Expat in the U.S.? Tips for Avoiding Tax and Investment Stumbles

By David Kuenzi, Thun Financial Advisors

Link to Original Article Published in Wall Street Journal Aug 11, 2015

U.S. expats abroad tend to complain about their financial reporting burdens. Less well-known is that foreigners in America face many of the same tax and compliance challenges. Financial adviser David Kuenzi of Thun Financial Advisors reviews common tax and investment mistakes made by expats in the U.S., and offers some tips:

Foreign nationals who are U.S. residents (with some exceptions) are subject to U.S. taxation on their world-wide income, just like American citizens. Nevertheless, foreigners routinely fail to report assets held outside the U.S. (usually acquired before coming to America). Waiting years or decades to fully report foreign assets is likely to result in large tax penalties and require expensive legal and accounting work to become compliant. In the age of the Foreign Account Tax Compliance Act (Fatca), U.S. taxable individuals with unreported foreign assets must assume that the IRS will eventually catch up with them. Ignoring these issues is no longer a viable strategy.

When legacy foreign assets include pensions, mutual funds, business interests, trusts or insurance policies, severe complications often arise because the U.S. tax code levies taxes and applies complex reporting rules to such foreign assets. Ideally, new residents of the U.S. should develop a plan to deal with these tax issues before arrival. Unpleasant tax outcomes can be mitigated if the assets are reported properly from the beginning. Be aware that the best strategy is often to sell assets that are particularly U.S. tax-toxic.

Foreign trusts are particularly common time bombs that lurk undetected in the old-country investment portfolios of many new arrivals in America. Many structures (including pension funds and family businesses) often meet the IRS definition of a trust even though they aren’t commonly thought of as trusts. Unfortunately, many new Americans and new green card holders go years without properly reporting interests in foreign trusts, only to find out that cleaning up the problem carries very unpleasant financial implications for all trust beneficiaries, not just the one with the U.S. tax reporting obligations. Here are two examples from our practice:

  • A Brit came to America and became a U.S. resident and later a citizen. Long before moving the U.S., he was named as a partial beneficiary of a U.K. trust that housed his family’s estate. Many years went by before the trust was properly reported to the IRS, resulting in large fines and years of complicated amended tax returns.
  • A young Asian student studying in America ended up marrying her American sweetheart and acquired U.S. citizenship in the process. The whole time she was a one-third beneficiary (along with her siblings) of a legal structure that housed her family’s business back home. Although not called a “trust,” the structure met the IRS definition of a “foreign trust.” The ownership stake became reportable and taxable from the moment she became a U.S. permanent resident (but not when she was a student).  Furthermore, to properly report her taxable share of the business’ income, the family was required to prepare income statements to U.S. accounting standards and report annually on all of the business’s income retroactively to the time the daughter becomes U.S.-taxable.

Foreigners in America who acquire U.S. assets and then leave the U.S. and continue to own those assets need to be aware of estates tax rules. The U.S. imposes a 40% estate tax rate on U.S. assets (called U.S. situs assets) above a $60,000 exemption threshold when those assets are owned by foreigners not resident in the U.S. (so-called “non-resident aliens”). The most common assets subject to this tax are real estate and U.S. stocks (see Investing and Financial Planning for Foreign Nationals in the U.S.).  In some cases, this exemption is overridden by estate tax treaties the U.S. maintains with 19 countries around the world. Where no applicable treaty exists, however, large potential estate tax burdens are faced by non-resident aliens with U.S. assets.

One possible solution to this common problem is to hold U.S. assets in the name of an American family member who benefits from the much higher $5.4 million dollar estate tax exemption for U.S. citizens or residents. Another potential solution is to hold the U.S. assets through an offshore corporation. Foreign corporations are not subject to U.S. estate tax.

Many foreigners build up substantial U.S. retirement account (401ks, IRAs, etc.) balances during their working years in America. Deciding what to do with these accounts when they leave the U.S. can be a daunting task. Generally, high taxes and early withdrawal penalties will apply if the accounts are cashed in before retirement age. Furthermore, U.S. retirement account investment options are often much better than investment options available back home. On the other hand, a U.S. retirement account is considered a U.S. situs asset, which means it will be subject to a potentially substantial U.S. estate tax if the non-resident alien holder dies still owning the assets (see above).

In many cases, leaving financial assets in the U.S. may be a surprisingly advantageous option for non-Americans. Financial assets held by foreigners aren’t subject to U.S. capital gains tax. Dividends and interest will be subject to a withholding tax at a rate of up to 30% (usually reduced to 10% or 15% by treaty). This withholding tax, however, can usually be recovered as a tax credit in the country of residence. The net effect, therefore, is that foreigners, even after returning to their home country or to a third country, can continue to benefit from the U.S.’s investment environment. These investment advantages are substantial and include low fund and brokerage fees, greater range of investment options and greater market liquidity (see Morningstar Global Investor Fund Experience). The main caveat, again, is the potential estate tax implication of U.S. assets (see above).

Mr. Kuenzi is the founding partner of Thun Financial Advisors, a U.S. investment firm based in Madison, WI, that provides investment management and financial planning services to Americans abroad.