December 13, 2013

New tax rules on American expats are causing many to give up their citizenship. American expatriates have always been required to report and pay taxes on their international assets. That is, after all, why Earl Tupper, founder of Tupperware, bought an island off the coast of Costa Rica and gave up his citizenship back in 1958. It’s also why Tina Turner is now a Swiss citizen and no longer American.  However, the new rules give the IRS additional powers which may require taxpayers to be more accurate when declaring their offshore assets. 

As of July 2014, a new tax law called the Foreign Accounts Tax Compliance Act, FATCA, will require all financial institutions to report to the IRS all the assets and income of US citizens who have more than $50,000 on their books. The law allows the IRS to withhold 30% of the dividends and interest payments due to financial institutions who do not comply with this requirement. 

The US Exit Tax

Renouncing your citizenship does not exempt you from the taxes you already owe, and if you are wealthy, you may have to pay additional taxes. The Heroes Earnings Assistance and Relief Tax Act of 2008 created an exit or “expatriation” tax on the unrealized gains on all the assets – US and worldwide – of US citizens and permanent residents who renounced their citizenship or permanent residence status.

The exit tax is calculated by estimating the market value of all assets on the day before expatriation. Any gains arising from the hypothetical sale of the assets is then taxed as if it were income on the taxpayer’s tax return for that year. For wealthy expatriates, this can mean a 30% tax rate on their worldwide assets. The silver lining is that, as of 2013, the first $663,000 of a taxpayer’s assets are exempt from taxation. The exclusion amount adjusts for inflation and therefore varies from year to year.

Timing can have a huge effect on the value of many assets, such as real estate, stocks and bonds. Taxpayers can minimize their tax burden by timing their expatriation to when the market value of their assets is low, particularly when this places them below the exit tax threshold.

However, there is another tax strategy expatriates can follow to minimize the tax burden on their worldwide assets that do not require them to renounce their citizenship.

Foreign Grantor Trusts

Foreign grantor trusts are becoming popular with wealthy US families who want to avoid taxation on their worldwide assets but have members who wish to keep their US citizenship. These trusts require a settlor, usually a family member, who isn’t a U.S. citizen and who has complete control over the assets in the trust. This is because foreign trusts are revocable – which means the settlor can remove the assets at will – US beneficiaries aren’t considered owners of the assets so the IRS doesn’t tax them until the assets are distributed to them. 

The catch with foreign grantor trusts is that when the assets are distributed to the beneficiaries the IRS may impose an ultra-high tax rate on the income generated by the previously tax-exempt assets and require the trust to withhold the tax before distributing it. Many beneficiaries create pour-over trusts designed to receive foreign asset without incurring in punitive tax rates. 

Foreign grantor trusts as well as other tax planning instruments are complex and can easily blow up in your face if not properly managed. Therefore, taxpayers should seek the advice of accountants and tax lawyers who are experienced with the complexities of international tax issues before committing to a particular taxation strategy.

Photo: Alan Cleaver