Tax Consequences of Renouncing US Citizenship
When a US Citizen formally renounces their US citizenship and is no longer a US person, there are various tax implications that they have to be aware of. For the most part, the tax consequences are benefits — in that the person is no longer taxed on their worldwide income, but is rather taxed on their US-sourced income only. In general, the US taxation rules for nonresident aliens are different than they are for US persons. In general, non-resident aliens only pay US taxes on US-sourced income as either ECI (Effectively Connected Income) or FDAP (Fixed, Determinable, Annual, and Periodic). In addition, there are very specific rules for taxpayers who are considered covered expatriates in which the withholding may be higher on items such as 401(k).
Exit Tax and Renouncing US Citizenship
One important tax consequence that expatriates must consider before renouncing their US Citizenship is whether or not they will be considered a covered expatriate — and therefore required to pay an exit tax. The exit tax rules are very complicated and you should speak with a Board-Certified Tax Law Specialist attorney who specializes in these types of matters before committing the expatriating act such as formally renouncing their US Citizenship.
No Longer Taxed on Worldwide Income
Once a person is no longer considered a US citizen – – assuming that they are not otherwise a US person by way of being a lawful permanent resident and/or meeting the Substantial Presence Test –– they are no longer taxed on their worldwide income. Rather, nonresident aliens are taxed only on their US-sourced income — which generally falls into two different categories: ECI and FDAP
ECI (Effectively Connected Income)
Effectively Connected Income is typically income associated with a US trade or business. In this type of income, the non-resident alien will report the income BUT is also allowed to take deductions associated with the income. For example, if a nonresident alien owns a US rental property and makes an election to be treated as ECI (default category is FDAP) then they can deduct all of the expenses that they would ordinarily deduct, such as marketing, commissions, taxes, depreciation, etc.
FDAP (Fixed, Determinable, Annual, Periodic)
FDAP is essentially passive income such as dividends and other types of passive income. For the most part, FDAP is withheld 30%. Taxpayers may be able to submit a W8-BEN in order to rely on a tax treaty article that reduces or eliminates the withholding —
Whereas a US person submits a W9, a nonresident alien submits a W8-BEN. This is the form that is submitted to the financial institutions to identify whether the investor is either a US person or not, and is used to determine if the institution should withhold 30% or not.
Covered Expatriate Gifts and Deferred Compensation
If the person who renounced their US citizenship was considered a covered expatriate, then there may be significant post-expatriation tax implications to consider. For example, there may be some immediate gift tax consequences at the time the covered expatriate gifts to a US person — along with very strict rules regarding the withholding limitations for 401(k). Moreover, the 30% withholding requirement for 401K(k)of nonresidents can typically not be modified either —even if the expatriate resides in a country that has a tax treaty with the United States which otherwise limits withholding on that type of income.
International Tax Lawyers
Golding & Golding specializes exclusively in international tax, specifically in Expatriation and IRS offshore disclosure.
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