Worldwide Income Taxation vs. Expatriation Tax

Before seeking U.S. citizenship or resident alien status, certain tax-related aspects should be taken into account. In this article we discuss two rules of taxation of U.S. citizens and resident aliens that are especially relevant to individuals doing business internationally and potentially planning to leave the U.S. in the future: worldwide income taxation and expatriation tax. Please mind that this article is neither legal or tax planning advice nor should be treated as an exhaustive description of all applicable laws.

Things to Consider Before Seeking U.S. Citizenship or Resident Alien Status: Worldwide Income Taxation and Expatriation Tax

Consideration No.1: U.S. citizens and resident aliens are required to pay taxes in the U.S. on their worldwide income regardless of the place of their residence.

Consideration No.2: U.S. imposes expatriation tax (also known as exit tax) on the assets of U.S. citizens who relinquish their citizenship and long-term residents who end their residency.

In other words, if you are a U.S. citizen or resident alien, and decide to leave the U.S., you are required to either continue paying taxes in the U.S. on your worldwide income or relinquish your citizenship (end your residency) and pay the expatriation tax.

Regarding consideration No.1 – Worldwide Income Taxation

U.S. may be the land of the free, but it is also probably the most fiscally aggressive country among all the first-world nations. U.S. citizens and resident aliens must comply with the rules for filing income, estate, and gift tax returns and pay the estimated tax in the U.S. regardless of whether residing and earning income or returns in the U.S. or abroad. In other words, if you are a U.S. citizen or resident alien, your income is subject to a hefty U.S. income tax even if you live outside the U.S. or earn such income on the other side of the globe. To comply with the abovementioned requirement, U.S. citizens and resident aliens are required to express the amounts reported on U.S. tax returns in U.S. dollars (if all or part of income is received or some or all expenses are paid in foreign currency, such U.S. citizen or resident alien must translate the foreign currency into U.S. dollars).

Practically speaking, as a U.S. citizen or resident alien you are required to file taxes in the U.S. annually and report the earnings gained in any other country and any other currency, even if you are residing outside the U.S. or – sometimes – even if you do not know or are unsure about your citizenship, as in the case of so called “Accidental Americans”, i.e. individuals born in the U.S. or to a U.S. citizen parent and both having grown up and living in a foreign country.

Surely, U.S. collaborates with a number of countries on tax issues and has entered into several tax treaties that protect U.S. citizens and resident aliens from becoming subject to double taxation (i.e. paying taxes on the same income in two countries). Furthermore, there are a few tax mechanisms provided by the Internal Revenue Code which alleviate the strain, e.g. Foreign Earned Income Exclusion (Form 2555), allowing to exclude a certain amount of foreign-based income from taxation in the U.S., or Foreign Tax Credit (Form 1116) allowing to subtract the tax paid to a foreign government on the income exceeding the amount excluded from taxation in the U.S. by filing Form 2555. Still, the general principle applied by the U.S. Internal Revenue Service is that no matter where you reside and no matter where the source of your income is located, your income is subject to U.S. income tax, and you must always file your annual tax returns in the U.S., even if your tax liability in the U.S. amounts to $0.

Regarding consideration No.2 – the Expatriation Tax (Exit Tax)

Given the burden imposed by consideration no.1, some U.S. citizens and resident aliens are likely to look into alternative options to optimize their tax liability, including relinquishing their U.S. citizenship or residency. The reality, however, is that the U.S. Department of the Treasury cannot afford to simply let its high-net-worth individuals go. Therefore, all U.S. citizens who relinquish their citizenship and all U.S. long-term residents who terminate their lawful permanent residency and fall under the definition of a covered expatriate, are subject to the U.S. expatriation tax.

Long-term Resident

You are considered a long-term U.S. resident if you were a lawful permanent resident of the U.S. in at least 8 of the last 15 tax years ending with the year your status as a long-term resident ends.

Covered Expatriate

You are considered a covered expatriate if you expatriated after June 16, 2008, and (1) your average annual net income tax liability (not to be confused with net income) for the 5 tax years ending before the date of expatriation is more than: $139,000 for 2008; $145,000 for 2009; $145,000 for 2010; $147,000 for 2011; $151,000 for 2012; $155,000 for 2013; $157,000 for 2014; $160,000 for 2015; $161,000 for 2016; $162,000 for 2017; $165,000 for 2018 or (2) your net worth was $2 million or more on the date of your expatriation or (3) you fail to certify on Form 8854 that you have complied with all federal tax obligations for the 5 tax years preceding the date of your expatriation.

Dual-Citizens

It must be noted that dual-citizens and certain minors can also be treated as covered expatriates unless they file Form 8854 and certify that they have complied with all federal tax obligations for the 5 tax years preceding the date of expatriation. Furthermore, the abovementioned persons only fall outside the covered expatriate definition if they meet both of the following requirements: (1) they became at birth a U.S. citizen and a citizen of another country and, as of the expatriation date, they continue to be a citizen of, and are taxed as a resident of, that other country, and (2) they were a resident of the U.S. for not more than 10 years during the 15-tax-year period ending with the tax year during which the expatriation occurred.

Expatriation Tax Calculation

If you are a covered expatriate in the year you expatriate, you are subject to income tax on the net unrealized gain in your property as if the property had been sold for its fair market value on the day before your expatriation date. This applies to most types of property interests you held on the date of your expatriation. It must be noted, however, that the amount that would otherwise be includible in gross income by reason of the deemed sale rule is reduced (but not to below zero) by $600,000, which amount is to be adjusted for inflation for calendar years after 2008 (for example, for year 2019 the exclusion amount is $725,000).

Summary

Even though obtaining U.S. citizenship or resident status is lucrative for foreign individuals for a number of reasons, before making such decision, individuals doing business and earning income internationally should definitely take the above discussed considerations into account. A variety of visas is available to persons seeking to reside in the U.S. temporarily, even as long as running and managing a successful business in the U.S., without having to commit to becoming a U.S. citizen or resident. In other words, in the long term, obtaining U.S. citizenship or resident alien status might not be the right decision for everyone seeking to take advantage of market opportunities in the U.S., especially if potentially planning to move elsewhere.