Renouncing US Citizenship
One of the primary motivations for a US Taxpayer seeking to formally expatriate from the United States is to avoid having to pay US taxes on their worldwide income. In order to achieve expatriation, a Taxpayer must formally renounce their US citizenship or relinquish their green card — the latter only if they are considered a long-term resident. It is important to note, that just because a US person renounces US citizenship does not mean that they are no longer subject to US tax. Depending on whether or not there are still assets located in the United States and/or whether or not the person is considered a covered expatriate will impact future tax liability. Let’s take a look at a few important factors to consider when determining whether renouncing your US citizenship is right for you.
Covered Expatriates and Exit Tax
When a person is considered a covered expatriate, they may become subject to exit tax at the time they renounce their US Citizenship. But, just because a person is a covered expatriate does not mean that they will have to pay an exit tax, it just means they have to prepare the analysis to determine whether or not they are subject to the exit tax.
Covered Expatriates and Future Gift/Estate Tax
When a person is considered a covered expatriate, there are some future gift and bequest tax implications when transferring assets to a US person. In other words, the US government has protocols in place to prevent a covered expatriate from being able to renounce their US citizenship and then begin gifting money back to the United States without any tax implications. As a result, the US person recipient of the gift or bequest may have to pay a tax at the time of receipt. This is supposed to be covered on IRS form 708, but that form has not been created yet.
Covered Expatriates and 401K
When a covered expatriate renounces US citizenship and they still have a 401(k), the United States will treat them as a non-resident alien in future years –– with an important caveat. The caveat is that the taxpayer is not allowed to make a treaty election to reduce or eliminate withholding, noting that many tax treaties between the United States and foreign countries provide for reduced or elimination of the withholding. In other words, at the time a covered expatriate renounces their US citizenship, they lose the right to claim treaty benefits on the 401K withholding.
Investments in US Assets
Whether or not a person is considered a covered expatriate or not, once they have renounced their US citizenship and then invest in the United States, they are considered a non-resident alien. As a non-resident alien with US income, they will be taxed 30% on their FDAP or at the progressive tax rates for their Effectively Connected Income in the United States. This is important for taxpayers to realize, that simply because they were announced a US citizenship, does not mean that they can invest tax-free in the United States.
When a Non-Resident Alien invests in the United States economy, one of the most important aspects is to determine the sourcing rules of the particular type of income. For example, dividends are typically considered to be US-sourced, and therefore there will be a withholding tax on that income. Conversely, capital gains are generally taxed in the country where the taxpayer resides which means subject to certain exceptions, exclusions, and limitations, capital gains by non-resident aliens are not taxable in the United States.
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