The cost of being a US citizen living abroad extends well beyond going through the motions of staying US tax compliant annually. It includes legal/accounting fees, huge failure-to-file penalties if late (totalling tens of thousands of dollars), staying on top of the ever-changing US tax law landscape - not to mention the yearly stress, sleepless nights, and lost time in dealing with the situation.
What is often overlooked is potentially having to pay US tax on top of everything else. Many expats falsely believe that a tax treaty with the US and the country they live in will always save them from ever owing US tax. While a tax treaty can help, there is an extensive list of financial transactions and situations where the treaty does not assist the US expat avoid owing Uncle Sam. It's a list most people never consider until it is too late. This, among other costs, has record numbers of US citizens renouncing worldwide to make it all stop.
US citizens living outside of the United States are taxed on their worldwide income and assets in life and death. The US and Eritrea are the only two countries in the world that tax based on citizenship (not just residency). In short, if you're a US citizen living abroad, every dollar, pound, euro (or whatever currency you earn) is subject to US tax and reporting, even though you don't live in the US!
A US citizen living abroad is taxed by the US and by their country of residency. You might ask yourself - does that result in a double tax? Depending on where you live in the world, you may be able to lean on the fact that your country of residence has a tax treaty with the US. If so, generally, if you pay tax in your country of residence, you can use that as a credit to offset what you also owe the US. For example, if a US citizen lives in Canada and earns $100,000 in taxable ordinary income, you might owe around 50% in Canadian taxes and about 35% to the US. Do you owe an 85% combined tax rate? No.
You can use the tax paid in Canada ($50k) to offset what you owe the US ($35k). A foreign tax credit for what is paid in Canada can be used to result in $0 tax owing in the US (in fact, you have a $15k credit to carry forward). But if you live in countries like Saudi Arabia, Singapore, UAE, or the Cayman Islands where income tax levels are below the US rate or are at zero (or there's no tax treaty with the US), that same $100,000 is subject to the full US tax rate, which is then owed to the IRS.
Beyond salaried income, there are many other situations where the US expat is at risk of owing Uncle Sam (even with a tax treaty), including, but not limited to:
1. The sale of your principal residence
The sale of your principal residence may be tax-free in your country of residence, but is not tax-free in the United States. The US exempts only the first $250,000 USD in gain, which becomes a huge problem for US citizens selling their properties in places like Vancouver, Toronto, Sydney, Melbourne, Auckland, London, Paris, or anywhere real estate markets are booming (which is just about everywhere right now). You risk owing hundreds of thousands of dollars on the sale of your home if you don't renounce before selling.
Many US citizens located in Canada, Australia, England, France, the UK, and around the world, purchased homes when they were still affordable. Over the years, they've seen the value of those homes skyrocket in value by upwards of 3000%. Let's say you bought your home in Toronto for $100,000, and years later, you sell it for $2.2 million. While the entire $2.1 million gain in Canada is tax-free, the US will also tax the same gain because you are a citizen, and the principal residence exemption is not unlimited, but capped at the first $250k of gain. Everything over that is taxed at 20% (an even higher rate of 40+% may be coming under the Biden administration for certain capital gains scenarios). Thus, in our example, the $2.1 million gain, minus $250k, is subject to a 20% tax in the US ($370k in US tax owed). Even with a tax treaty between the US and Canada, there is no tax paid in Canada to offset what you owe in the US. Now is time to get your cheque book ready for Uncle Sam, on what many thought was their tax-free retirement nest egg in the form of their principal residence. Not good!
Even big-name UK politicians who are/were US citizens are not immune to paying US tax on the sale of their principal residence. In 2015, then London mayor (and current Prime Minister) Boris Johnson was forced to pay US capital gain taxes on the £730,000 he made on the sale of his North London home. Johnson was born in New York (making him a US citizen) and did not renounce his US citizenship until 2017 (after he sold the property). If he had renounced his US citizenship and THEN sold the property, he would have owed $0 to the US. Boris got terrible legal advice and sold the property, THEN renounced. Not good - and he paid for it!
2. Having an interest in a non-US privately held company
This is another situation where double taxation can dramatically impact your net worth as a US expat. Whenever a US citizen has an interest in a non-US privately held company anywhere in the world, a whole slew of tax regimes works against them. These punitive measures were implemented to prevent tax cheats from avoiding/deferring US tax by hiding money in non-US corporations. Now innocent US citizens living abroad are paying the price for a few bad apples.
A US citizen holding an interest in non-US privately held company, can be subject to PFIC (Passive Foreign Investment Company) tax, CFC (Controlled Foreign Corporation) tax, and a one-time transition tax (a one-time lump sum). You could also be subject to the ominous-sounding GILTI (Global Intangible Low-Taxed Income) tax which the Trump administration passed in 2017. The Biden administration is proposing to double that tax rate from the current 10.5% to 21%. The sky-high accounting fees to file returns each year in a situation like this are another added cost. In short, if you're a US citizen and you're incorporated outside the US, it will almost certainly spell financial disaster in life and in death.
3. Non-US mutual funds
The other issue from a double taxation point of view is non-US mutual funds. ETFs (Exchange Traded Funds) and non-US mutual funds are classified as PFICs for US purposes. So, if you're a US citizen living abroad who is investing in non-US mutual funds or ETFs, the IRS can have some nasty tax treatment that doesn't match with your country of residence and require extra reporting forms with the potential tax owing. Individuals begin running into trouble when their country of residence doesn't tax such holdings at the same time the US does. Even though you may be paying, or will pay, a high tax rate in your country of residence, one could end up paying much more to the IRS.
4. Divorce settlements among a US citizen and non-US citizen spouse
If you're a US citizen married to a non-US citizen, you need to be extremely cautious. When two US citizens separate or divorce, it's a tax-free event because the IRS knows that no matter how you divide the assets, they still end up in the hands of someone they can continue to tax. Issues begin to arise when you have a US citizen married to a non-US citizen. Any separation of assets with gain going from the US citizen to the non-US citizen becomes fully taxable to the US citizen.
In many divorces, the attorneys/parties involved are aware of this pitfall issue and act accordingly. The non-US spouse will adjust the settlement negotiations in their favour to squeeze the US citizen spouse to get more, but help avoid a bigger hammer from the IRS on their soon-to-be-former partner. A tough spot for the US citizen spouse! In many cases, US citizens stuck in this jam will often renounce their citizenship before the separation of assets is finalized to even the matrimonial playing field.
5. US estate tax (death tax)
The US does not have an inheritance tax, but it does have an estate tax. The difference between an estate tax and an inheritance tax is that an estate tax taxes the deceased before any money is distributed to beneficiaries. The inheritance tax is imposed on the person receiving assets from the dead person. If you are a US citizen when you die, you are subject to the US estate tax regime.
In short, the US government determines a number that is estate tax-free to die with. Anything you die with above that watermark, is hit with a 40%-65% tax on the value of said pool (not the gain). The Trump-era exemption of $11.7M is currently in effect (one of the largest exemption amounts in US history) with the tax rate imposed above that mark at 40%. The Biden Administration recently proposed increasing the estate tax rate from 40% to 55%, and many believe they are eyeing an exemption amount of around $2M USD. A far cry from the current mark.
Thus, to plan accordingly as a US expat for estate tax purposes, you need to know what you will be worth when you die, what order family members will likely die in, when you will die, and what political party will be in control when everyone dies. Not easy!
If you're a US citizen expat, and you want to ensure your beneficiaries receive the maximum amount possible at death, you should consider renouncing your citizenship the right way before making your succession plans. The US estate tax applies to a US citizen's worldwide assets when they die an American. But if they die a non-US citizen, said estate tax does not apply.
6. Lottery Winnings
Just because lottery winnings are tax-free in the country you live in doesn't mean they're tax-free in the US. If you're a US citizen who won big, get ready to pay a big US tax bill right after you get your photo taken with that oversized cheque - unless you renounce before buying the lucky ticket!
That's a lot to digest, and it's just the tip of the iceberg. There are dozens of other problem scenarios for the US expats owing Uncle Sam (gift tax, generation-skipping tax, income splitting, Net Investment Income Tax (Obamacare), medical expenses, non-US trust interests, etc).
In short, all these double-tax risks of living abroad as an American can be eliminated if one successfully renounces their US citizenship prior. Having said that, the US has a gauntlet of tricks and traps to avoid when renouncing properly (exit tax, inheritance tax, disbarment from the US for life, etc). We specialize in making sure you renounce the right way to avoid all the potential land mines.
Moodys Tax Law is only about tax. It is not an add-on service, it is our singular focus. Our Canadian and US lawyers and Chartered Accountants work together to develop effective tax strategies that get results, for individuals and corporate clients with interests in Canada, the US or both. Our strengths lie in Canadian and US cross-border tax advisory services, estateplanning, and tax litigation/dispute resolution. We identify areas of risk and opportunity, and create plans that yield the right balance of protection, optimization and compliance for each of our clients' special circumstances.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.