‘Accidental Citizens:’ How To Comply With U.S. Tax Laws When You Don’t Live in the U.S.
April 8, 2021
If you are an American citizen living abroad, the Internal Revenue Service wants to tax you.
This is true no matter how tenuous or limited your connection to life in the United States is: If you are an American citizen and you have income coming in, the IRS expects you to file a tax return to check if you need to pay taxes on that income, from whatever source.
The issue isn’t limited to just income taxes: Depending on your circumstances, you may also have to file gift tax and estate tax returns, you will need to disclose any businesses you have a percentage of ownership outside of the United States, plus your bank and investment accounts.
The United States is one of the few nations that taxes income its citizens earn entirely abroad. And this can cause headaches for U.S. citizens living outside its borders – even if you have no ties to the United States whatsoever, other than being born here.
The Dilemma of ‘Accidental Citizens’
The term “Accidental Citizen” refers to those who are U.S. citizens from birth. They may have been born in the U.S. and moved away as a child or were born outside the U.S. but received their U.S. citizenship status via a U.S. citizen parent. In many cases, they are not even aware that they are a U.S. citizen.
In any case, if you are a citizen, the IRS expects you to file a tax return and check if any tax is due on income you earned entirely outside the U.S. – a requirement that catches many such accidental citizens by surprise. Their U.S. citizenship can cause other headaches, too. For example, if you list your birthplace as the United States on any financial documents abroad, the financial institution (banks) may ask you for your Social Security Number. Which you probably don’t have if you moved away from the U.S. as a child.
In some cases, banks outside the United States won’t even open an account at all, or they will make it very difficult for you because they don’t want to deal with the reporting requirements under the Foreign Account Compliance Act (FATCA). This law requires foreign banks and other financial institutions to report the balances and transactions of all accounts opened by U.S. citizens.
Congress originally passed the law to crack down on wealthy Americans attempting to evade U.S. taxes abroad. But FATCA has become a major headache for many ordinary people with American citizenship who are just trying to get on with their lives as ex-pats living in a foreign country.
What to do
- Get a Social Security Number or Tax ID number.If you don’t have a Social Security number or tax identification number, the first thing you should do is apply for one.In practice, this is easier said than done; You’ll need to show up to a U.S. embassy or consulate with your birth certificate, and also a host of other documents to prove you have been living outside the U.S. for a long period of time. Check your consulate for details.If you don’t have your U.S. birth certificate, you’ll need to get one. In many cases, this involves paying a notary public to go to the county clerk’s office in the city of your birth to obtain a raised seal certificate.
- International disclosure: Foreign Bank and Financial Accounts Report (FBAR) and a Form 8938 (Statement of Financial Assets)You must also file the so-called International Disclosure forms, like the Foreign Bank and Financial Accounts Report. You need to file this report if you have at least one financial account outside the U.S., and the total value of all your accounts combined exceeded $10,000 at any time during the year.In some cases, you will also need to file an IRS Form 8938 (Statement of Financial Assets). Compliance is important. Failure to file these forms may result in stiff penalties from the IRS.For more information on FBAR requirements, click here. You can read more details on both the FBAR and Form 8938 requirements on our blog, here.
- On the Income Tax Side: take advantage of the IRS’s Streamlined Filing Procedures for Ex-pats Living Abroad.If you’re an “accidental U.S. citizen” living abroad, and you’re just now coming to grips with your tax obligations to the U.S., you aren’t alone. Thousands have gone through the same process.The IRS has developed an amnesty program, called the Streamlined Filing Compliance Program, for people whose failure to comply with U.S. tax law was not due to willful misconduct. The Streamlined Procedures allow you to file back taxes and come into compliance while avoiding fees and penalties.Under the program, you will have to file your last three years of federal tax returns, as well as FBAR reports for the past six years. You will also have to pay any taxes due during that time period.To apply for relief under the streamlined filing procedures, you must have a Social Security number or an ITIN. This is why the first step we suggest is to apply for a Social Security number or Tax Identification Number.You can find more information on the IRS’s website.
OVDP is Closed.
A previous initiative, the Offshore Voluntary Disclosure Program (OVDP), is closed as of 2018. This program was designed for U.S. citizens living abroad who had exposure to potential criminal liability and/or substantial civil penalties due to a willful failure to report foreign financial assets.
The Nuclear Option: Renouncing Your U.S. Citizenship
If you don’t want or need to retain your U.S. citizenship status, you can avoid these compliance headaches by formally renouncing your citizenship.
But even that may not get you off the hook. You’ll still have to clear your U.S. tax obligations for the year in which you disclaim your U.S. citizenship, and for the five years prior to that as well, and you could wind up subject to the expatriation tax.
Ex-Pats and Accidental Citizens: How to Reduce Your U.S. Tax Obligation
Some good news: Foreign income taxes are tax-deductible in the United States. In many cases, U.S. citizens living abroad can claim the Foreign Tax Credit. Sometimes this offsets the taxpayer’s entire U.S. tax obligation. In other cases, you may benefit from filing for the Foreign Earned Income Exclusion. This lets you exclude a certain amount of foreign earned income.
Some individuals may be able to use both provisions (though not for the same income).
U.S. tax laws are almost unfathomably complex – and penalties for failure to comply can be steep. Don’t try to deal with them alone. It’s vital to work with an accounting firm experienced in dealing with the tax and compliance issues specific to American citizens living abroad.
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