Tax Challenges Faced by Americans Living Overseas
When Americans leave the United States to live long-term in another country, many are surprised to learn that the U.S tax regime comes with them. While this may, at first, appear to be benign, for most Americans it is anything but. The United States imposes punitive taxation and reporting requirements on income streams and assets that are “foreign.” From the perspective of the United States, all non-U.S. income and assets are “foreign,” even if they are local from the perspective of the American living in another country.
Under U.S. rules, non-U.S. retirement plans, non-U.S. small businesses, and non-U.S. mutual funds and other investments are subject to punitive treatment. This includes punitive and highly complex reporting requirements, together with punitive taxation. As a result, Americans outside the United States have difficulty, as examples, investing and planning for retirement, owning small businesses, holding title to their principal residence and other family assets, holding bank and other financial accounts, and holding certain positions of employment. Some even find themselves shut out from positions of community service.
The current system was first conceived more than a century ago, during the Civil War, with the first income tax. At first only the U.S.-source income of Americans living overseas was taxed. But this was quickly changed to include all their income, regardless of the source. In justifying this change, members of Congress at the time said nothing about the need to collect revenue from overseas Americans. Instead, the change was motivated by the desire to discourage Americans from living outside the country and to punish them if they do. Senator Jacob Collamer explained: “we do not desire that our citizens […] should go out of the country,” and if they do, they “ought to pay a higher income tax.”
The U.S. extraterritorial tax system has evolved considerably from its first iterations during the Civil War and in 1913 with the adoption of the 16th Amendment (granting Congress the authority to levy an income tax). Like the domestic tax system, the extraterritorial system started as something relatively simple and concerned only those with the highest incomes. Over the same period, U.S. citizenship also evolved considerably. A century ago, most Americans who lived outside the United States on a long-term basis lost U.S. citizenship by operation of law (due, as examples, to marriage to a non-citizen or naturalization in another country).
Today the U.S. extraterritorial tax system is highly complex and highly penalizing. The system is separate from and more punitive than the domestic tax system applied within the United States. It concerns all overseas Americans except those who take the active step to renounce U.S. citizenship, thereby incurring a high renunciation fee as well as, depending upon their circumstances, a penalizing exit tax. Because of these developments, the U.S. extraterritorial tax system is far-reaching and highly consequential for Americans living outside the United States.
Different Americans experience the system in different ways. A given individual’s experience is dependent upon a variety of circumstances, such as the country where they live, the types and sources of their income, and the types of assets they hold. Further, as an American’s life circumstances change (marriage to a non-U.S. citizen, purchase of a home, starting a business, retirement…), so do their experiences with the system. As a general matter, the more an American’s financial interests are – or evolve to be – centered outside the United States, the more likely they are to encounter problems at some if not multiple touch points in their lives.
Americans living in other countries are not the only victims. Administering an extraterritorial tax system is an impossible task, both procedurally and substantively. The IRS cannot adequately serve U.S. tax residents in the more than 100 countries in the world where they live, let alone in the languages they speak. Nor can the IRS know how U.S. tax laws apply to the investment vehicles, business structures, welfare benefits, and retirement plans that are common in all those other countries. At the same time, because of this very complexity, combined with the ever-present threat of excessive penalties in the event of even error, many overseas Americans require support from the IRS.
There are organizations and individuals working for change. Because the policies are so poorly understood, the education of policymakers as well as the public is a key component of their activities. Regardless of where they may live today or in the future, if you think that all Americans should be free – not just physically but also fiscally – to live outside the United States, you are warmly invited to join their efforts.