Why knowledge is power.
There is nothing more frustrating than having all your ducks nicely lined up in a row, and then have an earthquake come an knock them all down. Well, for many, this is the impact of finding out too late that you are an Accidental American, owing US tax and penalties on painstakingly negotiated financial settlements.
Although the actual figure is unknown, the US Government estimates over 9 million Accidental Americans are living abroad. It is therefore likely that many people are ignorant of their American citizenship and tax status, and it is essential that you are proactive in seeking advice to avoid penalties and tax-inefficient settlements.
What is an Accidental American?
America is one of only two tax jurisdictions in the world who tax based on citizenship as well as residency, and this is a trap that catches millions of people unaware. The expansive definition for US citizenship creates a whole new category of ‘Accidental Americans’; those people with only nebulous connections to America but who are deemed to be US citizens and are therefore tax liable to America (regardless of whether they pay tax to any other jurisdiction).
A person may be considered a US citizen if, for example:
- The individual was born in the US (even if they never returned there or were only there for a short period of time and never intended to live there)
- Their parents were married and were both born in the US or are US citizens (including if they are Accidental Americans), and at least one parent lived in the US prior to the birth
- One of their parents was born in the US or is a US citizen, and:
- If the individual was born on or after 14 November 1986, the US citizen parent must have been physically present in the US for five years prior to the birth, at least two of which were after the age of 14.
- If the individual was born between 24 December 1952 and 13 November 1986, the US citizen parent must have been physically present in the US for at least 10 years prior to the child’s birth; at least five of those were after the age of 14.
- If they do not know their parentage, but lived in the US before the age of five.
Therefore, you need not have lived or ever been to the US to have US citizenship and owe tax in the US. You don’t even need to have a social security number to be considered a US citizen.
Tax filing liability
US citizens are taxed on their worldwide assets. Expats (including Accidental Americans) and green card holders are liable to tax in the US and have the same tax filing requirements as those US citizens living in the US. Failure to file your taxes on time will result in penalties.
Expats and green card holders can, in certain circumstances, claim credit for foreign tax paid under the UK/US Double Taxation, but this does not exempt the reporting requirement. Expats and green card holders can also sometimes find that they need to pay tax in the US in respect of income and gains that would not suffer tax in the UK because of different tax exemptions/reliefs.
An example of this is where an individual realises a gain following sale of a property that is their principle private residence. In this case, there would likely be an exemption from capital gains tax in the UK, but there would probably be tax due in the US on this gain. Our former Prime Minister, Boris Johnson, faced this when he was deemed an Accidental American following the sale of his London House, and was faced with a tax bill of an estimated £100,000 for the sale alone. Declaring it ‘an accident of birth’ and thinking it ‘absolutely outrageous’ did not save our former Prime Minister the cost of paying his tax dues in the US, which he eventually settled in 2015, despite paying no tax on the sale to HMRC.
It is easy to see, from the former Prime Minister’s example, how divorce settlements can often result in triggering high tax bills – more often than not, there will be a sale of the former family home and if you are a US citizen, you need to make sure that you have calculated for this tax bill before finalising the terms of your agreement. If you do not, then this pot of money that you anticipated you would have to rehouse yourself and the children could be drastically reduced.
Catching you unaware
Certain financial institutions outside the US are members of FATCA (Foreign Account Tax Compliance Act). Under FATCA, these institutions are duty bound to report anyone suspected of being a US citizen to the IRS. FATCA is enforced in the UK, and many British institutions will ask clients for their place of birth and/or social security number when they open an account to comply with the FATCA obligations. It is therefore difficult for Accidental Americans to plead ignorance and hope they can continue under the radar.
As such, if a person is suspected of being a US citizen, it is possible that they will be reported to the IRS. It is therefore not uncommon that divorce settlements trigger someone’s Accidental American status and tax-compliance obligations, leading to a nasty financial shock just when they think that they have certainty regarding their finances.
Note, of course that individuals who are Accidental Americans but are not in the process of divorce will be subject to similar reporting requirements and tax liabilities.
Consequences of being caught
If you are proactive in reporting their status as an Accidental American, you can take advantage of several amnesty programmes and the streamlining procedure to nullify and mitigate your tax penalties.
You can also make the decision to renounce their citizenship, and changes since 2019 have made this process less expensive for certain individuals (particularly for those without US assets or income sources) by allowing them to renounce citizenship without a social security number and waiving up to $25,000 per year in taxes owing.
If you fail to take advantage of this process, and fail to submit the necessary tax forms, then you can face hefty fines, audits and even criminal charges. It is therefore important that seek advice on your options and which assets/income to avoid acquiring to make renunciation/compliancy more cost and tax effective.
How to proceed
In short, proceed with caution. This is a trap that many people may find themselves falling into unaware; so, if you think that you may be an Accidental American upon reading this article and you are contemplating divorce proceedings or separating your finances, or if you are already proceeding with these steps, please contact our offices for early advice.
At Birketts we have specialist family and tax advisers who will ensure your settlement is tax and cost effective. In this way, we can ensure that any tax or compliance reporting costs are considered a matrimonial asset to be deducted from the overall value of the pot before your share of settlement is calculated.