019, viewed 28 Oct 2019.
- As little as six years and two days of US permanent resident status may be enough to trigger the US expatriation tax; that is, December 31 in year one to January 1 in year eight inclusive.
- This exemption for certain citizens arguably violates most US tax treaty 'non-discrimination' clauses.
- The referenced article in the Florida Bar Journal conveys the impression that gifts could be disallowed on expatriation within three years. Later clarification suggests however that this is wrong; instead, it would only apply on death within three years of the gift. See: Bogleheads® forum topic: , AtticusFin. November 10, 2021
- The UK is one known case where the US/UK tax treaty preserves the nature of Roth accounts for UK residents. For other countries, you will need to study local tax laws and any applicable US tax treaty very carefully.
- For a high-profile example of this, see: "Royal baby: Could Harry and Meghan's son pay US taxes?". BBC. Retrieved November 4, 2019. Also: "Royal baby Archie faces a complicated tax situation". CNBC. Retrieved November 4, 2019.
- Taxation as a US person living abroad
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- Vanguard US domiciled ETFs that are UK HMRC reporting funds
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