Too often, people who live outside the United States and are citizens of other countries discover that they're U.S. citizens as well and, therefore, owe U.S. taxes.

Most countries have rules that allow the transmission of citizenship through descent, with the result that many individuals can be citizens of more than one nation. Rarely does this cause them any problems, as those nations tax people on the basis of residence or location of assets in those countries.

The United States is unique, however, in that it imposes its taxes — on a worldwide basis — on its citizens regardless of where they live.1 There's a corollary: The imposition of a citizenship standard of taxation materially complicates the lives of Americans living overseas in a way not experienced by people of other nationalities. Americans who go to live overseas may enter into this new complicated world with their eyes open. The same isn't true for people who find themselves U.S. citizens inadvertently (for example, because they were born in the United States even though they only lived there for a short time or because they may have an American parent).

To make matters more complicated, a steady liberalization of rules relating to the acquisition of U.S. citizenship by persons born overseas has taken place at the same time the Internal Revenue Service has significantly increased its focus on the foreign activities of Americans. The result: people who have no sense of being American find themselves caught up in a maze of rules really aimed at the U.S. resident citizen seeking to defer or evade U.S. taxes by holding assets offshore.

What does this mean for our client families?

Complications and Cost

First, we must help our clients determine whether any of their family members are, in fact, U.S. citizens. (I'll address this issue in a hypothetical later in the article.)

If they are U.S. citizens, untangling the U.S. taxes that are due will potentially be an expensive and cumbersome process. Estate and gift tax may be a problem, especially when local estate-planning techniques have been used that are detrimental from a U.S. perspective. The various anti-deferral rules aimed at preventing the accumulation of income offshore, without the payment of U.S. taxes, may also result in a materially worse U.S. tax result than would otherwise have been the case.

For example, an accidental American family will quite likely have invested in local funds and other investment vehicles that the U.S. government will treat as passive foreign investment companies or controlled foreign corporations. This classification will generally result in a worse tax outcome for a U.S. taxpayer than would be the case if the funds were invested in comparable U.S. tax efficient vehicles. This is the case even though the local investment products and long-term savings plans are fully compliant with local requirements, because they weren't structured from a U.S. perspective. Given the complexity of the U.S. Tax Code, there are all sorts of issues that impact a U.S. citizen living overseas that would be of exotic interest to an American living in the United States, all of which increase the impact of U.S. taxes on the U.S. taxpayer abroad. Foreign currency gains may be a problem, as well as the foreign tax credit limitations and differences in timing on the taxation of various events. And then there's the potential mismatch between the country of residence's tax system and the U.S. system, which usually results in the taxpayer paying the worst combination of both nations' taxes.

The concerns accumulate: The recently enhanced U.S. reporting rules — especially the Report of Foreign Bank and Financial Accounts — and the enhanced penalties for understatement of foreign financial assets, which doubled the normal understatement penalty from 20 percent to 40 percent — will make the potential cost of accidental non-compliance very expensive.2 You will need to tell the U.S. members of a family that they must not only file U.S. returns, but also a foreign bank account report for each of their non-U.S. accounts if the balance at any point in the year exceeded $10,000. Each failure to file can result in severe penalties.3

Renounce U.S. Citizenship?

Given these substantial drawbacks, accidental Americans often ask whether they can give up their citizenship to avoid these issues. The answer is “yes.” Generally, there are no restrictions on the rights of a U.S. person to give up citizenship.4 However, just as the rules on retaining U.S. citizenship have become more liberal over the last 35 years, making it easier to be an accidental American, the rules relating to the tax implications of expatriation have become more complex.

Under the current rules, if a person gives up: (1) U.S. citizenship; or (2) his green card after having held it for eight out of the 15 taxable years ending with the year of expatriation, there will be an exit tax if the expatriate has assets in excess of $2 million or if the average annual net income tax of the expatriate for the five prior taxable years exceeds $147,000. In addition, the tax is due if the person expatriating fails to certify that he's met his U.S. tax obligations for the five preceding taxable years. The exit tax is imposed as if the expatriate had sold all his assets on the day of expatriation, with special rules for deferred compensation, tax deferred accounts and trusts.5

Two special exemptions to the exit tax will often help the accidental American, regardless of his wealth. The exit tax won't be imposed if:

  1. The renunciation of U.S. citizenship takes place before the individual turns age 18½ and he hasn't lived in the United States for more than 10 taxable years prior to the renunciation; or

  2. The individual was a dual citizen at birth and a citizen and resident of the non-U.S. country at the time of renunciation and hasn't lived in the United States for more than 10 out of the 15 taxable years before the taxable year of renunciation.

The same five-year certification is also required to take advantage of the two special exemptions

These exemptions make it possible for many accidental Americans to relinquish their U.S. citizenship if they wish, but there likely still will be a cost — potentially in taxes and certainly in professional fees as they file back returns and deal with their prior U.S. tax obligations.

The Moral

The moral of the story? As advisors, we need to be even more alert to the potential for an individual to be an accidental American. Sometimes the tip off is obvious — for example, the client's foreign passport says he was born in the United States. Too often, though, it won't be obvious at all.

Listen closely when allegedly foreign clients make chance remarks revealing:

  • They have an American parent or grandparent;

  • They have spent time in the United States; or

  • They had a green card at some point.

Inevitably, most rational people will be disconcerted to learn they have to deal with U.S. tax issues. But, there's some comfort in the fact that the U.S. expatriation rules can help many go back to what they thought was their true position.

On the other hand, they might want to take advantage of their newfound citizenship!

Can You Spot the Americans?

Here's an example of a family tree in which some members are U.S. citizens and other are not:

Otto was born in New York in 1900, while his parents were visiting family in the United States. Shortly afterwards, he and his parents returned to their home country of Ruritania. Otto never returned to the United States. In 1928, his only child, Hanz, was born in Streslau, the capital of Ruritania. Like his father, Hanz is a Ruritanian citizen because Ruritania grants citizenship on the basis of descent, following the civil law rule of jus sanguinis.

In 1938, fearing the outbreak of war in Europe, Hanz was sent to the United States to stay with distant relatives. After the war, he attended college in the United States and, after he graduated in 1950, returned to Ruritania to enter the family business. Hanz married a Ruritanian wife and has three children, Kurt, born in March 1952, Frank, born in 1954 and Natasha, born in 1957. All were born in Ruritania.

Other than occasional visits to the United States, Kurt and Frank remained residents of Ruritania, married Ruritanians and each had two children. Natasha attended college in the United States as an undergraduate and graduate student from 1976 to 1983, then returned to Ruritania, where she also had two children, Karl and Suzanna. One of Kurt's children, Michael, decided to spend some time in the United States and applied for a green card. He lived in the United States from 2001 to 2005, then decided to return to Ruritania.

You meet Michael at a cocktail party in Streslau while you're on holiday. He tells you that the family has been having a difficult time getting TrustyBank, based in New York, to release an account held by his grandfather, Hanz, at the time of his death because the bank is concerned there might be a U.S. estate tax exposure on the non-U.S. assets in the account.

You tell Michael that the bank is right to be concerned. Whether there is U.S. estate tax to pay will depend on:

  1. whether his grandfather had been a U.S. citizen at the time of his death (in which case all of his assets, foreign and U.S., will be subject to tax); and

  2. if the assets in the account were foreign or U.S. situs (if Otto wasn't a U.S. citizen, then only the U.S. assets in the account would be subject to estate tax absent a treaty).

He asks you to research the point.

After some time wrestling with the rules relating to citizenship, you email Michael to say that not only was Hanz a U.S. citizen at the time of his death, but also that several other members of the family are currently U.S. citizens. (See “A Family Tree,” p. 61 for a summary of the research results.)

The news comes as a surprise to Michael, but he's particularly upset when you tell him that, because the United States taxes its citizens on a worldwide basis regardless of where they live, the family has some very difficult tax issues to resolve. He asks how it's possible that some family members are U.S. citizens, even though they've never even had a U.S. passport. This is what you tell him:

  • Otto, when he was born in New York in 1900, was immediately a U.S. citizen. The United States applies the old common law rule of jus soli, which provides that the place of a person's birth determines citizenship. The only exceptions to that rule generally are for children born in the United States to foreign diplomats, but, otherwise, all births in the United States, even if the parents are in the United States temporarily or illegally, will give rise to U.S. citizenship.6
  • Hanz also was a U.S. citizen, because his father was a U.S. citizen by birth. Under the law prevailing in 1928, a U.S. citizen father, born in the United States, would transmit U.S. citizenship to his children born overseas. Hanz wasn't required to spend any time in the United States to keep his citizenship.7
  • Kurt isn't a U.S. citizen now, but he was when he was born. In an effort to ensure that persons born abroad with only one U.S. citizen parent developed ties to the United States, the law was amended in 1934 and amended again by the Nationality Act of 1940 to impose residency requirements on both the U.S. parent and the child. First, the U.S. parent had to have been physically present in the United States or in a U.S. possession (that is, a territory controlled by the United Sates) for 10 years prior to the child's birth; at least five of which are after the age of 16. Hanz meets the parent requirements. Second, Kurt had to spend two years of continuous physical presence in the United States between the ages of 14 and 28, which he did not. As a result, his U.S. citizenship ceased.8
  • Frank and Natasha are both U.S. citizens. Although rules similar to those applying to Kurt were enacted in 1952, the law was amended in 1978 to eliminate the child's residency requirement for persons born on or after Dec. 24, 1952.9 Thus, even though Frank hasn't lived in the United States, unlike Kurt, he has retained his U.S. citizenship. The fact that Natasha has lived in the United States isn't relevant to her citizenship status. It is, however, highly relevant to her children, as the residency requirement needed for a U.S. citizen parent to transmit citizenship were relaxed even further for births occurring on or after Nov. 14, 1986.
  • Karl, born in 1985, isn't a U.S. citizen because his mother hadn't lived for 10 years in the United States (five of which must be after the age of 14).
  • Suzanna, however, is a U.S. citizen, as the new rules only require Natasha to have lived in the United States for five years (only two of which must be after the age of 14) before Suzanna's birth.10
  • None of Kurt's or Frank's children are U.S. citizens, as neither father meets the residency requirement for transmitting citizenship.
  • Michael isn't a U.S. citizen, but he has complicated his U.S. tax position by retaining his green card even though he no longer lives in the United States. As a green card holder, he's viewed as a tax resident of the United States.11 In addition, there's no tax treaty between the United States and Ruritania which might otherwise result in him being treated as a Ruritanian taxpayer. As a result, Michael remains subject to the U.S. tax system as a resident rather than as a non-resident alien until such time as the green card status is properly terminated. 12

Endnotes

  1. In 1995, the Joint Committee on Taxation reported that, in addition to the United States, only two other countries in the world imposed taxation on the basis of citizenship, namely The Philippines and Eritrea. Joint Committee on Taxation, Issues Presented by Proposals to Modify the Tax Treatment of Expatriation, JCS-17-95. The origin of the citizenship rule apparently goes back to the Civil War when the federal government sought to penalize Americans who left the country to escape taxation and the draft. Jackie Bugnion, “Overseas Americans Should Have a Say in National Tax Reform Debate,” 62 Tax Notes Int'l 875 (June 13, 2011).
  2. Internal Revenue Code Section 6662(j), which was added in 2010 by the Hiring Incentives to Restore Employment Act, P.L. 111-147.
  3. In general, the penalty will be up to $10,000 unless: (1) there was reasonable cause for the violation; and (2) the balance in the account was properly reported. Willful failure to file will result in a penalty equal to the greater of $100,000 or 50 percent of the account in question. 31 U.S.C. 5321(a)(5).
  4. The State Department permits minors to relinquish U.S. citizenship, but will only do so once it's satisfied the minor understands what he's doing and isn't acting under duress. In all cases, once the minor reaches age 18, he has six months to ask for reinstatement of his citizenship. 7 FAM 1290.
  5. IRC Sections 877, 877A.
  6. United States v. Wong Kim Ark, 169 U.S. 649 (1898). The State Department's Foreign Affairs Manual has a detailed commentary on what exactly is “birth in the United States.” For example, does it include birth in a territory and if so, what's the status of that territory, or does it include a birth in a U.S. military base overseas or a U.S. registered aircraft or ship? See State Department Foreign Affairs Manual, 7 FAM 1112-1115.
  7. The law in effect in 1928 was Section 1993, Revised Statutes of 1878. In 1934, the statute was amended to: (1) extend the rule to U.S. citizen mothers, and (2) require the child to spend time in the United States to retain his U.S. citizenship.
  8. If the period of residency began before Oct. 27, 1972, the period of residency was five years rather than two. 7 FAM 1100, Appendix L. Kurt may, if he wishes, apply to restore his U.S. citizenship following passage of Section 103, Immigration and Nationality Technical Corrections Act of 1994, P.L. 103-416, which amended Section 342(d) of the Immigration and Nationality Act, effective from March 1, 1995.
  9. Public Law 95-432.
  10. Section 301(g) of the Immigration and Nationality Act ,which applies to persons born on or after Nov. 14, 1986. 7 FAM 1133.2-1.
  11. IRC Sections 7701(a)(30); (b)(1)(A) and (b)(6).
  12. See IRS Publication 519, U.S. Tax Guide for Aliens, p. 4, which warns that a person who has a green card will remain a U.S. tax resident even if U.S. Citizenship and Immigration Services doesn't recognize the validity of the green card because it has expired or the individual has been absent from the United States for a period of time. The tax status will only cease when there has been a final administrative or judicial determination of abandonment.

Gavin F. Leckie is managing director of the cross border advisory team at J.P. Morgan Private Bank in New York

SPOT LIGHT

The “Bear” Necessities

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