US Expatriation

The United States is the only major country that imposes tax on a citizen's worldwide income, no matter where that citizen lives. If you live in Britain, Botswana, Bulgaria, or almost any other country, all you need to do to avoid the obligation to pay tax on your worldwide income is to leave. After an extended period—normally 1-2 years, sometimes longer—you no longer have any obligation to pay taxes on your income outside that country (although you may continue to be subject to gift and estate taxes).

But not the USA. To permanently disconnect from U.S. tax obligations, a U.S. citizen must not only leave the United States, but also take the radical step of giving up U.S. citizenship. This process (from a U.S. standpoint) is called expatriation. It also requires that you acquire citizenship and a passport from another country, and also live outside the United States, if you're not already living overseas.

If you're wealthy, giving up U.S. citizenship or residence can save millions or even billions of dollars in future taxes. The total combined state-federal income tax burden for most high-net-worth earners in the United States is close to 50%. And President Obama promises to hike that burden to pay for his tax-and-spend policies. For instance, if you anticipate earning US$2 million over the next five years, expatriation could save you a cool US$1 million in income tax. Not to mention millions more in the years ahead, and millions more again in estate tax savings.
What's more, expatriation eliminates the increasing difficulties U.S. citizens face investing or doing business outside the USA, no matter where they reside. As a consequence of the ongoing and intensifying crackdown against anything "offshore" by the U.S. government, most offshore banks now prohibit anyone with any connection to the United States, no matter how remote, from opening an account. Giving up your U.S. citizenship and passport eliminates this problem.

Only a few hundred people, many of whom are not wealthy, give up their U.S. citizenship annually. However, the popular image of unimaginably wealthy former U.S. citizens living tax-free in tropical paradises is an irresistible political target. Former Congressman Sam Gibbons, a Florida Democrat, once spoke of "the despicable act of renouncing allegiance to the United States." Former Congressman Martin Frost, a Texas Democrat, supported tax penalties on expatriates on the basis of "basic patriotism and basic fairness." The ferocity with which U.S. politicians have seized upon the expatriation issue has resulted in a series of increasingly stringent laws that put real teeth into rules penalizing U.S. citizens who give up their U.S. citizenship.

Because these anti-expatriation rules have historically been relatively easy to circumvent, there have been periodic calls to make what critics call the "billionaire's loophole" stricter. The latest effort to thwart the migration of wealthy individuals from the USA came in 2008, when Congress replaced the existing rules in their entirety with an "exit tax."

The exit tax is based on the legal fiction that an expatriate sells all of his or her worldwide property on the day before the date of expatriation at its fair market value. Tax on the fictional gain is due at the time the expatriate's tax return is due for the year of expatriation. Unrealized gains in non-grantor trusts and some retirement and pension plans are exempted from the exit tax, but subject instead to a 30% withholding tax on future distributions.

Moreover, the exit tax applies not only to former U.S. citizens, but also to long-term green-card holders who have resided in the United States for at least eight of the 15 years preceding expatriation.

How are you supposed to pay the tax without selling your assets? That's your problem—not the IRS's—although the law permits deferral by posting acceptable security with the U.S. Treasury and paying an interest charge on the amount deferred. The law also imposes a substitute estate tax of 'covered gifts or bequests' that exceed US$13,000 annually received by a U.S. citizen or resident from a covered expatriate, payable by the recipient. The US$13,000 exclusion is adjusted annually for inflation.

Fortunately, there are some loopholes in the law that provide planning opportunities for prospective expatriates:

The first US$600,000 of unrealized gain isn't subject to the exit tax. This amount is adjusted annually for inflation, and for 2009 the exemption is US$636,000. The exemption doubles for a married couple, both of whom expatriate. In addition, even if unrealized gains exceed US$636,000, the exit tax only applies to individuals who:

Have a global net worth exceeding US$2 million (US$4 million for a married couple); and/or An average annual net income tax liability for the five preceding years ending before the date of expatriation the loss of U.S. citizenship or residence exceeding US$124,000 (adjusted for inflation, US$136,000); and/or Fail to certify under penalties of perjury that they have complied with all U.S. federal tax obligations for the preceding five years or fail to submit evidence of compliance as required by regulation. Only certain dual citizens and minors with few ties to the United States are exempted from these requirements.

The best that can be said about the exit tax is that the new rules offer a clean break with the U.S. tax system as of the date of expatriation. Unlike prior law, there is no longer a 10-year period after expatriation during which special punitive tax and immigration rules apply.

Is expatriation for you? The decision to give up U.S. citizenship is a serious one. It also requires substantial advance planning, including the acquisition of a second passport, if you don't already have one. It's a step you should take only after consulting with your family and professional advisors. But it's the only way that U.S. citizens and long-term residents can eliminate U.S. tax liability on their non-U.S. income, wherever they live. And it's a tax avoidance option that Congress may eventually eliminate altogether.

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