The Perils of Accidental US Citizenship

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Compared to most other countries, it’s comparatively easy to acquire U.S. citizenship.

You become a U.S. citizen merely by birth within the geographic boundaries of the United States. In most cases, you’re also a U.S. citizen if you were born outside the United States, and at least one parent was a U.S. citizen or green card holder. In both these examples, citizenship is automatic. Generally, you need not take any affirmative action in order to acquire or retain U.S. nationality. Only in the case of naturalization after an extended period of legal residence in the United States do you need to make a petition for U.S. citizenship and passport.

The ease of acquiring U.S. citizenship by birth means that there are hundreds of thousands of “accidental” U.S. citizens roaming the world. Many of these individuals don’t realize they’re U.S. citizens.

Nonetheless, because the United States, alone among major nations, imposes income tax, capital gains tax, gift tax, and estate tax based on citizenship, accidental U.S. citizens have the same fiscal responsibilities as U.S. citizens resident in, the United States. Among other obligations, they must file a U.S. personal tax return annually and pay any tax due. They must also file a gift tax return to report details of any gifts they make in any one year that exceed $13,000. If they make lifetime gifts more than $5 million, they must pay gift tax on the excess.

Finally, at death, their heirs must file a U.S. estate tax return and pay estate tax at a top rate of 35% (increasing to 55% in 2013). The estate tax applies to all property owned by the deceased U.S. citizen, valued at its “highest and best use.” (An estate tax treaty or credit for estate tax paid in another jurisdiction may reduce this burden.)

Numerous additional obligations also come with U.S. citizenship. For instance, all U.S. citizens must disclose any investments in non-US “bank, financial, or other financial accounts.” Failure to make this disclosure is punishable with a fine up to $250,000 and a five-year prison sentence.

U.S. citizens, accidental or otherwise, face additional tax pitfalls with reference to their non-US investments and business activities. U.S. tax provisions for interests in non-U.S.-registered mutual funds, controlling interests in non-U.S. corporations, and interests in non-U.S. trusts are but three examples of the many “tax landmines” that accidental U.S. citizens may inadvertently detonate.

The tax and reporting perils of U.S. citizenship came to mind recently when I learned of the tribulations of a lifelong citizen and resident of Mexico. I’ve changed the facts a bit to protect his identity, but this gentleman, now well past retirement age, grew up in a tiny town in Mexico near the U.S. border. At the time of his birth, the town lacked any medical facilities, so when his mother went into labor, his parents drove to the nearest hospital, which happened to be just inside the U.S. border.

Fast forward 70 or so years, and this gentleman was longing for some relief from hot Mexican summers. So, he did what countless other wealthy Mexicans have done – he purchased a condo in San Diego. At closing, though, he encountered a strange anomaly. The closing documents listed him as a U.S. citizen. He tried to correct what he believed to be a mistake, but the broker assured him there was no mistake. Since he was born in the United States, he was indeed a U.S. citizen, although he had never applied for a U.S. passport.

Our hero thought that was the end of it, but when he came to spend his first summer in San Diego, one day, he received a notice from the Internal Revenue Service. Since he was a U.S. citizen, the notice informed him, he was obligated to file U.S. tax returns. And there was no record of him filing a U.S. tax return for the preceding three years. The notice invited him to respond immediately.

A few days later, he drove over to the local IRS office to see if he could resolve the situation. After a brief conversation, he was shocked to learn that the IRS had already commenced an examination. The agent started using terms such as “willful failure to file,” “criminal penalties,” and “jeopardy assessment.”

At this point, our hero hired a criminal tax defense attorney. He’s spent about $100,000 in legal fees to date, but recently received a notice from the IRS informing him that they no longer believe that he willfully failed to file U.S. tax returns.

Unfortunately, since an examination was already underway, he’s not eligible to participate in the latest IRS offshore amnesty program. As such, he’ll need to pay 25% of the peak value of his unreported non-U.S. accounts for the period 2003-2010. Unfortunately for him, the value of these accounts fell about 35% in the global economic turmoil of 2008-2009. The accounts that were once worth $2 million are now worth about $1.3 million. Nonetheless, he’ll need to pay a $500,000 penalty to avoid criminal prosecution.

In addition, he’ll need to file six years of past due tax returns and information returns disclosing his interests in Mexican corporations and other Mexican entities. These returns must be prepared according to U.S. Generally Accepted Accounting Procedures (GAAP), which means that the Mexican financial statements for each year must be converted to U.S. GAAP. He estimates that will cost an additional $50,000, perhaps more.

To tally things up: our hero’s total cost of accidental U.S. citizenship: $650,000, and counting. Total benefit of U.S. citizenship: none.

Needless to say, this elderly Mexican gentleman has now filed a formal petition with the State Department to surrender his U.S. citizenship and expatriate. That will eliminate any future U.S. tax or reporting obligations on non-U.S. income or property, but doesn’t affect his past tax or reporting obligations.

There are many, many more accidental U.S. citizens in similar circumstances. And the IRS is making it a very high priority to find them. Those U.S. citizens who have already acquired a U.S. passport are at particularly high risk.

If you were born in the United States, or have at least one U.S. citizen or resident parent, you’re almost certainly a U.S. citizen. In that event, if you’re not 100% compliant in your U.S. tax and reporting obligations, you too may find yourself on the receiving end of an IRS audit.

Don’t wait to get audited. If you fit this scenario, you have until Aug. 31, 2011 to take advantage of the latest “offshore voluntary compliance initiative” from the IRS. You may be eligible to pay a 5% penalty, rather than 25%. Plus, of course, any taxes that might be due, plus interest. Fortunately, in many cases, you can credit taxes you paid in the country in which you reside against any U.S. tax liability.

For more information on the IRS 2011 Offshore Voluntary Disclosure Initiative, click here. And, if wish to participate, don’t hesitate to contact me at for a referral to an international tax attorney who can assist you.

Finally…if you’re fed up with the continuing and escalating obligations that come with your U.S. citizenship, contact me. My firm has helped dozens of U.S. citizens permanently and legally eliminate future U.S. tax and reporting obligations through the process of expatriation. We can even help you obtain a second passport, if you don’t have one already.

Reprinted with permission from The Nestmann Group, Ltd.