For US citizens living abroad, it is understandably easy to lose sight of potential tax obligations to the US government. This can be a costly mistake, as the US Tax Code casts an incredibly wide net in terms of potential tax obligations—even for US citizens who have not resided or even stepped foot in the US for decades. In fact, it’s possible to become a US citizen without being born in the US, and along with that citizenship will come potential US tax obligations.
The circumstances into which Uncle Sam can poke his head to collect tax are seemingly endless. This article highlights some common instances.
Income Tax. A US citizen is taxed on his or her worldwide income from any source, which includes earned income, unearned income, and capital gains. Both disclosure obligations and potential tax liability to the US may arise regardless of the source and even if the income earned is completely unconnected to the US. Various countries have tax treaties with the US that could impact any ultimate tax owed. However, even if a treaty reduces the US tax to zero a US return usually must still be filed.
Estate and Gift Tax. The US Tax Code imposes an estate tax on the value of a US citizen’s assets at death. This includes all property of a decedent, whether real or personal, tangible or intangible, and wherever situated. Under current law, the federal estate tax exemption is $11.7 million per person, reduced by the amount of lifetime taxable gifts. Therefore, if a US citizen dies outside of the US but her assets exceed the current exemption amount (adjusted for lifetime gifts), her estate may have a US tax filing obligation and a potential US federal estate tax liability.
The particular circumstances of each individual are critical to this analysis. Consider a US citizen living abroad who has a will that directs all of his property at his death to his wife, also a US citizen living abroad. In this case, any assets passing to the spouse should be eligible for the unlimited marital deduction. So, even if the decedent’s assets exceed the federal estate tax exemption, no federal estate tax should be owed at the husband’s death, although his estate may still have a filing obligation with the IRS. However, if the decedent’s surviving wife were not a US citizen, then his estate would not be eligible for the unlimited marital deduction, potentially triggering a US federal estate tax liability. As mentioned above in the context of the income tax, the terms of a US estate tax treaty with the country of the decedent’s domicile may impact his US estate tax obligation.
If a US citizen living abroad owns real estate located in the US, then the considerations with respect to potential estate tax liability become even more complex. Consider a US citizen living abroad who owns a home in Cape Cod, Massachusetts. On her death, it is possible that her estate may owe Massachusetts estate tax, even if her total worldwide assets are below the federal estate tax exemption.
In the gift tax context, the US Tax Code also imposes a tax on the lifetime transfer of property by a US citizen. The federal gift tax exemption is unified with the estate tax exemption (currently $11.7 million per person). This allows for a US citizen to either make gifts of property while living or transfer property at death without incurring tax liability, if the collective amount of the gifts made and the assets owned at death is below the exemption amount. That said, any gifts made to a recipient in a single year over the annual gift tax exclusion amount (currently $15,000 per recipient) need to be reported to the IRS on a gift tax return. Consider a US citizen residing in London who makes a gift of $50,000 each year to each of her five grandchildren. Assuming that Grandma has not exhausted her federal gift exemption, no US federal gift tax would be owed with respect to each gift, but because each gift exceeds the $15,000 annual exclusion amount, Grandma must disclose the gifts on a gift tax return.
Trust instruments drafted by US attorneys often include provisions designed to reduce or eliminate adverse US gift and estate tax consequences as a result of a beneficiary’s interest in the trust. Trust instruments created outside of the US may not include these safeguards, potentially exposing a US citizen trust beneficiary to US federal tax liability, and in any case such interests usually trigger US disclosure obligations. If a US citizen is a trustee or beneficiary of a trust, the terms of the trust instrument and the trust activity need to be carefully analyzed to ensure that the US citizen complies with any US disclosure requirements and satisfies any US tax liability resulting from his status as a trustee or beneficiary.
In short, US citizens living abroad must tread carefully to navigate potential US tax liability and disclosure obligations to the IRS.