By Vincenzo Villamena, CPA
In the last decade, the number of US citizens renouncing their citizenship has increased drastically. Complex tax filing requirements and banking hassles related to FATCA accelerated this trend for US Americans living abroad. For many people, their solution is renunciation.
However, renouncing US citizenship is not a quick fix or an easy way out of tax obligations. The process is complex and costly and can even create tax obligations. Nonetheless, with the right planning and mitigation strategies, you can minimize the implications.
Still, it is a big and irreversible step.
In this article we cover:
- Renouncing your US citizenship – What does that mean?
- What happens when you renounce your US citizenship?
- How much does it cost to renounce the US citizenship?
- Tax implications of renunciation
- What is a Covered Expat?
- Exceptions to Covered Expat rules
- What is Exit Tax?
- Higher taxes for non-citizens on inheritance and gifts
- Pre-expatriation tax planning
- Tax mitigation strategies for US spouses
- Social security and retirement payments after renunciation
- How to renounce your US citizenship – Step by step process
- Penalties for not filing the expatriation form
- Renunciation relief for accidental Americans
- Navigating the complexity of renunciation
Renouncing your US citizenship – What does that mean?
“Renunciation – The voluntary act of relinquishing one’s citizenship or nationality”
This is also sometimes referred to as Expatriation.
While this sounds simple, citizenship renunciation is actually a complex process governed by US laws.
Instead of just moving abroad and cutting up your American passport, you must file paperwork, pay a steep fee, take an oath in front of a US consular officer, and potentially even pay additional tax. (More about the tax an how to renounce your US citizenship with detailed process steps later in this article.)
Despite these significant hurdles, more and more Americans are giving up their passport. Before taking this drastic step, make sure you understand all implications of renouncing.
Video: What are the Implications of Renouncing US Citizenship?
What happens when you renounce your US citizenship?
Though renunciation has become increasingly popular, it is a decision that requires significant consideration. When giving up your US citizenship, you are fully surrendering all the rights associated with being an American citizen.
This includes the right to vote, your ability to visit and work in the United States, eligibility for military pensions, and potential support from the US government in an emergency.
There are many aspects to consider before deciding to renounce. Some of these aspects will be personal, such as your financial circumstances, your long-term plans, and the expected taxation in your new country.
However, tax issues such as whether you will be considered a “covered expat” and the impact on future gifts and inheritance should also be a key factor in this decision.
It’s also important to realize that renouncing US citizenship is not an easy way out of paying taxes. Depending on your specific situation, it could even cost you. Before renouncing your US citizenship you should plan carefully with the help of an expert to avoid costly mistakes.
How much does it cost to renounce the US citizenship?
You do have to pay to renounce your US citizenship, it is not free. Far from it. The renunciation fee alone is a steep $2,350. In addition, you have to travel to a United States consulate at least once for the interview and renunciation oath.
On the tax side, you need to file and pay back taxes if you have not been tax compliant in the prior 5 years. For Americans that are “covered expats”, exit tax is another cost of renunciation. We explain this in detail below.
You want to engage the help of an experienced tax accountant to navigate this. He or she can also advise on the pre-expatriation planning tips and tax mitigation strategies mentioned above.
Additional cost can include acquiring a second citizenship if you don’t have one already. Some countries offer citizenship by investment, which usually comes at a significant price tag. Citizenship through residency is cheaper but can take many years. Acquiring a passport based on ancestry is another option but also can take a few years. We can advise on options for acquiring a second passport.
Tax implications of renunciation
A common myth about renunciation is that it means you will be free from the American tax regime.
However, when you have US-sourced income, maybe from a rental property, you still must file a tax return, even when you are not a US citizen anymore.
In addition, the process of renunciation and no longer holding a US passport can create new tax liabilities. These potential new expenses include an exit tax for “covered expats” and increases in inheritance and gift taxes.
What is a Covered Expat?
If you renounce your US citizenship and are a “covered expat” you may have to pay an exit tax.
You are considered a covered expat if you fit into one or more of the following categories:
- Your average annual US income tax liability over the last five years is greater than $168,000 (2019).
- Your net worth is equal to or greater than $2 million at the time of renunciation.
- You have not been tax compliant for the last five years.
Married couples must each qualify individually.
Exceptions to Covered Expat Rules
The IRS allows exceptions to the Covered Expat rules for certain dual citizens and minors. If you meet the exception definition below, the amount of your income tax liability or net worth won’t matter. But you must be tax compliant and certify that by filing IRS form 8854.
- Dual citizens by birth who are still a citizen and tax-resident of the other country AND who have not been a United State resident for more than 10 of the last 15 years.
- Minors who expatriated before they are 18 ½ years old AND who have not been a United State resident for more than 10 of the last 15 years.
Use the Substantial Presence Test to determine residency.
To find out if you qualify, talk to a consultant with renunciation experience.
What is Exit Tax?
You can think of exit tax as the theoretical taxes incurred if you sold your entire worldwide estate and financial accounts the day before renunciation. This even applies to assets that cannot be sold. The phantom profits of these deemed sales are then taxed.
You can exclude the first $725,000 (2019, indexed annually for inflation) of deemed capital gains from the tax. The taxes apply only to capital gains exceeding $725,000. If you qualify as a “covered expat” you pay tax at the highest marginal tax brackets. Some exceptions are made for eligible deferred compensation plans and cash in accounts.
You should also keep in mind that your country of residence may tax profits from these same assets again if, for example, you sell the assets or receive deferred compensation.
Higher taxes on inheritance and gifts for non-citizens
Another critical change after renunciation is increased taxes on inheritances and gifts. A key concern is that US heirs of non-US citizens face higher estate taxes. While US citizens can shield up to $11.58 million (2019) from estate taxes, non-US citizens are only exempt up to $60,000.
The only plus side is that for non-US citizens or residents, estate and gift tax applies only to assets “situated” in the United States. For these reasons, it is crucial to structure your estate properly.
Likewise, gifts from non-US spouses to US spouses are taxed. A gift from a non-US spouse to their US spouse is taxed after only $154,000 (2019). Alternately, between two US spouses, tax-free gifts are unlimited.
Pre-expatriation planning tips
To minimize the tax implications of relinquishing your US citizenship, there are several steps you can take. For example, giving away assets can help you stay below the net worth threshold of $2 million for covered expats. Common ways to do this include moving your assets to a trust and giving assets to a non-US resident alien spouse or next of kin.
US citizens can gift up to $11.58 million tax free (as of 2019) under the lifetime gifting exemption. It may be beneficial to make gifts above this amount to minimize future inheritance taxes depending on your situation.
An additional strategy is to give away appreciated assets to minimize the mark-to-market tax. A covered expatriate may make gifts before expatriation, but it is important to do so carefully and strategically.
Tax mitigation strategies for US spouses
American spouses with assets in the US may consider having only one spouse renounce. The US spouse would keep any US assets, e.g. a house. The non-US spouse would take the foreign assets.
By the US spouse taking ownership of the US assets, it mitigates not only the estate tax risk. It also allows for the non-US spouse to file any US taxes or deal with withholding requirements for dividends, interest or sale of real estate (known as FIRPTA rules).
The non-US would hold all the non-US assets, therefore not needing to report foreign bank accounts, income etc. By keeping one spouse as a US person, it also allows the renouncing spouse the opportunity to get sponsored for a green card should the couple decide to return to the US.
Social security and retirement payments after renunciation
After expatriating, you are still eligible to receive social security if you previously qualified by having enough credits.
You can also still receive your 401k and pension, albeit both are subject to US taxes. You may have to file the 1040NR return unless there is an automatic withholding.
Military pensions however are revoked when one expatriates as the person can no longer be called into active military service as a non-citizen.
How to renounce your US citizenship – Step by step process
Renouncing the American citizenship is not a quick event but a complex and often long process.
These are the 6 steps to renounce the American citizenship:
- Obtain a second passport
- Be up to date on your US taxes
- Prepare expatriation paperwork
- Book your appointment
- Attend your renunciation appointment
- File your final US tax return
Let’s review each step in more detail.
1. Obtain a second passport
Even though it is your right to expatriate, if you expatriate without a second passport, you run the risk of becoming stateless if there is a visa issue in your current country of residency. For this reason, you should obtain a second passport before renunciation.
You can typically obtain an additional passport through family, investment programs, or residency programs which lead to citizenship. Popular programs include Nevis, Antigua, Malta, Bulgaria, Granada, Domenica, Spain, Portugal, Panama, Turkey, and more.
2. Be up to date on your US taxes
In order to expatriate and not automatically be considered a covered expat, you need to be up to date on filing the last 5 years of tax returns. If you haven’t filed your US taxes, the Streamlined Procedures can provide some reprieve.
3. Prepare expatriation paperwork
You will need to fill out the form called “Request for Determination of Possible Loss of US Citizenship,” also known as form DS-4079, and attach supporting documents, including a birth certificate or certificate of naturalization from the country of your second passport.
Be aware that the reason for renunciation cannot be taxes. You will need to have a valid reason. For example, a stronger connection to another country, you no longer live in the United States and will not return, or an injustice experienced as an American.
4. Book your appointment
Ideally, book your appointment at the embassy or consulate in the country or city where you plan to live once you renounce your passport. However, if you are not able to, you can also use a consulate in another country or city.
We have seen clients save time by going to renounce in a neighboring country as some of the more common countries have waiting lists of over a year (UK, Canada, Singapore, etc). It makes sense to shop around and research the consulates. Besides wait times for appointments, there are process inconsistencies. Some require at least two visits, others let you complete it in one day.
5. Attend your renunciation appointment
Make sure you bring the following to your renunciation appointment:
- US passport
- Second passport
- Birth certificate or naturalization certificate associated with the second passport
At the end of your appointment, you will receive a Certificate of Loss of Nationality (CLN).
6. File your final US tax return
Your final tax return will be from January 1 through the day that you expatriate. If your renunciation date is any day other than December 31, you will need to file Form 1040 and 1040NR (if applicable) for your final return.
If you are considered a covered expat, you will need to calculate your exit tax on IRS Form 8854. Failure to file this form means you are still liable for U.S. income tax indefinitely – even if you have completed renunciation for immigration purposes.
If you had foreign accounts already in existence before expatriation, you will also need to file FinCEN Form 114 also known as the FBAR.
Keep in mind that if you still have income in the US, including pensions or rental properties, you must still file annual tax returns.
Penalties for not filing the expatriation form
You must file your IRS Form 8854 when you expatriate. If you do not, you could be subject to a significant fine from the IRS.
As of 2020, the fine for failure to submit this form is $10,000. The IRS takes this issue seriously and will send notices to expatriates who have not complied. It applies the penalty of $10,000 as appropriate.
In some specific situations, the new Relief Procedures for Certain Former Citizens (Expat Relief) may eliminate the taxes, interest, penalties and exit taxes incurred when relinquishing citizenship. It is difficult to qualify for the Expat Relief.
Renunciation relief for accidental Americans
Accidental Americans who acquired citizenship of the United States through birth but never lived there often have a rude awakening when they find out that they were supposed to file US tax returns every year.
Fortunately, the IRS currently has a relief procedure for certain US citizens. The relief is only available for Americans who meet strict requirements. If accidental Americans qualify under these rules, they must still submit their prior five years of tax returns before renouncing. But they won’t be liable to pay any tax or penalties.
As any IRS relief program, this may end in the future. If it applies to you, you should use it while it is available.
Navigating the complexity of renunciation
Giving up your citizenship is a big life decision – you want to do it right.
The process of renunciation is complex with a high risk of mistakes and potential unintended consequences. Without careful planning, you can be exposed to substantial taxation.
Before giving up US citizenship, consulting a tax professional is highly advisable. At Online Taxman we have guided many clients through the process of renunciation and can advise you on the exact strategies you need to make the process successful. Book a renunciation consultation with our expert here: