U.S. persons working or living abroad will generally invest as they would if they were living in the United States. Their investments aren't treated any differently. However, the investment parameters may be very different from those suited for local citizens. Key issues to investigate before embarking on a relationship with a foreign investment provider include:
The types of mutual funds and other pooled investments a U.S. person can own without triggering Passive Foreign Investment Company (PFIC) rules.
The accounting and reporting requirements for a U.S. person's accounts.
Ensuring an advisor has the necessary capabilities to properly report on a U.S. person's account.
Increasingly, the new reporting requirements imposed by the Foreign Account Tax Compliance Act (FATCA) and heightened enforcement have been making things difficult for U.S. citizens and resident aliens working or living outside the U.S.
Many institutions are reluctant to take on new accounts for U.S. persons because of the many disclosure requirements imposed by the U.S. government. It is increasingly difficult for U.S. citizens living abroad to open a bank account with a local institution or to purchase life insurance. In addition, they often have to work with an institution in the U.S. in order to make investments.
What is a Passive Foreign Investment Company?
The IRS defines a passive foreign investment company as a foreign corporation in which:
75% of the gross income is passive (e.g., interest, dividends, capital gains) or
50% of the average assets produce or could produce passive income or produce no income (e.g., cash).
While some U.S. persons continue to own an interest in a PFIC to hold their investments, there is no tax advantage in doing so and in fact such ownership will impose numerous reporting requirements to the U.S. government. As a result of the enactment in 1986 of the more stringent PFIC rules, any U.S. person who holds an interest in a PFIC, whether directly or indirectly, no matter how insignificant, is subject to these rules. The previous economic benefit of deferral is eliminated with respect to all income of a PFIC. The PFIC rules are not only complex but also comprehensive in their application.
Moreover, some people may not realize they are invested in a PFIC if they own an interest in an offshore mutual fund. However, these are PFICs and will be subject to all the reporting requirements related to a PFIC. As such, it may be best to only own U.S. mutual funds.
Wealth Transfer Tax and Structures: Ensuring Proper Planning is in Place
If a U.S. person who is living abroad is married to a non-U.S. citizen, they may need to have in place a qualified domestic trust (QDOT) to limit the taxation of their estate while still a U.S. citizen. This should be coordinated with an applicable credit trust and possibly an irrevocable life insurance trust (ILIT), since these two trusts, unlike a QDOT, are not subject to estate tax on principal distributions to the non-citizen spouse.
Separately, planning should include consideration of the estate planning of the parents or other relatives of the U.S. person. Where the parents or others are foreign to the U.S. and have substantial wealth, transfers to or for the benefit of the child may simply increase the child's eventual exposure to the U.S. estate and gift tax that they have been trying to avoid. It would be preferable if the parents were encouraged to fund a U.S. dynasty trust or to fund an existing trust that allows for additions by others which benefit that child's descendants.
If they are not yet ready to do that, the non-U.S. parents might establish an offshore revocable trust (also known as a "foreign grantor trust"), with their children designated as beneficiaries. This can provide significant gift, estate and income tax savings for the family while maintaining flexibility for the parents to gift some or all of the assets to a dynasty trust for the benefit of the U.S. child's descendants in the future. Further, any remaining assets would be available to other children who are not U.S. citizens.
"Tax" on Net Investment Income
To aid in funding the Affordable Care Act of 2010 (ACA), the U.S. government has embedded a number of taxes within the ACA legislation, many of which target higher wage earners. These taxes apply to all U.S. persons, regardless of where they reside.
Effective January 1, 2013, U. S. persons whose modified adjusted gross income (MAGI) is over $200,000 (for singles) or $250,000 (if married filing jointly) are subject to a 3.8% Medicare tax on net investment income (NII). The 3.8% applies to the lower of the NII or the amount that the MAGI exceeds the ACA thresholds, which are not indexed for inflation. Investment income subject to the new 3.8% tax includes interest, dividends, annuities, royalties, rents, passive-activity income and capital gains.
Tax advisors to U.S. persons living abroad have noted that taxes incurred under the NII cannot be offset by the foreign tax credit, because it is not technically a "tax." Although deemed by many tax analysts to be the equivalent of an additional income tax on upper income taxpayers, it is imposed by the new section 1411 of the Internal Revenue Code, ostensibly intended to help fund Medicare. As a result, it seems that Americans working outside the U. S. who are subject to the NII may wind up paying it in full, even if foreign taxes exceed the total of U.S. regular tax and NII tax on that income.
In addition to the NII surtax, ACA provided for a 0.9% increase in the Medicare payroll tax for individuals making more than $200,000 and married couples making more than $250,000. Under 2012 law, the Medicare payroll tax was 2.9% on all wages, with the wage earner and the employer each paying 1.45%. As a result of the health care reform legislation, the worker's share of the Medicare tax (but not the employer's share) increased by 0.9% to a total of 2.35% of total wages. The 0.9% increase in the Medicare tax only applies to wages that exceed the thresholds. The extent to which this applies to Americans working abroad depends on many factors, including but not limited to whether they work for an American company and whether the U.S. has a totalization agreement with the country in which they are working. This is yet another area where expert tax advice will be needed.
The insurance portion of ACA, commonly referred to as "Obamacare," went into effect January 1, 2014. U.S. persons living outside the U.S. should not assume that this legislation does not apply to them, as the requirements are far reaching and complex.
Next: The Implications of Relinquishing U.S. Citizenship
In the next section of our Wealth Planning for Americans Abroad series, we'll discuss the legal, financial, and tax implications of permanently giving up U.S. citizenship and the affect it may have on someone's investments, assets, retirement savings and estate plans.