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).
Although the actual figure is unknown, the US Government estimates over 9 million Accidental Americans are living abroad. It is therefore likely that practitioners will encounter clients who are ignorant of their American citizenship and tax status, and it is essential that professionals are primed to ask the right questions to protect their clients’ interests and help them avoid penalties.
In the realm of family law, and particularly for those clients contemplating divorce or separation, practitioners must be mindful of potential tax issues (arising in the UK or elsewhere) to ensure that the painstakingly negotiated settlements are sufficient to meet their client’s needs after accounting for tax liabilities. It is also important to ensure that implementing your client’s settlement doesn’t trigger the financial institutions’ IRS reporting obligations before your client has been given the opportunity to declare their tax status to enable them to avoid unattractively high penalties.
What is an Accidental American?
An Accidental American is a person who does not realise that they have US citizenship. They will also likely be unaware that, as a result of their US citizenship, they are subject to US taxes on worldwide income and gains.
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 14th 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 24th December 1952 and 13th 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, clients need not have lived or ever been to the US to have US citizenship and therefore owe tax in the US. They 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 to HMRC.
It is therefore important that clients properly consider their tax liability in the US, and do not automatically assume that reliefs that apply in the UK will also apply in the US, or that the UK tax will completely nullify any US tax liability.
Catching clients 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.
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 individuals 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 for being caught
If individuals are proactive in reporting their status as an Accidental American, they can take advantage of several amnesty programmes and the streamlining procedure to nullify and mitigate their tax penalties.
Clients 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 individuals fail to take advantage of this process, and fail to submit the necessary tax forms, then they can face hefty fines, audits, and even criminal charges. It is therefore important that clients are made aware of their 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.
Asking detailed questions at the outset
In early meetings with clients, be sure to ask them questions about their place of birth, parentage, citizenship and green card status so you can be mindful of any potential tax issues arising and so you can make appropriate referrals to US tax advisers.
Review your terms of business
Finally, to avoid potential professional negligence issues, ensure that your terms of business are clear about your ability (or inability) to advise on tax issues or citizenship status.
Francesca Skakel, Solicitor, Birketts’ Family Team