Increased tax-reporting requirements are making some high-net-worth clients consider leaving the U.S. for good, but experts warn that a considerable amount of tax and estate planning is in order before such investors tear up their passports.
A recent analysis of U.S. Treasury data by blogger and international tax lawyer Andrew Mitchel found that 2,999 individuals renounced their U.S. citizenship or ended their long-term residency in 2013. Comparatively, the number is huge, considering that the previous record for expatriations was in 2011, with 1,781. In 1998, only 398 people took that drastic step of giving up their American permanent residency or citizenship, according to Mr. Mitchel.
Tax experts note that while there are many reasons why people who are citizens or long-term residents might consider leaving, one key consideration is increased tax-reporting requirements on foreign accounts.
You might remember the scandal that bubbled to the surface when the IRS and the Justice Department reached an agreement with UBS AG in 2009, revealing that hundreds of U.S. clients held accounts offshore and failed to report them to the IRS using a Report of Foreign Bank and Financial Accounts or pay the appropriate taxes.
That scandal gave rise to the Foreign Account Tax Compliance Act, which became law in 2010 and sought to target U.S. taxpayers with foreign accounts who fail to comply with tax-reporting laws.
For U.S. citizens and permanent residents, the issue is that they are still subject to U.S. tax requirements even if they're living elsewhere, as the U.S. administers taxes based on citizenship and not the residence of a given taxpayer.
It's a problem that comes up in situations as simple as a U.S. citizen who moves to Europe for work and ends up with a retirement plan there that needs to be properly documented. Or an individual who was born in the U.S. but has spent the majority of his or her life elsewhere.
“The world continues to be a shrinking place,” said Henry P. Alden II, an accountant and founder of Everest International Group. “People are moving around and relocating, and it's a burden to be fully compliant [with tax laws] in two jurisdictions.”
“A substantial portion of the expatriations we're handling are people who may have been born in the U.S. but have spent virtually all or most of their lives outside of it,” said Steven Cantor, an attorney at Cantor & Webb. “And they have not felt the continued need or desire to pay taxes on a worldwide basis and be subject to reporting requirements.”
For those who are willing to take the plunge and renounce their U.S. citizenship or permanent residency, a ton of tax planning will be in order.
First, the client needs to determine if he or she is a “covered expatriate” under U.S. tax law by meeting one of the following conditions, as of 2014:
• The person has a net worth of at least $2 million on the date of expatriation.
• The individual has an average annual net income tax of more than $157,000 for the five tax years ending before the date of giving up his or her citizenship.
• The person fails to certify on Form 8854 that he or she has complied with all U.S. federal tax obligations for the five years before the expatriation.
Complying with all U.S. tax obligations requires prospective expatriates to come clean about any undisclosed foreign bank accounts and file six years of returns, according to Scott Bowman, an attorney in the personal planning department at Proskauer Rose.
If a client is deemed a “covered expatriate,” he or she should then prepare to face an exit tax. This means the person's assets in the U.S. are treated as if they were all sold the day before expatriation, subjecting those holdings to a bevy of levies. There is an exclusion of $680,000 for 2014.
There is also a special inheritance tax of 40%, which is imposed on U.S. citizens who receive property from expatriates, noted Mr. Bowman. Think of it as an estate or gift tax in reverse — the person transferring the property has left the U.S., so the Tax Man will take his share from the recipient.
What's especially risky about the inheritance tax is that the property the expatriate passes on will likely continue to accumulate value even after he or she leaves. So at death, the U.S.-based recipient of the property could face a larger-than-anticipated tax bill, according to Mr. Alden.
Though leaving the country for good is far from affordable for wealthy clients, there is a tactic to help soften the blow of exit and inheritance taxes: Build a trust.
Mr. Bowman noted that these clients can sell their assets to an irrevocable trust, where they'll grow without being subject to an inheritance tax.
There are also pre-expatriation trusts, where U.S. citizens can take advantage of their $5.34 million estate and gift tax exemption while they still have it. Be aware that once a client renounces his or her citizenship, the estate and gift tax exemption goes down to $60,000.
“Before they expatriate, we have them fund trusts to use up every last penny of their estate and gift tax exemptions,” Mr. Bowman said. “At least you have set up those trusts and they're outside of the inheritance tax regime.”
Finally, family limited partnerships also can be an effective tax savings vehicle. Property placed in the family limited partnership can receive a lack of marketability and lack of control discounts, which will depress the value of the property for transfer tax purposes, according to Mr. Bowman.
“This is a basic, everyday transaction that domestic estate planners do in their sleep,” he said. “It's an awesome way to produce savings.”