Dateline: Alicante, Spain
If you’re a US citizen doing business or investing overseas, you surely know that you’re a unique breed. That’s because US citizens are just about the only people on earth required to pay taxes on both active and passive income, no matter where they live. That’s exactly why more and more Americans are renouncing US citizenship.
After all, you could never set foot in the United States and, even still, you’d be required to file an annual tax return. At least, so long as you’re a US citizen. You’re also required to report all of your foreign bank accounts in any foreign state, foreign brokerage accounts, and your interest in any offshore companies.
While some entrepreneurs are able to minimize or even eliminate US taxation through the Foreign Earned Income Exclusion, not all business owners and self-employed individuals can shield all their income from US tax.
Even worse, tax exemptions only apply to actively earned income, not investments. Investors in real estate, equities, and just about anything else, are liable for US tax on 100% of their gains. The only exception is a dollar-for-dollar tax credit on any tax paid overseas (i.e. income tax on rental income paid to a foreign country).
When Giving up U.S. Citizenship is The Answer
The obvious challenge, then, is that the US is one of the highest tax countries in the world. Most entrepreneurs, investors, and even employees moving overseas these days do so for lower tax rates.
In some cases, however, the only way to successfully eliminate US taxes and the onerous reporting requirements that come with US citizenship is to renounce that citizenship. Each year, record numbers of people are giving up their American passports for that very reason.
Choosing to renounce US citizenship is a hard decision, particularly if you don’t already have a second passport. Most of my friends who have renounced were born with equally good passports; my friend Daniel, for instance, had a Swiss passport from his father’s side.
If you don’t have a second passport, you will need to devise a plan to obtain one. You’re required to have another passport before renouncing your US citizenship. Not having one would render you stateless and unable to travel, which isn’t worth the tax relief no matter how much you would save.
The renunciation process is formal and simple.
United States citizens who want to do so have to make a formal renunciation of nationality before a diplomatic or consular officer, according to the Immigration and Nationality Act.
Appearing before a consular or diplomatic officer is one of the main elements of revoking your citizenship. The consular officer has to know that you are acting voluntarily without any influence.
You will also pay an exit tax, that doesn’t have to be immediate.
The following are several case studies of individuals with various situations that led them to consider surrendering their US nationality. Among their considerations is a calculated potential “return on investment” of giving up US citizenship. Each case study assumes the following:
- The individuals profiled hold only US citizenship, or US citizenship plus another citizenship they do not wish to renounce (i.e. an Iranian passport)
- The cost of any foreign passport you will get through a citizenship by investment program evaluated is based on a single applicant. In many cases, it would make sense to pay a little bit extra to include a spouse and/or children, as the biggest cost is for the first applicant. However, as this case study is about tax savings and not about second passports, those additional fees are not included.
- The cost of legal fees for any citizenship program is not included. Since I’m not counting the (often rather expensive) US tax preparation expenses these individuals pay every year, I figured it wasn’t fair to count one-time legal fees either.
Before we begin, remember that I am NOT a tax advisor or lawyer, but rather an entrepreneur in the same boat as some of these people. If you need help with your particular situation, ask a US tax lawyer or request help from me here. With that said, let’s evaluate a few archetypal case studies of Americans considering renouncing their citizenship. Which one are you?
1. The Employee
I have a friend (we’ll call him Matt) who works as a private banker in a tax haven. The last time I spoke with him, he estimated that his annual salary would be close to $1,000,000 a year, none of which would be taxed in his country of residence since it has no personal income tax.
Of course, his income far exceeds the limits of exemptable personal income in the United States. He’s been paying a lot of tax, which is what led him to consider renouncing his citizenship. To use round numbers, let’s assume his salary and bonuses totaling $1,000,000 per year. In 2016, the Foreign Earned Income Exclusion allowed him to exempt the first $101,300 of that income.
As his spouse is not a US citizen and he files a tax return alone, that leaves $898,700 of income open to be taxed. As an employee, Matt can’t control how he receives his income. Since he is the foreign equivalent of a W-2 employee, and since his foreign employer doesn’t provide any tax deferral options for its executives, he’s stuck with a federal tax bill of $333,258.
In Matt’s case, he had the good sense to move out of California before leaving the US and is now a resident of Florida, meaning he doesn’t owe state tax. However, had he stayed in California, he would owe an additional $96,603, for a total of $429,861.
Yep, nearly half a million bucks in taxes to a country he spends no more than one week per year in, and from which he derives no income. As my friend is an employee, he doesn’t have much time to visit the United States and, as such, his US passport is not very useful for granting him entry to the US. He decided that he wanted to seriously consider renouncing.
In the case of an employee like this, time is of the essence. Every year he earns a large salary is another year he’ll pay at least $333,000 in taxes. He won’t stop paying unless he quits his job or renounces.
Since he’s an employee and can’t change his country of residence, the only European option available to him is Cyprus, which requires a substantial investment above and beyond his needs for renouncing. Therefore, I would be likelier to recommend a cheaper Caribbean passport for ROI and would advise him to seek a European residency if he requires it for lifestyle reasons after renouncing.
Return on Investment Analysis:
Dominica citizenship by investment will require a donation of $175,000 for a single applicant. The process will take about six months, which is ironic because that’s almost exactly how much tax he’ll also pay in that six months. After obtaining Dominican citizenship, he can renounce his US citizenship and be relieved from paying taxes anywhere. It will take him six months to recoup his investment.
Future Tax Benefits:
Since Dominica does not tax its non-resident citizens, my friend would save $333,000 per year every year his employment continues. He plans to continue in his job for five years before moving on, which means about $1.66 million in savings, plus any investment returns as he goes.
2. The “Too Big” Business Owner
You’re probably familiar with the Foreign Earned Income Exemption that allows US citizens to exempt their first $101,300 in income earned overseas. Some small-business entrepreneurs use this exemption to earn six-figure profits in their company while paying themselves a reasonable salary within the limits of the tax exemption.
However, there are limits to this strategy. For one, the money you don’t take out of your offshore company must be held overseas as “retained earnings”. That limits your access to the money and basically serves as tax deferral rather than tax reduction. The other challenge is that you must pay yourself a reasonable salary.
What is “reasonable” is up to the discretion of the IRS (Internal Revenue Service), but suffice it to say you can’t serve as CEO of a $100 million company for a meager $101,300 salary free of stock options or other taxable perks most similar CEOs would demand. I recently spoke with a guy named Rory who ran a smaller company but had a similar tax problem.
His company’s revenues were $5 million a year, but he only had four employees, of which he was one. As CEO, Rory’s job was the most important, and it would be a tough sell to tell the IRS that he could find someone else to work full-time in his job for a mere $100,000.
The problem with a situation like Rory’s is that it’s hard to determine how much his salary should be. That’s something that can only be done on a case-by-case basis with professionals, and even then you’ll never know what the IRS will say.
The bigger you are, the bigger the potential future problem. In Rory’s case, we determined that a fair market salary for his job would be at least $500,000 due to the nature of his industry.
That means that, even after the FEIE, he would owe $184,079 in federal income tax. However, as Rory’s last residence in the United States was in New York City, he was subject to both New York state and city income taxes on top of his federal tax.
That means he would also owe $14,545 to NYC and $26,547 to the state, for a total tax bill of $225,171 (not accounting for any federal deductions or the alternative minimum tax). Unlike an employee, Rory does have some control over his income, but his company is large enough to where he may not qualify for a full tax exemption.
Rather than cause problems for himself down the road, Rory wanted to purchase another citizenship and expatriate from the United States.
Rory prefers to invest money back into his company, so he preferred the least expensive option available. Since Rory enjoys working from the beach, a Dominica passport will be sufficient to give him visa-free entry to the Caribbean, Southeast Asian, and some European countries. Chances are he could even live as a perpetual traveler.
Return on Investment Analysis:
A Dominica passport will cost Rory $175,000, as he is unmarried. It will take him about eight months post-renunciation to earn a return on his investment.
Future Tax Benefits:
Since he will live as a perpetual traveler in a foreign government like Malaysia and Panama, he will pay no tax anywhere. That means a savings of $225,171, which he can re-invest in the business. With each dollar he invests earning $1.80, that’s a “real world” tax benefit of about $400,000 every year.
3. The Consultant
Similar to the “Too Big” Business Owner above, US citizens abroad who engage in consulting work do not benefit from a clear-cut tax reduction strategy.
While many US citizens living abroad and are performing personal services outside of the US is eligible for the Foreign Earned Income Exclusion if they meet the criteria, consultants who sell their time by the hour have some issues.
One of my tax attorney friends (we’ll call him John) is a perfect example of this. John doesn’t actually want to renounce, so this is purely hypothetical. However, as someone who trades hours for dollars, he can’t use the strategies someone with a “real business” would use. John charges $400 per hour for his “consulting services” and earns $400,000 per year. Because he lives and works full-time in Thailand, John claims his first $101,300 in income tax-free, just like everyone else.
However, John does not technically run a business because he is the only one providing services and because his personal services are needed for the business to keep running. John cannot use an offshore company and pay himself a salary because, without him, there is no business.
If John wanted to hire other tax attorneys and tax preparers to work underneath him and run a Four Hour Workweek-style business, that’s a different story. That’s a business. For now, however, John is liable for tax on his entire income above $101,300.
John earns all of his money in his own name, only using a corporation for limited liability benefits, and not for tax deferral. The federal tax obligations of being a US citizen consultant are $94,128, plus another $10,000 or so in state taxes to Illinois.
John is Jewish which, thanks to a few friends in Israel, allows him to claim Israeli citizenship under Israel’s Law of Return. Despite being a great travel document, an Israeli passport does not allow visa-free entry to the United States but will work just fine for Mexico and elsewhere. John will need to visit Israel to complete the process, which will take up to a year.
Return on Investment Analysis:
Considering we are not including legal or consulting fees in these case studies, the government costs involved with any citizenship by descent are very nominal. John can expect a 5,000% or greater return on investment in his first year.
Future Tax Benefits:
Once he is no longer a US citizen, John can provide consulting and earn as much money as he wants tax-free. While Israel does impose relatively high-income taxes on residents, he is not required to reside in Israel long-term and may return to Thailand or any other territorial tax jurisdiction which does not tax his foreign income.
4. The Real Estate Investor
I was recently approached by an investor named Joaquin who had just sold his company in the US and pocketed approximately $4.5 million in the process. At age 41, he was ready to retire and put his money to work for him, Having owned a few rental properties already, he decided he wanted to invest in real estate overseas.
Joaquin asked me how he could avoid high property and profits taxes. I told him that, while there are few countries with no property tax, we could find places to lower his income and capital gains tax.
The only problem is his US citizenship.
Joaquin was born in California but had since moved to Florida to save on state income tax.
However, the fact that he is a US citizen meant that his passive earnings and gains would be taxed, whether he purchased real estate in Florida or Florianopolis. Such is the price of having an American passport.
Joaquin and I put a plan together involving four countries, mostly in Europe, that will earn him an ongoing income, as well as a third passport in several years.
By investing $3 million of his savings in real estate, he expects to earn about $270,000 per year in income, thanks to yields ranging from 7% to 12%. That would generate $64,513 in federal income tax every year if he retained US citizenship.
He also estimates a rather conservative 5% annual appreciation over the next ten years, which will create an additional $1,887,000 in capital gains when he sells the properties. Joaquin plans to renounce US citizenship in the next year so that his passive income, which is not exemptable under the Foreign Earned Income Exclusion, is tax-free.
Of course, the host countries he is investing in will tax him on his rental income, but our plan involves countries with an average income tax rate of just 13%.
Like most of our other case studies, Joaquin doesn’t have ancestral or religious ties that entitle him to a cheap second passport. Joaquin will invest $225,000 in Dominican citizenship for him and his wife to be able to renounce within six months. During that time, he will complete his property deals and find tenants to generate income. About 20% of his investment will be made in Portugal real estate in order for them to get a Golden Visa, year-round access to all of Europe, and Portugal citizenship after six years; this will cost an additional $24,000 in government fees over the next five years.
Return on Investment Analysis:
With about $237,000 invested upfront, it will take Joaquin about 43 months to get a return on his investment, considering that real estate investments tend to generate a smaller percentage return than an operating business. However, renunciation may be even more beneficial to an investor because of the fact that they will likely incur larger and larger passive gains over their lifetime; in this case, another 40 years.
Future Tax Benefits:
Joaquin will continue to enjoy the benefits of drastic tax savings by not being a US citizen. However, he also stands to avoid US long-term capital gains taxes when he sells the properties in ten years. With an expected $1,887,000 in future gains, he would be subject to about $370,000 in US capital gains taxes at today’s rate (which I expect to go up).
One of the countries we’re investing in has no capital gains tax after two years, while others have reduced taxes. Even if he saves half of that $370,000, it’s a great deal. Do any of these case studies apply to you? It’s impossible to personally diagnose anyone’s US tax or citizenship issues in an article read by thousands of people.
If you’d like help figuring out how to minimize tax and determine if renouncing United States citizenship is the best strategy for you, click here. Renunciation may or may not be the best option for you.