The U.S. is one of only two countries that imposes tax on a citizen’s worldwide income, no matter where that citizen lives. (The other country is, of all places, Eritrea.)

If you’re from anywhere else, it’s easy to—legally—avoid the obligation to pay tax on your worldwide income. You simply relocate to a lower-tax jurisdiction, or one that taxes only local income. After an extended period—normally one to two years—you become “non-resident” in your home nation for tax purposes. You no longer have the obligation to pay tax on your worldwide income to the country that issued your passport. You may, however, still be subject to gift and estate taxes.

Expatriation is a Radical Step

But it’s more complicated if you’re a U.S. citizen. To permanently disconnect from the obligation to pay U.S. income tax, you must not only leave the United States, but also take the radical step of giving up your U.S. citizenship and passport. This process (from a U.S. standpoint) is called “expatriation.”

Before giving up U.S. citizenship, you have to acquire citizenship and a passport from another country. And you must also live outside the U.S., if you’re not already doing so.

If you’re wealthy, expatriating could result in big tax savings. The total combined state-federal income tax burden for most high earners is close to 50%. And that is likely to go up. If you anticipate earning $2 million over the next five years, expatriation could save you a cool $1 million in income tax during that period. Not to mention millions more in the years ahead, and millions more again in estate-tax savings.

Expatriation also eliminates the increasing difficulties that U.S. citizens face when they invest or do business overseas. Many non-U.S. banks and brokers now prohibit anyone with any connection to the United States from opening an account.

A Stiff “Exit Tax”

Until 2008, it was relatively easy to circumvent these anti-expatriation rules. But last June, Congress replaced the existing law in its entirety with an “exit tax.” The exit tax establishes a legal fiction that you sell all your worldwide property the day before expatriation. If you’re a “covered expatriate,” you must then pay tax on this fictional gain. Unrealized gains in non-grantor trusts and some retirement and pension plans are exempt from the exit tax. Instead, payouts that would be taxable to a U.S. person are subject to a 30% withholding tax.

Only certain dual citizens and minors with few ties to the U.S. are exempted from these requirements. Long-term green card holders must also pay the exit tax, if they’ve lived in the U.S. for at least eight of the 15 years preceding expatriation.

How are you supposed to pay the tax without selling your assets? That’s your problem! However, the law permits deferral by posting acceptable security with the U.S. Treasury and paying an interest charge on the amount deferred.

The $626,000 Exemption

Fortunately, the first $600,000 of unrealized gain isn’t subject to the exit tax. This amount is adjusted annually for inflation, and for 2009, the exemption amount is $626,000.

The exemption doubles for a married couple, both of whom expatriate. In addition, even if your unrealized gains exceed $626,000, the exit tax applies to you only if you’re a “covered expatriate.” This means that you:

• Have a global net worth exceeding $2 million ($4 million for a married couple); and/or
• Have an average annual net income tax liability for the five years preceding the date of expatriation exceeding $124,000 (adjusted for inflation, $145,000); and/or
• Fail to certify under penalty of perjury that you have been tax-compliant for the preceding five years, or fail to submit evidence of compliance as required by regulation.

The “Nuclear” Option

The decision to give up U.S. citizenship is a nuclear option—a radical solution. It requires substantial advance planning, including the acquisition of a second passport, if you don’t already have one. It’s a step you should take only after consulting with your family and professional advisers.

But it’s the only way that U.S. citizens and long-term residents can eliminate U.S. tax liability on their non-U.S. income, wherever they live. And it’s a tax-avoidance option that Congress may eventually eliminate altogether.

About the Author

Mark Nestmann is the author of The Billionaire’s Loophole. In this report, you’ll learn more about expatriation, and the potentially huge payoff in tax savings. See: www.nestmann.com/catalog.

SIDEBAR

How to Reduce Your U.S. Taxes without Expatriating

The U.S. Tax Code contains an escape clause that allows you to earn up to US$91,400 a year tax-free if you work outside the U.S. If your spouse accompanies you overseas, you can double this exemption and jointly earn up to US$182,800, free of U.S. tax obligations. This is the Foreign Earned Income Exclusion (FEIE).

You must be a bona-fide resident of another country to qualify for FEIE under one of two tests:

1. Bona fide residence test. You have established legal residence in another country for an uninterrupted period that includes at least one “tax year” (generally Jan. 1 to Dec. 31).

2. Physical presence test. You have been physically present in a foreign country or countries for at least 330 full days during any period of 12 consecutive months.

For more information, see: www.sovereignsociety.com.