IRS Says Americans Renounce Citizenship in Record Numbers

Mitchel’s observation is that many non-compliant expats knew they should file but were simply negligent and often didn’t even owe any tax.

The international tax lawyer typically helps clients structure a tax-efficient overseas business with a U.S. operation rather than the reverse. These business people naturally have foreign assets. Some were working at a large multinational firm when they were transferred overseas; others were born in the U.S. when their parents were living here, but they spent nearly their entire lives abroad.

Tax compliance is a greater burden for expatriate U.S. citizens, taxed under a worldwide income system regardless of which country they reside in, than for most of the world’s expats, who are only taxed when residing in that country.

Mitchel gives the example of one client he has served (through a referring CPA) who was born in the U.S. but returned to his family’s country of origin when just a baby. This person doesn’t have “a Social Security number, never filed U.S. tax returns, probably didn’t know they have to file tax returns and is now trying to come clean.”

The individual is a citizen of—indeed a government official of—a European country, in whose army he served; the country has a high rate of taxation, so he clearly was not seeking to dodge lower U.S. taxes.

“He was dreading the fact he was a U.S. citizen, he wished so badly he wasn’t a U.S. citizen […]. It was a nightmare to him to be a U.S. citizen,” Mitchel recalls, because of the threat of tax penalties to which he was subject. Thankfully, a new program, that only commenced last July, enabled him to certify his non-willful failure to file; prior to that program, the passage of one year without filing placed him in the category of a criminal.

U.S. tax law is also a snare for U.S. citizens in situations that are far more ordinary—those likelier to be encountered by financial advisors whose clients decide to retire in lower-cost locales such as Costa Rica.

“In various countries, Costa Rica being one of them, if you are going to buy real estate […] the local advisors will often recommend you form a corporation […] to hold the real estate because you can avoid some transfer taxes,” Mitchel says.

“But […] they don’t know,” he continues, “that if you’re a U.S. citizen and own interest in a foreign corporation, you’re obligated to file an annual form, and you’re not going to be able to get the exclusion if you sell the home through a foreign corporation. Not only that, but the gain on any sale of the home will likely be taxed as ordinary tax rather than as capital gains.”

Mitchel often hears from distressed Americans who learn all this after the fact, and who must now file IRS Form 5471 along with intrusive requirements for financial statements, disclosures and the risk of $10,000 penalties that can be applied not simply for failure to file but for inadequately filing.

A wholly separate snare involves passive foreign investment companies (PFIC), which an American may inadvertently come to own shares in simply by buying a foreign mutual fund. Because of all the rules involved, including payment of higher-taxed ordinary income rather than capital gains and interest charges, it’s nearly impossible to come out ahead with this kind of investment.

The solution for most U.S. expats would be to buy U.S.-based mutual funds, though even that is not so straightforward. Australia, for example, has its own PFIC rules, says Mitchel, so a U.S.-born resident of Australia encounters trouble either way he goes. A third, possibly safer approach entails buying shares of companies directly through a foreign brokerage account, then disclosing it on both your FBAR and 8938 forms.

With all the difficulties attendant on U.S. expats, Mitchel recommends the unpleasant task of learning all the rules yourself.

“Even if they’ve got a CPA, they should read the form themselves and understand the rules. The CPA looks at your [case] once a year, maybe twice a year; but individuals know their own circumstances. They should know which forms need to be filed,” he says.

“Most CPAs are not dealing with cross-border transactions; it is a specialty area,” he continues. “Most CPAs don’t know the rules well enough, and it costs a lot to pay a tax attorney to hold your hands. If you can’t figure something out, that’s where I can help you.”

But, Mitchel says, some American-born expats have figured out that the costs of U.S. citizenship have exceeded its benefit.

“They’re living outside the U.S., they’re [often] citizens of other countries; they don’t feel they’re ever going to move back to the U.S.; it’s costly for them to continue to file U.S. tax returns; they’re concerned about potential penalties; Congress keeps increasing the number of forms needed to be filed along with the potential penalties; they’re worried—what is Congress going to do next? And they say, ‘Enough is enough—I don’t need citizenship anymore.’”

— Check out Global Clients Need Global Advisors on ThinkAdvisor.