“When a person has a parent or grandparent who is a U.S. citizen, that person is generally a U.S. citizen as well, no matter where they were born,” says Carol Bernatzky, Wealth Advisor at the International Private Bank.
Dual citizenship is very common among our global families, and in most cases does not create tax problems as most countries tax individuals only when they live within their borders or own property there. “By contrast, the United States imposes taxes on income, gains and assets regardless of where a citizen may live,” says Lindsay Martin, Senior Wealth Advisor at the International Private Bank.
“That is what accidental American really means—being accidentally subject to U.S. tax and reporting whether or not you live in the country, or for some people, even if they have never stepped foot in the United States,” says Bernatzky.
In this episode, we will cover the ways of acquiring and relinquishing U.S. citizenship, the tax and investment implications of being a U.S. national, and the unintended consequences of becoming an “accidental American.”
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Lindsay Martin: Welcome to our Wealth Advisory series, where we discuss topics related to Life and Legacy. Today we will be discussing the concept of Accidental Americans— or -- stated differently, how someone can end up being a US citizen without knowing, or understanding the implications. We will cover ways of acquiring and relinquishing US citizenship, tax and investment implications of being a US citizen, and provide some client case studies. As Wealth Advisors, we work with clients with global footprints so these topics are at top of mind for us.
I’m Lindsay Martin, and today I am joined by my colleague Carol Bernatzky to discuss these important topics and to delve into the intricacies of wealth and tax planning in the context of unintentional US citizenship. Let’s get started.
Carol Bernatzky: Thanks, Lindsay. Accidental American –what an odd expression… How can someone ”accidentally” be American? And is that different than being “accidentally” Argentine or British?
LM: Funny you should ask that …. Generally, all people born in the US are considered US citizens whether or not their parents are US citizens or residents. Like most other countries, the US grants citizenship because a person is born within its borders… or is born to a US citizen parent… or through naturalization later in life. The rules to determine US citizenship by birth and bloodline have changed over time. For people born outside the US, the usual pre-requisite to be an automatic citizen of the US is a US citizen parent -- and sometimes for the child to have lived in the US for a specific period of time. The good (and the bad) news is that if a person has a parent or grandparent who is a US citizen, that person is generally a US citizen as well, no matter where born.
CB: So Lindsay it seems you are saying that many people may acquire US citizenship and genuinely not realize it at all. I feel like many of our colleagues and friends re-locate for jobs or decide to study abroad for a masters or doctorate program and during those times families seem to expand. Recently I was speaking with a colleague in Chile and he mentioned that 25 years ago he went to California to study for his MBA and while he was there studying he had his first child. When he completed the MBA program he moved back to Chile and during his time at “home” he had his second child. Three years later he accepted a job in NY to further his career in global financial services and while living in Connecticut he had his third child. The 3 children are currently living in Chile and only have one passport – a Chilean passport. Does this fact pattern indicate that 2 of the 3 children are really dual/US citizens?
LM: You raise a really important point. People who meet the criteria for U.S. citizenship are automatically U.S. citizens, whether or not they apply for a U.S. passport or are citizens of another country.
CB: Well Lindsay that does not seem to be such a bad result. It seems like it is useful to have a second citizenship and passport given all of the global uncertainty nowadays – it gives options to move around. Are there any tax consequences to having dual citizenship?
LM: It is very common on a global basis to have dual citizenship and in most cases does not create tax problems. This is because almost all countries tax individuals only when they live in that country or own property there. By contrast, the United States imposes taxes on income, gains, and assets regardless of no matter where a citizen may live. So it’s important to determine whether an individual is a US citizen with US tax obligations. The fact is -- many people are unknowingly U.S. citizens – meaning they and some close family members are subject to U.S. taxation and reporting. So refer to them as “Accidental Americans” since the US tax and reporting results seems “accidental” to them – they didn’t volunteer to be US citizens.
CB: So that is what “Accidental American” really means – accidentally subject to US tax and reporting whether or not you live in the US or in for some people even if they have never stepped foot in the US.
LM: Yes, that’s right. For our clients, being a US citizen carries some profound implications. They touch not just income tax, but also estate and gift tax, what you need to report to the IRS, and how you construct a portfolio of investments. So let’s talk about income tax first
From an income tax perspective, it’s important to understand that if you hold a US passport, or you were born in the US, then US imposes tax on your global income, even if you live in a different country. Only one other country in the world, the tiny nation of Eritrea, has a similar set of laws, but even then its citizens abroad pay only a special 2% tax. For US citizens, it’s the same rate of tax if you live in Paris Texas, or Paris, France.
Carol, as income tax goes, what else should be people think about if they are US citizens?
CB: Well, to be honest, the income tax rules are quite tricky for US citizens who own foreign companies or foreign investments, and these rules frequently trip up our clients. While they might be living outside of the US, and following all of the rules of the country they are living in, the US has some counter-intuitive laws that can trip you up.
I have been working with a client in Uruguay who is a US citizen. She and her brother inherited a company owned by her grandfather. It is located in Bahamas, and all it owns is an investment account located in the US with stocks and bonds. Under the local rules in Uruguay, if money isn’t taken out of the company, it’s not taxed. Well, she owns 51% percent of the shares, and so under US rules, that means she owes taxes on her share of the company’s income, even if there’s never a distribution. That was a big surprise to her.
Worse still, she bought some foreign mutual funds: those are generally heavily taxed when owned by US persons, even though they are tax efficient in Uruguay. The tricky part here is that you may be living outside the US, and following all the rules that apply there; but the US rules may be very different and quite unforgiving.
LM: That’s right: the US income tax rules are designed to defeat the use of non-US companies, non-US trusts, and non-US investments to reduce or defer taxes in the US. So what might seem perfectly acceptable under local rules can end up being a real problem if you are a US citizen. Sometimes, the rules are so harsh that the penalties are imposed, even if you genuinely didn’t know they applied to you.
But you know similar rules apply for US estate and gift tax. If you’re living in Hong Kong, and never set foot in the US, thanks to a US passport, your local business, home, and assets will be subject to US estate tax, just the same as if you lived in Chicago. Carol, what are some of the implication of US estate and gift tax, for Accidental Americans.
CB: Not being aware of the rules is really the biggest problem, Lindsay. I met a family in Argentina last year, and while we were talking, I found out that one of the sons was a US citizen. He was born in Houston, Texas, over 30 years ago, but never really got advice around what that meant. I explained to him that his global estate, which meant all of his assets whether located in the US or Argentina, were subject to US estate tax. This was a huge problem, because he was a major shareholder in the family’s local business. He hadn’t made any plans about how to transfer his shares to his own kids because he assumed it would pass according to the rules of Argentina. Additionally, he never considered that his brothers, who also own the company, are looking at a US estate tax payment imposed on the family business when the Accidental American passes away. That’s a big issue for the family as a whole, not just that one brother.
LM: Right, it’s the details that really drives some of the risk for Accidental Americans. A lot of people just don’t know the rules, and get into some trouble when they take actions that seem perfectly acceptable and normal, but don’t check what’s expected of them back in the US, oftentimes because they don’t even know they are US citizens.
For instance, the US has rules that say, in addition to paying tax, US citizens are also obligated to raise their hands and volunteer certain kinds of information, and that failing to do it right can mean a big penalty. These are the rules around reporting requirements, and they are pretty tricky:
I have a client who lives in China. He is a very successful entrepreneur who founded his own company. He’s also a US citizen. Well, the company was doing so well that his bankers were able to get him fast-tracked for an initial public offering on the NASDAQ exchange in New York.
He hired the corporate lawyers to help him get the listing together, and was getting close to the listing date. He was pretty excited. But when the team came together for a final look at the underwriting, someone asked the entrepreneur if he ever reported his ownership of the non-US company to the IRS, and if he know about his reporting requirements as a US citizen.
He said never reported his foreign company to the IRS because it never made any profit, and never issued a dividend. The advisors had to inform him that the reporting rules aren’t about whether he got any dollars out of the company: it was whether he owned ten percent or more of a foreign company. Well, the IPO was delayed, because the owner needed to go back and pay penalties for failing to report his ownership in that company.
And similar reporting rules apply to non-US financial accounts, foreign partnerships, and other assets. A lot of the assets of a US person abroad really need to be reported, even if they don’t generate any income. In fact, failure to report a foreign bank account can be considered a crime under US law. So it’s not just about tax, Accidental Americans also have to contend with these reporting requirements that sometimes just aren’t that straightforward. (9:20)
CB: Ah that’s right. And these reporting rules are not just about assets that the US person owns herself: it can even be assets held in trust or gifted to her. One of my favorite clients received a gift from her grandfather a few years ago. She lives in Peru, but holds a US passport since she was born in Miami. She has a CPA in Florida, who files her taxes in the US, but here’s where the reporting rules get tricky:
When she received the gift it was very clear that under the US rules, the grandfather didn’t owe any gift tax to the IRS, or have any filing requirements. The issue is that my client never told the IRS that she received the gift from her foreign family member. She was shocked to learn that the penalty for failing to tell the IRS about a ”tax-free” gift could cost her up to 25% of the value she received. Like we keep saying, it’s all the fine print and details that make holding US citizenship really complicated, because if you don’t know the rules, you could end up with a nightmare.
LM: Carol, what do you if one day, you find out you’re an Accidental American, or you always knew, but someone finally tells you about some of these rules?
CB: I would say that would be a good time to get professional advice, since these issues are really hard to work through on your own. I will say that it’s getting more common for our clients to ask about this, and that’s because under new transparency rules, even their local banks are asking if they are US citizens.
LM: For sure, I see the same thing. Most clients in this situation work with a lawyer or CPA to make certain that all their past taxes and filing obligations are brought up to date. Then, they take a look at their investment management approach. If they can, they get out of non-US mutual funds, or other assets classes that are really unfriendly to US taxpayers, and then build a portfolio that looks to be more tax efficient and easier to manage for reporting purposes. (11:20)
CB: Right, then they work on doing some estate planning and try to see if there’s a way to be efficient with the family business outside the US, or just how to handle having a US citizen in the family. These issues are complicated, but we help our clients get through them. Still, sometimes, they suggest just giving up US citizenship -- but it’s not that easy.
LM: Yes, giving up US citizenship is possible. It’s legal, and more and more people are actually surrendering US citizenship -- but sometimes it comes with a big price. There is a special exit tax that applies to people over a certain income or asset threshold. And that can make giving up the US passport pretty painful. Plus, if you are subject to the exit tax, it makes estate planning for US kids or grandkids almost impossible. So sure, I guess some people who are Accidental Americans are trying to be former Americans on purpose, but most folks work through these issues with some help.
CB: Well, the most important message we can give is that if you were born in the US, or carry a US passport or were born to a US Person and live outside the country, our best advice is to GET advice. The last thing you want is a surprise that you may have lost half the value of your business or balance sheet or your family’s patrimony.
The Wealth Advisory Team at JPMorgan Private Bank is here to help you plan for and structure your assets with an eye on your global portfolio. We believe this kind of thorough and thoughtful planning can help preserve your legacy and pass your vision to generations to come.
That’s it for this episode. Thank you for listening to our wealth advisory series on topics of life and legacy.