For Americans living overseas, keeping up with US tax obligations can be a hassle. This leads some to consider renouncing their citizenship. However, taking such a drastic step can lead to quite a few complications, such as the US exit tax.
What is the exit tax, and what does it mean for Americans abroad? Here’s what you need to know.
Key Takeaways
- The exit tax allows former citizens and residents to fulfill their tax duties before permanently removing themselves from the US government’s tax jurisdiction.
- US citizens and long-term residents who the IRS considers “covered expatriates” are subject to this tax.
What Is the Exit Tax?
When US citizens and residents choose to sever their ties with the United States, they are expected to resolve any potential outstanding tax obligations. In some cases, that means paying an exit tax. The exit tax is not a penalty for leaving the US. Instead, it’s a final bill for your unpaid tax debts. This could include:
- Unfiled tax returns
- Assets that haven’t been taxed yet but would be in the future, such as capital gains on stocks or funds in retirement accounts
In essence, the exit tax allows former citizens and residents to fulfill their tax duties before permanently removing themselves from the US government’s tax jurisdiction.
Who Must Pay the Exit Tax?
Not everyone who leaves the US is required to pay an exit tax. Only US citizens and long-term residents the IRS considers “covered expatriates” are subject to this tax if they renounce their citizenship. The US exit tax is a tax on your worldwide assets. The tax applies to all property that you own on the date of renunciation, including personal items such as cars, boats, and jewelry. There are very few exceptions to this, such as foreign pensions you earned before becoming a US taxpayer.
Covered vs. Non-Covered Expatriates
For both US citizens and long-term residents, your status as a covered or non-covered expatriate will determine whether you have to pay an exit tax. So what’s the distinction? Let’s take a look.
US Citizens
US citizens who renounce their citizenship are the most common category required to pay an exit tax, as long as they qualify as covered expatriates. If you are a US citizen, the IRS will judge whether you are covered or not based on the following factors:
1. Net Worth
If your personal net worth exceeds $2 million when you renounce your citizenship, you will be considered a covered expatriate.
To calculate your net worth, the IRS will add up the value of all of your belongings (including unrealized capital gains) and treat them as if you’d sold them all on the day of expatriation. (In almost all cases, the value of an asset will be determined by the current fair market value.)
This math can get complicated fast, especially if you have a retirement account or foreign pension. We recommend always getting help from a tax professional when calculating your net worth for exit tax purposes. If you make a mistake, the penalties can be steep.
2. Annual Net Income Tax
If the average net income tax over the past five years exceeds a set threshold, you will be considered a covered expat. The exact threshold changes from year to year to adjust for inflation. In 2022, it was set at $178,000.
3. Tax Filing Compliance
When filing Form 8854, you will be asked to indicate whether you’ve filed tax returns for the previous five years. If you have not filed for all five years, you will be considered a covered expat.
Long-Term Residents
Green Card holders who have lived lawfully in the US for eight years in the last fifteen years may be subject to the exit tax regardless of their income, net worth, or filing compliance. Because of the way the law is written, this could be as short as six years and two days, so your time in the US needs to be looked at carefully.
There are exceptions to this rule, however. The most common exception is making a treaty election. If you are able to make a treaty election and do so, this will stop the year count. However, you must be very careful with treaty elections if you are a Long-term resident. If you make a treaty election after you have already met the Long-Term Resident test, you have expatriated whether you intend to or not and are now subject to the exit tax.
How to Calculate the Exit Tax
The purpose of the exit tax is to pay off your final tax bill once and for all. The amount you owe will depend on what tax obligations you still have when you renounce your citizenship or residency. This includes taxes owed on the income or capital gains.
Take Note
As the exit tax only deals with unpaid taxes, you won’t have to worry about double taxation. If you’ve already paid a tax on your income or assets, that won’t be included in your exit tax bill.
Once again, this calculation gets complicated. It’s never a good idea to attempt to determine your own exit tax liability without getting help from an expert.
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Can I Avoid Paying the US Exit Tax?
Even if you currently qualify as a covered expatriate, you may be able to modify that. For example, you could strategically distribute your assets between yourself and your spouse. (The $2 million net worth standard only applies to your individual net worth.)
With that said, you should only ever use financial strategies that are 100% legal. The penalties for tax evasion can be devastating.
If your exit tax is likely to be more than you’re comfortable paying, you may want to reconsider renouncing your US citizenship or residency. Of course, this would mean you will still have to file an income tax return every year and possibly a few other tax forms, such as an FBAR or FATCA report.
(The good news is that most expats don’t end up owing any taxes when they file.)
An experienced expat tax professional can help you make the right decision. They can also help you meet your tax obligations no matter which choice you make.
I Expatriated, Paid Exit Tax, and now am I done?
This depends on if you have any accounts or other assets remaining in the US. For some types of accounts, you have to file a form 8854 every year after expatriation. With other accounts, you may have to file a form 1040NR (Non-Resident) tax return and be subject to a flat 30% tax on all income. You might even be subject to a 10% early withdrawal penalty from certain retirement accounts. Treaty elections will not help you as part of the renunciation process is that you agree to never be eligible for treaty benefits.
Knowing the future US tax filing requirements, you may have and the US tax you will have to pay, even after renouncing, takes careful planning. This should all be done before expatriating. Consulting with an expert is highly advised.
What If I’m Behind on My US Tax Returns?
Every US citizen must file an annual tax return regardless of where they live in the world. However, if you weren’t aware of that requirement, don’t panic. The IRS provides an amnesty program, the Streamlined Filing Compliance Procedures, that might help expats come into compliance without facing any penalties.
To use the Streamlined Filing Compliance Procedures, all you have to do is:
- Self-certify that you failed to file out of ignorance, not willful refusal
- File the last three delinquent income tax returns and pay any taxes you owe with interest
- File FBARs for the past six years
Once you’ve completed those steps, the IRS will regard you as compliant. (You may even be able to claim certain expat tax benefits such as the Foreign Earned Income Exclusion or Foreign Tax Credit to reduce or erase your tax debt.)
This won’t necessarily protect you from the exit tax, though. You will need to file a tax return for any of the last five years you’ve missed—even if that means going beyond the three delinquent returns required by the Streamlined Filing Compliance Procedures. Then, you can check the box on Form 8854 stating that you’re up-to-date on your filing obligations.
Pro Tip
Don’t wait to come into compliance. The IRS typically only offers amnesty if you reach out to them first. If they discover that you’ve failed to file and contact you first, you will lose the privilege of amnesty and face heavy penalties.
Do You Need Help with Your Expat Taxes?
Hopefully, this guide has helped you understand how the exit tax can impact expats who renounce their US citizenship. If you’re ready to be matched with a Greenback accountant, click the get started button below. For general questions on expat taxes or working with Greenback, contact our Customer Champions.
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