Carlie: Welcome to another episode of the Expat Focus Podcast. I’m your host Carlie, an Australian expat living in France, and today on the program we’re talking how to avoid disaster with the US tax code.
Before you create that shortlist of your favorite North American cities, get your head around how tipping works in the country, or how you’re going to go about looking for your dream job once you land stateside, it’s important to understand as to where you sit as an expat in the US tax system.
How does it apply to you and what about any savings or investments you might have back home or in this great land of opportunity that you’re moving to?
Well, joining me today to chat about some of the common tax traps that expats in the USA can find themselves in is Anthony E. Parent. He’s an attorney and the founding partner of Parent & Parent LLP based in Connecticut. He has more than 10 years’ experience in dealing with international tax compliance. Anthony, welcome to the show.
Anthony: Thank you, Carlie. It’s great to be here and to explain to people the traps before they become a US person. Because it’s usually… people just get a job, and then it’s after the fact they realize they have a whole host of problems they didn’t plan on.
Carlie: You’ve come across first hand, Anthony, some real disaster situations that expats in the US can find themselves in.
Anthony: Yeah, they’re really heart-breaking a lot of times. And the number one thing that I think will cause these terrible things is if there is a lot of assets overseas already, if there is, say, a trust somebody has, a foundation, a retirement plan, or just a large amount of savings. So usually, when people are younger, those concerns aren’t quite there unless their parents gave them something in their names, which actually can do more harm than good in many cases.
Carlie: First up, you’re going to talk me through capital gains and how it can become a trap for you, as an expat in the US. You mentioned you might have some assets back home, and it’s something you have to think about when you move to a new country.
Anthony: This is how a trap works, and it’s really unfair. One of the first things you need to understand is the US has a citizens-based taxation. Your taxed on your worldwide income, wherever you are, even if you’re in here as an H1B visa holder. It’s still – your worldwide income is taxable. So anything you have in your home country, regardless of its deferred tax treatment, it’s still subject to the US tax code. Now, there may be something t hat allows it to be deferred. The US-UK tax treaty allows certain pensions to be deferred and be tax-free, but a lot of other things don’t, like the Australian superannuations – that is not, and it’s a really big problem. So that’s something to look out for, although I’ll give a little bit of an easier example.
Let’s say that there’s Andrea, she lives in Taiwan, she has some company stocks that really weren’t a lot when she bought them, and now 20 years later, the stocks are worth a substantial amount of money. She moves to the US, becomes a US person. Let’s just say she’s got an H1B visa. She decides to sell her stocks to help pay for her children’s education. When she sells her stocks, she has a really big problem. What happens is the IRS taxes her capital gain not on the date she became a US person, but the date she acquired the stocks, way back when, 20 years before she even thought of coming to America.
So it’s really this… you could have a situation where somebody could actually have a loss while they’re a US person, and have a substantial amount of tax due. So here’s the thing, and there’s an actually easy workaround to this. So this is something that I really wish a lot of people knew, because you could just avoid this headache. All you need to do is the day before you become a US person, sell everything. Then immediately buy it back. And now your basis is basically fair market value, so if you do sell it while you’re a US person, you’re not going to have this terrible gain.
Carlie: And Anthony, when you say, “US person”, do you mean becoming a US citizen or a US person because you’re living in the US.
Anthony: Okay, so that – it is a term of art. When I say “US person” I’m using a legal definition of US person as a citizen. So a green card holder… it is many visa holders, and then it’s some visa holders depending on how much time you’re spending in the US. So a US person is the person subject to the US tax code, and that might be one of the surprises too. You would think if you’re a visa holder, what would make sense is just your US income would be taxable, not your worldwide. So that’s, I think, a little misleading. Again, we’re the only country in the world who does this. So when you’re coming from another country, we’re doing it totally different than anybody else.
Carlie: And it’s something we’ll talk about a little later, but definitely, when you’re in the US but you may be, say, earning in another country, the US does take that into account.
Anthony: If you are a US person and you are paying tax in other countries, you will get the foreign income exclusion if you’re living there, or a foreign tax credit if you’re not. So it is something where you can block some of it. It doesn’t automatically mean you’ll be subject to double taxation, but you can be.
Carlie: So when it comes to capital gains, Anthony, it definitely sounds like it’s a lot about timing.
Anthony: Right. And it would work for if you had a piece of land. If you had a property in your home country that you sold, your parents gave it to you years ago when it wasn’t worth anything, and now it’s appreciated tremendously, now somebody goes to sell it. Well, the IRS is going to say you have a capital gain from when back your parents gave it to you. And the real easy thing to do, to avoid that is you could have just sold it – you could have sold it to your brother, and then your brother could have sold it back to you for fair market value on the day before you became a US person.
Carlie: Another issue when you’re an expat in the USA is life insurance. It’s something we might not necessarily take out living back home, or maybe it’s just automatically covered in a work package, but especially when you’re moving abroad, it’s the sort of policy that a lot of people decide to consider to cover themselves. What is it about life insurance, living as an expat in the USA, that you need to be aware of?
Anthony: This is sort of the fundamental truth of the US tax code – that the US tax code really isn’t about raising revenue. What it really is about is sort of developing a public policy. And the public policy is whatever special interest group happened to be there at the right time. So the special interest group that really got into the tax code of 1986, which was really the last big rewrite, was the domestic life insurance company. They’ve always been there.
So the domestic life insurance lobby is great, because they are really powerful. They make sure that any US life insurance proceeds are tax-free. Imagine that. That’s wonderful. But they also want to make sure that the domestic industry is the one that’s benefitting. So what they did is they created this strange little definition where foreign life insurance – and foreign meaning non-US – isn’t technically life insurance, even though it acts in very much the same way.
Now, there’s a handful of non-US life insurance who have got certified as life insurance for tax purposes, but most of them aren’t, and it’s something that we see from India a lot, and in the UK we see it a lot. So what the IRS treats them as is an investment, that the build-up of value in there is something that’s going to be taxed on a year-to-year basis.
The IRS isn’t even done yet. The other thing they do is that they’ll say, “Well, your life insurance policy is a life insurance policy for the excise tax.” There’s an excise tax on foreign life insurance of 1% of the premiums. So it’s really something that’s completely unfair, unjust, but this is what the law is, so this is really something to think about if you do have a foreign life insurance that you haven’t put so much money into. What can you do with it? Maybe you just want to cancel it, surrender it before you become a US person. Because the compliance work that we have to do on it… the taxes usually aren’t the thing that are going to make or break you. But when we are filing these forms, you’re talking adding $2000 to someone’s tax bill just because they have a foreign life insurance program. Or they could do it themselves, but the chances of them getting it right are very remote.
Carlie: Anthony, where I’m from, home ownership is known as the great Australian dream, and it’s something many of us aspire to at some point in our lives. I mean, I recall a period after the market crash, when there was a lot of news stories about the amazing deals you could get buying property, especially in the US. But what can trip you up when it comes to investing in US real estate?
Anthony: Yeah, that’s right. We have a lot of clients from Australia who did buy a bunch of properties in California, Nevada, and I was wondering why, because the prices weren’t great. And I was like, “Well, why did you decide to get into real estate?” It’s like, “Oh, because to us, this is a great deal.” And so it really can be, and certain markets can be really, really good to get into. Now, here’s the –
Carlie: I think I read somewhere, at one point, there were houses going in one US city for like one US dollar or something.
Anthony: Well, there’s a reason why though. There’s a reason why.
Carlie: Exactly.
Anthony: [The house is on fire].
Carlie: But to us in Australia, it’s like, “Oh, my god! I can own a house for a dollar!” [laughs]
Anthony: Well, yeah, you could buy the house for a dollar, but now you owe $40,000 in back taxes to the city. So that’s why they want it… “Yeah, take it, take it!” And now they have someone to pay those taxes. But this is where you want to watch out. Because let’s say that you come to the US, you’re on an H1B visa, you’re working, and you’re Australian. And you’re thinking, “Man, the US is pretty good. I like the investments. Here’s my house. But I really want to go back to Australia. But you know what I’ll do, I’m going to rent my house out here. I’m going to rent my house, because I really like the income, I’m in a really good place, this is really good.”
So you move back to Australia. You’re no longer a US person for tax purposes, yet you own a US house. Now, your rental income, it won’t surprise you, is subject to US tax systems, US-sourced income. That probably wouldn’t surprise. But here’s where the trick comes. This is what’s really nasty. If you are a non-US person and you leave real property, you’re subject to this estate tax. And this estate is different than the estate tax for US persons. The US person estate tax… well, look, you have to have over $5 million before you have to worry about it. $5 million net. I heard somewhere there might be 36,000 Americans who are subject to the estate tax. So the vast majority of people never are.
But if you’re a non-US person, that exemption drops to $60,000. You could easily have a house in southern California, $1.5 million. Well, 1.4 of that is taxable, and it’s a very high rate. I believe it’s 35%. And that’s it – so you have a nasty, nasty tax bill. So it’s something… you don’t want to ever [own it your own] property, just from a liabilities standpoint. But what you do want to do – there’s a way to structure these. And usually, what you do is some sort of structuring with a US LLC and foreign corporation, and then you’re able to strip the ownership out, so it’s no longer a non-US person who owns it, so it’s not subject to the estate tax. You will have to pay your US income tax, you’re not going to get out of that. But you can avoid that nasty, nasty surprise.
And there’s been recent stories that the IRS hasn’t been collecting on this estate tax, that they’re pretty sure that they’ve been missing about 200… their estimates were $200 billion a year. Maybe that was total. So it is something that you’ve got to put some attention on.
Most important thing – if you are a non-US person or if you’re a US person who may become a non-US person, make sure any property you have is not owned in your name and using some structure to protect you from the estate tax.
Carlie: Anthony, we touched on it earlier, and I know for American expats there’s a requirement – for American citizens – to report their worldwide income to the IRS. What are you obligated to declare to the US tax office when you’re a non-citizen living in the USA?
Anthony: Well, the first thing is we have to determine if you are a US person or not a US person. You could be in the US and not be a US person for tax purposes. So we would want to look at which visa do you have, and depending… some visas, you have to satisfy the substantial presence, and some it doesn’t matter. So if you do have income assets overseas, this is where there are just really, really big traps. You might that think all this IRS compliance is there to punish expats, but really, what it was, all this was intended to do was punish US persons who left the country. That’s what it was –
Carlie: Oh, that’s a relief! [laughs]
Anthony: So you’re only unintentionally punished. So foreign bank accounts, you have to report those, if they’re over $10,000 in the aggregate with your other bank accounts, but bank accounts just doesn’t mean bank accounts. Bank account really means mutual fund too, as well as life insurance policies, various kinds of assets, any interest in corporations and partnerships, anything overseas that you have. And the penalties for getting these wrong is really, really draconian.
Carlie: This might be a bit of a cheeky question, but how likely am I to be found out, say if I am earning some money on the side back in my home or a different country, or I’ve got an investment that’s making me some money, while I’m living and paying taxes in the US? What happens if I just don’t say anything about it?
Anthony: Alright, you know what, I’m glad you asked that question, because it brings up something, a nasty little thing that came up. And this was in 2010, there was a foreign account tax compliance act. Every non-US bank has to do due diligence to go through their records to see if they have any US persons. And if they have any US persons, there’s a protocol they have to follow, sending letters, contacting them, to say, “Hey, you’re a US person. Fill out this W9 or we’ll tell the IRS all about you.” The [FATCA] has kneecapped non-US jurisdictions by putting this crazy requirement that they need to do due diligence to see who their US persons are.
So if you are in the US – I’m not going to tell you what to do – but if you are a US person who is working in the US and you still have a foreign account, I would make sure I don’t ever change my address to a US address, I never change my phone number to a US address, I never make sure anyone ever knows I work for a US person. I wouldn’t want to be bothered. Because the thing is, even after you’re no longer a US person, you’re still going to be tagged as a US person by that financial institution, and now you have to go through to prove, “Well, no, no! I’m no longer a US person subject to a tax code!”
That happened to a client of mine in Costa Rica recently. She was a UK expat in the US, left 10 years ago, and has been in Costa Rica since then. And she got a [FATCA] letter from her bank saying, “Hey, we’re going to report you to the IRS.” And she’s like, “Why? There’s nothing I need to do…”
Carlie: Just don’t send that letter! You don’t have to say anything! [laughs]
Anthony: Well, they have to, otherwise… the threat is if you don’t comply with this, that these foreign institutions will be kicked out of the US financial market, which would be devastating for them.
Carlie: So these foreign institutions might want to do right by their clients, but they also want to stay in the good books with the US.
Anthony: And good books with the US is more important than any one client. But can you imagine if the US did kick Switzerland out of the US market? There would be such blowback. So it’s really something where they work on so much fear and intimidation.
Carlie: Anthony, it is interesting times in the US, obviously. How do you see the future for expatriates in the country and, as we talked about, relations between the USA and other countries?
Anthony: Well, I can tell you what my hopes are. My hopes are that we do actually get some meaningful corporate tax reform and meaningful personal income tax reform. If we could see the US corporate tax rate decrease from the highest in the world, from 35% and in some cases 38% to something more reasonable – I think the proposal I saw is 15% – if we had a 15% corporate tax rate, there would be so much money flooding into the US, there would be so much opportunity for expats to come to the US, there would be so much demand for H1B visas, it would be incredible. So if we see some adjustments in the corporate tax rate, you really see the US hum. And some people say the US is a great tax haven in a way, because it doesn’t really share a lot of information with other countries, but it wants other countries’ information.
The other – right now, in Congress, there is some attention being paid to some of these terrible traps that I’ve talked about. One of our friends, Keith Redmond, he is helping Americans overseas, which also overlaps with a lot of expats. The issues are exactly the same. So he’s trying to get it changed from citizen-based to territorial-based taxation and get rid of some of these terrible things like [FATCA]. So it’s something that is actually getting attention. So really, everything I said could change in a couple of months, about how terrible things are.
Carlie: Is there anything else you need to consider when you’re looking for professional to make sure you’re staying on the right side of tax obligations in the US.
Anthony: Yes, well, just understand that in the United States attorneys have a very bad reputation, and we probably have earned.
Carlie: [laughs]
Anthony: So just something to really watch out for – I wish there was an easy way to tell people the difference, but – I would say this might be a way. My website irsmedic.com – just go there, learn a little bit, and then just… if you have someone who is a real tax expert, just start talking to them about some of these things and seeing what their answers are. And if it looks like they’re making up things or telling you things that aren’t true, then it’s like okay, this person might not be all as awesome as they seem to be. And really smart people have gotten fooled.
Carlie: Well, it does all sound a bit daunting, but navigating the US tax code and how it applies to your situation as an expat is something worth investing the time in to get right from the start. And you’ve got professionals like yourself, Anthony, there to help you stay on the right track.
Thank you so much for your time today. If you had to have one final piece of parting advice to everyone, what would you say?
Anthony: I would say this: When you sign a tax return, you sign anything, any form to the IRS, your tax responsibilities are a non-delegable duty. The fact that you hire someone because “Hey, look, I can’t understand this tax stuff, it’s too complicated for me,” that is not an excuse. You cannot 100% rely on a professional as an excuse if something goes wrong.
Carlie: Definitely worth doing your own research and taking that effort to develop your own understanding.
Anthony: Absolutely.
Carlie: Well, that’s it for today. If you’d like to discuss this episode, please head over to expatfocus.com and follow the links to our forums or Facebook groups. Also, remember to check out our previous episodes at expatfocus.com/podcast or on iTunes, and I’ll catch you next time!