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This is part one of a two part series on expatriating to save taxes.
The other day I got a call from a client who was concerned about the threat of tax increases if Democrats win the presidency and a Senate majority in 2020. He was particularly worried about the wealth tax proposed by presidential candidates like Elizabeth Warren, who advocates imposing a 2% annual tax on wealth above $50 million and a 6% tax on income above $1 billion.
His question: Could giving up his U.S. citizenship be the answer to avoiding these new taxes if the Democrats take power?
It’s a question I’ve received from other ultra-high net worth clients regardless of which party is in office. They hear about billionaire Jeffrey Epstein cutting his tax bill by 90% by switching his business and personal residence to the Virgin Islands. They read news reports about Facebook co-founder Eduardo Saverin renouncing his U.S. citizenship to reduce capital gains taxes on the company’s IPO.
They can’t help but wonder, “Could I do this, too?”
The short answer is yes. But it’s not easy, and it won’t be worth it for most people.
That’s because the U.S. is one of only two countries in the world that impose taxes based on citizenship rather than residency or income earned within the country. That means the worldwide income of U.S. citizens is subject to U.S. taxes regardless of whether they live here. The only other nation that does this is Eritrea in West Africa.
The reason for the U.S.’s uniquely frustrating international tax system is rooted in our history. Citizenship-based taxation was adopted during the Civil War on the rationale that U.S. citizens living abroad who weren’t risking their lives fighting for their country should at least contribute to the war efforts by paying taxes. The U.S. Supreme Court upheld this method of taxation for similar reasons in 1924.
As a result, the only way U.S. citizens can avoid paying U.S. taxes is to give up their citizenship. For those fed up with the long arm of Uncle Sam, this could be a viable strategy.
However, be aware that many of the countries that are desirable to live in, such as Canada, the U.K., Finland, and Japan, have tax systems with similar or higher tax burdens than the U.S. So, establishing residency in much of Europe or Asia will not reduce your taxes and could raise them. To achieve the financial savings, expatriates must establish permanent residency in a country that has low-or no-income-tax on residents, such as Monaco, the Cayman Islands, and the United Arab Emirates.
Where there’s a will, there’s a way
If giving up U.S. citizenship still sounds appealing, then your next step is contending with two significant tax barriers: the exit tax and the succession tax.
The exit tax was explicitly designed to discourage expatriation by wealthy citizens (defined as those with net worths of at least $2 million or average tax liabilities of $171,000 over the past five years). When a wealthy person gives up their U.S. citizenship, the U.S. government treats their assets as if they had sold them the day before the relinquishment. The deemed sale applies to assets that would be included in the expatriate’s estate for estate tax purposes and to trusts taxed to the expatriate under the grantor trust rules. Retirement plans are also treated as if they distributed in full on the day before giving up citizenship, although they are exempt from the 10% penalty for early distribution. The expatriate must pay tax on the capital gains and income from the deemed sales and distributions, minus an exemption on the first $735,000.
The succession tax requires that U.S. citizens who receive gifts or bequests from expatriates (who were subject to the exit tax) to pay a tax on those assets at the estate and gift tax rate, which is currently 40%. The succession tax closes the loophole that would exist if a citizen could expatriate and then transfer assets back to family members in the U.S. without a gift or estate tax.
Despite these hurdles, it can still save you money to go ahead and give up your citizenship, pay the exit tax, and move to a lower tax country. Here are some of those instances:
Scenario A: Your wealth comes primarily from a business you’ve recently sold.
In this case, you’ve already paid capital gains tax on the sale of the business, so there would be little or no exit tax. Although the succession tax could be an issue if you want to gift or bequeath assets to U.S. citizens after you leave, you could minimize taxes with effective estate planning, such as moving the wealth into irrevocable trusts before relinquishing your citizenship.
Scenario B: You inherited your wealth from someone who recently died.
Assets that you inherit from someone’s estate receive a “step-up” in basis, meaning any capital gains on those assets get erased at the time of the person’s death. So, expatriating with recently inherited wealth will result in paying little or no exit tax unless you have significant assets besides the inheritance or if the inherited assets were left in trusts that didn’t receive a step-up.
Scenario C: Your heirs are willing to expatriate with you.
Even if expatriation doesn’t save you much money from an income tax perspective, avoiding the estate tax could be a significant savings. That’s because the estate tax rate is 40%, whereas the exit tax ranges from 23.8% to 37%. And the estate tax applies to the entire value of the assets in your estate as opposed to the exit tax that is only assessed on your built-in gains and retirement plan assets.
By paying the exit tax now, you would potentially pay fewer taxes over your lifetime and upon your death by avoiding future U.S. income tax and the estate tax. Of course, if your family members are still U.S. citizens, leaving assets to them would trigger the succession tax. So, this plan would only work if they were willing to give up their citizenship too. Or, as Stephanie Moll, a partner with Bryan Cave Leighton Paisner, suggests, you are willing to use your estate and gift tax exemption now ($11.58 million per person in 2020) by making gifts outright or in trust before relinquishing your citizenship.
The larger issues
There are doubtless other scenarios under which expatriating makes financial sense and different ways to reduce the tax impact with careful planning. For the client who called me, paying the exit tax and expatriating could be sound tax planning. It would enable him to avoid the estate tax, future income taxes, and any potential wealth tax.
The bigger issues, however, are often practical ones, such as where you actually want to live and what it could mean to hold a passport from a less-than-desirable country – issues I’ll cover in my next article.