The Tax Consequences of Foreign Residency%2C Second Citizenship%2C and Expatriation
In the aftermath of the April 15 annual filing deadline, many people inquire what, if any, tax relief they might expect if they live, work, or retire overseas. Most people might want to add a foreign residency or citizenship to their existing U.S. status. While others hope to use their foreign residency and citizenship status as a platform from which to give up their U.S. citizenship, a process referred to as expatriation.
Moving offshore may be highly appealing for many U.S. citizens looking for a lifestyle change. Some may be looking to permanently retire offshore, while others are simply looking for a place to spend the winter months. This decision to explore offshore living can also be used by U.S. persons looking to enhance their own estate and asset protection plans. Offshore exploration comes in a variety of forms. A person may physically want to move offshore by creating a residence in a foreign jurisdiction. Alternatively, they may decide to pursue a second citizenship to have the security of possessing a second passport. Finally, one could take the ultimate step of expatriation. Each of these options have different considerations and a little bit of planning can help the individual make the best decision on whether to pursue foreign residency, second citizenship, or expatriation, while also minimizing or at least understanding the tax implications of each decision.
U.S. persons looking to create a foreign residency are usually motivated by a range of factors beyond simply the tax consequences. A retired person may desire a different quality of life, others may want to encourage children to experience a different culture or educational system, while a few may desire to remove themselves all together from the politics and business of the U.S. Ultimately, U.S. citizens and green card holders need to remember that regardless of their physical presence, they still have a tax filing obligation to the U.S. regardless of source of income or their physical location, since the U.S. taxes its people on their worldwide income. A U.S. citizen or green card holder living abroad and subject to foreign taxes will retain filing requirements with the U.S. government.
Despite filing obligations, there are still advantages to acquiring a foreign residency that an attorney may be able to help a U.S. taxpayer plan for and identify, such as the allowance to take credits, deductions, or exemptions. For example, if a person is employed abroad and those wages are taxed, then the U.S. taxpayer will be able to take a foreign tax credit against their U.S. income liability for foreign taxes previously paid. In addition to foreign tax credits, a potentially large exemption exists in the form of the Foreign Earned Income Exclusion (“FEIE”).
One of the greatest advantages of foreign residency is the Internal Revenue Code’s section 911 FEIE and housing allowance. For U.S. citizens and green card holders who work abroad, there is a FEIE for up to $99,200 on foreign salary or wages, in addition to the separate figure for a housing allowance. When a person is able to generate foreign income, the foreign residence combined with receiving foreign income may create the ability for the individual to claim that he is a resident of a foreign jurisdiction. An advantage to filing as a nonresident in 2014, is that the taxpayer will not be taxed on the first $99,200 of foreign earnings, due to application of the FEIE. For spouses who both work abroad, the FEIE amount is $198,400. This means a couple could expect to save a minimum of $55,000 dollars a year in taxes. In order to gain this benefit on foreign income the taxpayer must: have a tax home in a foreign country, have foreign earned income, and meet either the bona fide residence test or the physical presence test.
The FEIE requires that the taxpayer have a tax home in a foreign country and true foreign earned income. A tax home is the main “place of business” and can be temporary or indefinite. Foreign earned income encompasses only income that is considered “earned” as opposed to “unearned.” Earned income that may qualify includes salaries, commissions, bonuses, tips, professional fees, and noncash income or reimbursements for specified items. Unearned income includes items such as gambling winnings but also passive investment income. Although the FEIE is a great benefit it will not apply to passive investment income, such as dividends and capital gains.
The first of the two tests is that the U.S. taxpayer must be a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year. The bona fide residence test is a subjective test and requires an individual to: have no tax home outside of the foreign country, not have a closer connection to a country besides the one that the individual is claiming residency in, and meet a presence test. In other words, in addition to the presence requirement, the foreign country should be the intended home for an indefinite amount of time and the person should participate in activities, such as paying taxes abroad and contributing to the local community. The presence aspect requires only one of five requirements to be met, including: being present in the foreign jurisdiction for at least 183 days in the tax year; being present for at least 549 days during the current year and 2 proceeding years with a minimum stay of 60 days in the current year; being present in the U.S. for no more than 90 days in the tax year; having $3,000 or less of U.S. source earned income; or having no significant connection in the U.S., such as a permanent home. It will not be enough to simply be present for the entire year under the bona fide residence test, since residency is determined in a case-by-case basis and the IRS will not make this determination until the individual files the applicable filing requesting the FEIE on Form 2555. The subjectivity of this test makes it a harder test to meet; however, the advantage to qualifying as a resident under the bona fide residence test is that there is more freedom to spend time in the U.S. than with the physical presence test.
If the bona fide residence test is not met, the person could still qualify for foreign residency under a physical presence test. The physical presence test requires that the individual is physically present in a foreign country for at least 330 full days during any period of 12 consecutive months. It does not matter if the period is over two calendar years, provided any necessary tax filing extensions have been given. The physical presence test is simpler than the bona fide presence test as it does not inquire into the type or residence established and intentions about returning to the U.S. The drawback to qualifying under this test is that it does limit days the individual to spending only 35 days in the U.S. over the twelve month period. Additionally, if two spouses are trying to qualify for the FEIE, each may each qualify under either the bona fide residence or physical presence tests and do not have to qualify under the same test.
In addition to the FEIE, there is an additional housing allowance for certain foreign housing costs. The housing allowance is limited to certain expenses, generally more lavish living styles will not fall within allowable expenses. These amounts may be limited by the FEIE, as the housing amount is defined by using an equation that relies on a percentage of the FEIE. The IRS has the ability to change the housing exclusion allowed for each country, based on inflation. Both the FEIE and the foreign housing allowance are claimed using the Form 2555.Foreign residency provides a great escape hatch for those searching for a back-up residency or a beautiful retirement opportunity. For those interested in building business offshore, it is a strong tool for those employed offshore or self-employed entrepreneurs looking to draw a salary from their offshore venture. The potential tax and lifestyle advantages offer a great opportunity for people interested in creating a foreign residency.
There are several reasons that a U.S. citizen may choose to become a citizen of a second country. One reason could be the right to live, work, and easily travel in the second country. A person may decide to obtain a second passport and not change residency as an insurance policy, so that leaving and working abroad is simpler, but never pursue actually living abroad. Others may choose a second citizenship as a first step in a larger plan that involves expatriation.
A negative consequence to dual citizenship is the potential for tax filing requirements in both countries. While jurisdictions with more privacy and less tax liability may be identified when searching for the right place to attain a second citizenship, a U.S. person acquiring a second citizenship will remain liable for U.S. tax filing requirements as long as he or she remains a U.S. citizen. Ultimately, claiming a second citizenship may not be advantageous to lowering taxes unless other planning is completed concurrently or expatriation does occur. Regardless, a second passport will offer travel advantages, provide security, and be the necessary step in qualifying for even the possibility of future expatriation.
One way to generally remove or lessen future U.S. tax liability is to cease being a citizen or resident of the United States. This is a more extreme version of estate planning that some U.S. citizens may hesitate to embrace, or simply reject if ties to the U.S. are strong. Tax liability, alone, is not usually a reason for people to renounce U.S. citizenship. A number of factors must be taken into account, such as residence, marital status, source of income, asset location, desire to gift to U.S. citizens after expatriation, and which citizenship will be acquired to replace the U.S. citizenship. While expatriation is not right for most U.S. taxpayers, this decision will greatly impact U.S. tax requirements, both at the time of expatriation and going forward.
U.S. citizens and residents looking to leave the U.S. permanently cannot merely pick up their bags and leave, exit, or expatriate without completing the necessary IRS documentation. Instead, U.S. persons must see if they meet a threshold test to qualify as a “covered expatriate” since exit taxes only to those who are considered “covered expatriates.” This tax only applies to an expatriate if one of two tests is met: an income test and a net worth test. The net income test rests on whether the average annual net income tax for the five years ending before the expatiation is more than a specified amount. This amount is adjusted for inflation and available on the IRS website ($157,000 for 2014). Alternatively, a net worth test is met which looks to whether the U.S. person’s net worth is $2 million or greater on the day of expatriation. If the income or net worth tests apply, the person, leaving the U.S. on or after June 16, 2008, will be considered a "covered expatriate."
For valuation purposes, the property of a "covered expatriate" is subject to a mark-to-market regime. This means that all of the property of the expatriate is deemed sold for fair market value on the day before the date of expatriation. A more detailed explanation of how this applies is available on the IRS website in IRS Notice 2009-85. The gains from these deemed sales are considered taxable gains arising from a sale unless another rule from the tax code prevents this treatment. Fortunately, losses are also taken into account as losses from a sale for that same year. Additionally, the calculated gain amount that is includible in gross income for the tax year is reduced by $600,000, adjusted for inflation. This $600,000 dollar exclusion amount will not reduce the gain below zero and is not carried forward and taken into account for any gain or loss subsequently realized but this exclusion does eliminate the tax on approximately $2.2 million of unrealized gains.
Long-term residents, defined as those who held green cards in eight out of the last fifteen years, may also be subject to exit taxes and potentially cease to be a long-term resident in two situations. The first is that the individual’s status has been revoked in accordance with immigration laws or has been administratively or judicially determined to have been abandoned. The second situation would be if the individual notifies the IRS on Forms 8833 and 8854 that he or she has commenced to be treated as a resident of a foreign country per a tax treaty with the U.S. and that country and does not waive the treaty provisions applicable to residents of the other country. These residents are subject to the same exit tax consequences and mark-to-market regime.
When a person renounces their citizenship or long-time permanent residents end their U.S. resident status for tax purposes they must file an “Initial and Annual Expatriation Statement” Form 8854, which helps identify whether the citizen is a “covered expatriate.” Due to this filing requirement, an individual may still be considered a "covered expatriate" if that person has failed to certify on the Form 8854 that he or she complied with all U.S. federal tax obligations for the 5 years preceding the date of expatriation, regardless of the net worth or income test. Failure to file the Form 8854 may also lead to a $10,000 penalty. A "covered expatriate" is allowed to exclude a few assets from the determination of the exit tax base, such as non-grantor trust interests. However, additional filing requirements with a Form W-8CE exist for covered expatriates who have deferred compensation items or interest in a non-grantor trust.
For covered expatriates who expatriated prior to June 17, 2008, and after June 3, 2004, there are harsher results. The previous program could subject covered expatriates to taxation on their worldwide income for ten years after expatriation and in some cases classify these expatriates as residents for U.S. tax purposes. The rules affecting this group no longer apply to individuals currently contemplating expatriation.
Once the expatriate has completed the expatriation process, there are still a few potential scenarios that could trigger taxation in the future. An expatriate must make sure that he does not create tax residency in the U.S. by spending too many days in the U.S. under the substantial presence test, meaning that he has to evaluate prior to expatriation his future presence within U.S. jurisdiction. Any domicile in a U.S. state must also be ended upon expatriation. Prior to expatriating, the expatriate needs to take into account where his spouse and beneficiaries intend to reside, as the spousal community property laws and estate and gift tax consequences may affect the taxation and wealth of the expatriate. Other upfront considerations would be aimed towards further asset protection and tax planning, such as the source of income and the location of assets outside of U.S. jurisdiction.
The options of foreign residency, second citizenship, and expatriation all have different tax and living implications to the individual exploring these opportunities. It is best to engage in planning prior to taking these steps as a little forethought and planning can help keep an individual in legal compliance and also help preserve wealth for offshore living. Each of these tools can also lead to unexpected tax consequences if done incorrectly. Due to the different considerations and intricacies it is important to work with lawyers experienced in foreign residency and second citizenship matters. If you are interested in exploring these options further please contact Nagel & Associates at (412) 749-0500.
Anne Greene is an international asset protection and tax attorney at Nagel & Associates and currently practices in Pittsburgh, Pennsylvania. She is a graduate of Georgetown Law Center (L.L.M. in Taxation) and the University of Pittsburgh Law School.
Nagel & Associates is a law firm assisting clients in the area of asset protection cross-border transactions, global investment, taxation, immigration / emigration and estate planning. Anne can be reached via email at Agreene@ nagellaw.com or at 412-749-0500.