Leaving U.S. taxes, and your citizenship, behind

About the time you reach for your 43rd cup of coffee and the tax forms start to dance menacingly in the air, you probably share a common daydream with most tired tax filers: What if I could just leave the country and be done with the infernal Internal Revenue Service forever?

Sweet dream. The problem is, unless you're well-heeled enough to afford top-drawer international tax advisers on both ends and start to plan your break years in advance, the IRS is going to have its hooks in you for 10 years after you trade allegiances.

Even if you manage the money limbo and escape with most of your assets, there is no guarantee you'll be welcomed back into the United States even for a short visit, especially if you managed to land on the IRS list of folks who fled to avoid taxation.

What's worse, if you fail to secure citizenship in another country before handing over your U.S. credentials, you could suddenly find yourself the proverbial man without a country, and you do not want to go there.

"Anyone who gives up their citizenship in the U.S. without first establishing citizenship in another country is an absolute fool," says Vernon Jacobs, an international tax adviser in Prairie Village, Kan. "Even refugees are citizens of some country."

Beating "Benedict Arnolds"
Companies commonly incorporate in more tax-friendly locales. Tyco International, for example, became a Bermuda company when it merged with ADT Ltd., a move that gives the company a lower tax rate than its U.S.-based competitors.

If it works for corporations, then why shouldn't individuals benefit, too?

That question of personal "taxpatriation" prompted Congressional action during the Clinton years, when such big fish as Campbell Soup heir John T. Dorrance III and Star-Kist chairman Joseph Bogdanovich were slipping off to tax havens. Although the number of people who actually toss in their American citizenships each year has always been minuscule, when their net worth runs into the billions, Capitol Hill tends to take notice.

As a result, Congress passed two laws in 1996 that amounted to an alley beating for would-be taxpatriates.

First, Republicans slipped language into the Health Insurance Portability and Accountability Act that subjects expatriates with net worth of more than $500,000 (the annually-indexed figure is currently $622,000) to taxation on their U.S.-earned income for 10 years after they jump ship. That includes income from such sources as tax-deferred assets, pension plans, annuity contracts and stock options.

Congress set the arbitrary half-million threshold at the request of the IRS, which was flummoxed as to how to determine who was and was not a tax expatriate. As a result, if your net worth is above that threshold figure, you are automatically assumed to be fleeing the country for tax purposes.

Second, language in the Illegal Immigration Reform and Immigrant Responsibility Act of 1996 stripped all expatriates of their automatic rights to return to the United States. Instead, they must apply for a visa, even for short visits.

It gets worse. The U.S. Attorney General has the power to deny your visa if it is determined that you expatriated to avoid taxation.

How's that daydream holding up now?

The citizenship trap
The reason for all this gamesmanship is both obvious and (so far) unyielding: The United States is the only major country that collects taxes based on citizenship. That means that wherever you live geographically and wherever your income is derived, as long as you are a U.S. citizen, you owe U.S. taxes. By contrast, most countries in the world only want a piece of what you earn in-country or while you are living within their borders.

If you're a resident of Canada or the United Kingdom and you want to escape taxes, you can retain your citizenship and simply move offshore (think British rock groups). Tax treaties between your homeland and your adopted home protect you from double taxation.

But if you're a U.S. citizen, you can't be free of the IRS without renouncing your citizenship. Yes, tax treaties still protect you from double income taxation, but you'll be hit with U.S. estate and gift taxes, even if you're living in a country such as Canada that has neither.

David Lesperance, a Canadian lawyer who specializes in expatriation, says his U.S. taxpat clients tend to be "millionaire next door" types looking to avoid the U.S. estate tax hit.