Prologue
This is the Part 2 of two posts motivated by the story of a Canada/U.S. dual citizen living in Canada who sought help from the University of Washington “Low Income Tax Clinic” – “LITC”. The first post is here.
Part 1: The University Of Washington “Low Income Tax Clinic” And A Canadian Student
This was also discussed by “Tax Fairness Abroad“.
It’s worth reading the entire blog post from Tax Fairness Abroad titled “A summer job and bad advice land an American in Canada in international tax court“.
The post references a report from the University of Washington “Low Income Tax Clinic”. (Note that the “LITC” also provided assistance to Gabriel Morrow who is another American abroad who received advice from the clinic.)
The complete text of the “LITC” report AKA the drama of taxing Americans abroad
“Taxpayer is a dual US-Canada citizen; TP is a long-term resident of Canada and is employed there. TP’s father passed away in 2020 and client received an inherited retirement account in 2021 (approximately $110K). TP was misinformed by the retirement account custodian that the “taxes have been paid” (when,in reality, this was just the tax withholding from the transaction). TP believed that taxes had been reported and paid; the retirement account was not included in the 2021 tax return. TP also did not include 1099-income earned while doing a summer job in Canada for a U.S. domiciled company. TP received a notice of deficiency, and a tax court petition was filed. Unfortunately, the TP has a deficiency because the retirement account; nonetheless, IRS appeals refused to apply the LITC’s treaty claim in regard to the 1099 income and is invoking the US-Canada Treaty savings clause. The LITC will be requesting a competent authority determination on this issue (Revenue Procedure 2015-40, Section 6.04(3) and related IRM provisions). However, the TP will still have a liability because of the retirement account taxable income—this liability process will continue through appeals while the competent authority determination is submitted and a determination is received from the IRS.”
What facts can we glean from the report?
It appears that this dual Canada/U.S. citizen who resides in Canada filed a U.S. tax return for the 2021 year. That return omitted both distributions from the U.S. IRA AND income from the summer emmployment performed in Canada. It is likely that the IRS was able to match his Social Security Number with the information returns that had been filed for both the IRA distributions and the wages from the U.S. based employer. Put another way: the existence of the information returns combined with the Social Security Number on the U.S. tax return, alerted the IRS to the two specific income sources that should have been included on the tax return.
Question: What does this imply for Americans abroad who stand to inherit retirement plans or other income generating assets (for example a stock portfolio) from a U.S. relative? This is a recurring question. What about long term Americans abroad who may not be current on their U.S. tax returns? Should those people renounce U.S. citizenship prior to inheriting these assets? Should they remain American? If so, how do they manage U.S. tax compliance? Inheriting assets of a kind that would generate income and require the reporting of that U.S. source income implicates the question of U.S. tax compliance.
Two background points that are worthy of note:
1. The United States does NOT impose tax on the value of an inheritance. Rather it taxes the income generated from that inheritance. As per 102 of the Internal Revenue Code:
Gross income does not include the value of property acquired by gift, bequest, devise, or inheritance.
(Note that your country of residence may impose an inheritance tax.)
2. In most states, depending on the circumstances, it is possible to “disclaim” an inheritance. As always, the Internal Revenue Code – section 2518 – imposes specific procedural requirements. If you want to completely avoid these issues (perhaps because the amount of the inheritance is very small) you should be aware that a disclaimer is possible. That said, to disclaim an inheritance – although there may be good reasons to disclaim an inheritiance – is an erosion of your wealth.
The inheritance from America – The Good, The Bad And The Ugly
Inheritances (and gifts) can be income producing or non-income producing. It seems likely that inheritances that are non-income producing will not produce income tax (and therefore tax filing) consequences. For example, if a U.S. citizen were to receive personal property that would not be used to generate income there would be no presumptive income issues. The problem is more likely to arise where the American abroad receives assets that are (1) income producing and (2) reported as income producing. An obvious example of an income producing inheritance would be an IRA.
This purpose of this post is to discuss the quesion of “income producing inheritances” from various perspectives. The “LITC” case of the Canadian student reinforces why “information returns matter. The effect of the information return (reporting the fact of the inheritance of the IRA and the fact of the employment) is that the IRS would have a reason to expect income to be reported on a U.S. tax return.
If you are a U.S. citizen living outside the United States you should consider the implications of receiving any inheritance, but most particulary an inheritance from the United States. I suggest that the implications should be considered from the following perspectives in Category A, Category B and Category C.
Category A – You are up-to-date with your U.S. tax filing
1. If you are a U.S. citizen living outside the United States who is NOT a dual citizen from birth, will receiving the inheritance push your net worth above the 2 million USD mark? If so, the inheritance may make it difficult for you to renounce your U.S. citizenship without being a covered expatriate. This is a VERY SIGNIFICANT issue for those with U.S. citizen children (don’t forget the “covered gift” rules) or other family members.
Is the fact that you are NOT a dual citizen from birth a reason to renounce U.S. citizenship before receiving the inheritance?
If you are a U.S. citizen who is a dual citizen from birth and meets all the requirements for the dual citizen from birth exemption from the 877A exit tax, then this issue won’t matter as much.
2. What kinds of assets are being inherited? What if you are inheriting a significant amount of U.S. situs assets? If you remain a U.S. citizen you have a 15 million dollar estate tax exclusion. In other words you can have worldwide assets of up to 15 million USD without being subject to the U.S. estate tax. If you renounce U.S. citizenship and become a “non-citizen who is not domicled in the United States” then upon your death the value of the U.S. situs assets above $60,000 USD becomes subject to the U.S. estate tax regime. This “may” be a good reason to retain U.S. citizenship.
Example: The value of your worldwide estate is less than 15 million USD. You inherit a small apartment building located in the USA which is worth 10 million USD. In the absence of an estate tax treaty, if you were to die as a U.S. citizen, the apartment building would NOT be subject to the U.S. estate tax. If you renounced U.S. citizenship the apartment would be subject to the estate tax. In this example (subject to any estate tax treaties) the tax could be as high as 40% of ten million which is 4 million USD.
3. What is the difference between being taxed on U.S. source income if you retain U.S. citizenship vs. being taxed as a non-resident alien with U.S. income streams?
Considerations include …
– if you remain a U.S. citizen you you will have to continue to file U.S. tax returns which report your worldwide income (which includes income from the inherited income generating assets)
– if you renounce U.S. citizenship (depending on the asset inherited) you may (1) NOT have to file a U.S. tax return (if the proper witholding taxes place) and (2) may be subject to a different rate of U.S. taxation. For the purposes of U.S. tax treaties you will be eligible to no longer be treated as a U.S. citizen (which has significant benefits)
It is entirely possible that your U.S. tax obligations will be much less onerous!
4. If I plan to renounce U.S. citizenship, should you renounce before or after receiving the inheritance?
I suggest that the answer depends on whether you can meet the dual citizenship from birth exemption to the 877A Exit Tax and/or what your net worth would be after the inheritance. Put another way: what is the effect of renouncing U.S. citizenship for YOU on receiving the inheritance.
Bottom line: Inheriting form the United States is certainly easier if you are U.S. tax compliant.
Category B – You are NOT up-to-date with your U.S. tax filing requirements
4. What if you are NOT current with your U.S. taxes? Is this a reason to normalize your status? Should you come into compliance under the “Streamlined” or the “Relief Procedures For Former Citizens” program?
I suggest that this largely depends on whether you intend to remain a U.S. citizen or renounce U.S. citizenship.
The “Relief Procedures For Former Citizens” can be an excellent way to renounce your U.S. citizenship and clear the way to inherit your U.S. assets as a nonresident alien (making ongoing U.S. tax compliance easier but the mechanics of receiving your inheritance possibly harder).
Part C – Tax implications of a U.S. inheritance in your country of residence
Obviously you must be tax compliant in your country of residence. Some countries will tax an inheritance. Others won’t. Some countries have estate tax treaties with the United States and most do not. In some cases remaining a U.S. citizenship will actually give you treaty benefits that depend on your being a U.S. citizen. (How the U.S./France tax treaty taxes U.S. investment income received by U.S. citizens comes to mind.) If you are anticipating an inheritance of any significance, professional advice is important.
In conclusion
Inheritances from the United States are a common source of confusion and anxiety for Americans abroad. This post is intended to describe “some” of the factors that should be considered. Obviously this is a complicated area where planning and professional advice is critical.
John Richardson – Follow me on X.com/ExpatriationLaw