On July 20, the U.S. Tenth Circuit Court of Appeals unanimously upheld a decision from a Colorado district court that will have profound, negative implications for U.S. expatriates — those seeking to live and work abroad without renouncing their U.S. citizenship. If not limited or overturned by the U.S. Supreme Court, the ruling could lead to a new, two-pronged attack on a U.S. expatriate community already laboring under the burdens imposed by a U.S. citizenship-based taxation regime.
The U.S. system reduces Americans’ competitiveness abroad, disincentivizes investment, and treats nonresident U.S. citizens — including many who have lived abroad their entire lives — as full-time residents for tax purposes. If an American lives overseas and sources most of his or her income outside the U.S., it is destructive and unfair to tax that income as if it were earned in the U.S.
America’s citizenship-based tax regime has already made Americans toxic abroad for banks and potential business partners. If this case stands, it will represent yet another tightening of the ratchet. American expats will find that their ability to cross foreign borders (if they are outside the U.S.) or leave the U.S. has been dramatically curtailed or, in the latter case, ended.
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The case, Maehr v. U.S. Department of State, involved a challenge to the Fixing America’s Surface Transportation Act. Among other things, the FAST Act gives the IRS the power to notify the State Department if a taxpayer owes more than $50,000 in federal taxes — a sum against which the IRS has a tax lien. Once the IRS has certified that the taxpayer has such delinquent tax debt, the State Department is prohibited from issuing the taxpayer a new passport and has the authority to revoke a current one (subject to certain emergency or humanitarian exceptions).
The appellant, Jeffrey T. Maehr, owed $250,000 in federal taxes and subsequently had his passport revoked under the State Department’s FAST Act authority. Maehr then filed suit, challenging the Act’s tax provisions under the privileges-and-immunities clause of the 14th Amendment and the due-process clause of the Fifth Amendment.
The circuit judges primarily focused on the Fifth Amendment arguments — whether international travel is a fundamental liberty interest pursuant to the Supreme Court’s substantive-due-process doctrine and therefore requiring governmental restrictions to be reviewed with strict scrutiny. The majority held that, unlike the right to interstate travel within the U.S., international travel is not a fundamental liberty interest and restrictions imposed on it — including the revocation of passports pursuant to the FAST Act — should be judged by the lowest standard of review: rational basis. A third judge on the panel concurred, but advocated an intermediate-review standard for international-travel cases, noting centuries of common-law principles and precedents that tout the value of international travel and the right to seek another country’s citizenship while renouncing one’s own.
Nevertheless, if upheld by other federal courts, the holding dramatically expands the ability of Congress and the IRS to prevent Americans from leaving the U.S. to travel abroad or to permanently relocate.
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As mentioned, U.S. expats are already overburdened by our onerous tax regime. This includes stepped-up overseas Foreign Account Tax Compliance Act (FATCA) compliance and disclosure obligations, exit taxes payable by those who renounce U.S. citizenship (provided they meet certain net worth and income thresholds), and obligations to file foreign and U.S. federal-income-tax forms.
It doesn’t have to be this way. In fact, it isn’t this way for nearly every country in the world. Aside from the U.S., only Eritrea, reputedly North Korea (it’s complicated), and Hungary (for those without a second passport living in countries with which it does not have applicable tax treaties) have citizenship-based taxation regimes.
The consequences have already been felt. In 2020, 6,705 Americans chose to renounce their citizenship, a 260 percent increase from 2019 and the highest on record in a single year. Aside from being named and shamed by the IRS, these expats must pay a $2,350 fee and renounce in person at the U.S. embassy in their country of residence. Then, as referred to above, if an expat exceeds the IRS’s income thresholds or has a net worth of $2 million or more, he or she will face an exorbitant exit tax on top of other expenses and fees. U.S. citizenship-based taxation — particularly the burden of FATCA compliance — is a leading reason for U.S. nationals choosing to give up their citizenship. The State Department has estimated that there are some 9 million Americans living abroad. In a May 2021 report, CNBC noted that a recent survey had found that “nearly 1 in 4 American expatriates say they are ‘seriously considering’ or ‘planning’ to ditch their U.S. citizenship.” Four in ten of those blamed the filing requirements.
As referred to above, current law requires U.S. citizens to include details of their overseas financial assets with their federal tax returns irrespective of whether they live abroad or in the U.S. The reporting threshold is at least $200,000 for single filers living abroad and $50,000 for U.S.-domiciled filers. Furthermore, an American with a financial interest in or signature authority over foreign financial accounts must file a Report of Foreign Bank and Financial Accounts with the U.S. Treasury if the aggregate value of such accounts exceeds $10,000 at any time during the calendar year. All this adds an onerous layer of tax reporting, and there are harsh penalties for noncompliance.
Additionally, foreign financial institutions (FFIs), broadly defined to include any non-U.S. entity that (i) accepts deposits in the ordinary course of a banking or similar business or (ii) engages primarily in the business of investing, reinvesting, or trading securities, partnership interests, commodities or similar financial instruments, are effectively deputized by the IRS to submit extensive disclosure of the names, assets, and other financial information of American clients. Failure to comply could subject these FFIs to a 30 percent withholding tax on U.S.-sourced investment income. The net effect of these individual and institutional reporting requirements has been to make expatriate Americans pariahs for banks, insurance companies, pension funds, asset-management companies, and most every other financial institution necessary to engage with in order to live, work, start, or expand businesses abroad.
Seeking to catch a small group of tax cheats and make it harder to move or stash their money offshore, the FATCA, like so many ideas cooked up by governments to crack down on those who have broken their rules, has ensnared a large number of innocent, law-abiding citizens in its web. The FATCA, coupled with the obligation imposed on American expats to file U.S. federal tax returns regardless of whether they have any U.S.-sourced income — an obligation that flows logically from citizenship-based taxation — has pushed Americans living abroad with few ties to the U.S. to give up their citizenship.
To be sure, up to an annual $108,700 (for 2021) of foreign-earned income per person can be excluded by expats, but the paperwork burden remains intact. What’s more, that relatively low threshold (expat Americans also have to pay local taxes, of course, although they will get a credit for such taxes paid against any U.S. tax obligation) won’t be enough to dissuade some high-net-worth Americans abroad or even Americans still in the U.S. looking to relocate, start, or expand a business overseas to conclude that full expatriation is their best financial option. There is a reason that the “exit tax” — a measure with roots in Weimar Germany’s Reichsfluchtsteuer — is as draconian as it is. It is reasonable to assume that, without it, many more Americans would be renouncing their citizenship, something that underlines the basic unfairness of the U.S. regime.
The Maehr ruling compounds the harm from the FATCA and opens another front in the tax campaign against American expats or Americans still in the U.S. looking to shift their assets and/or businesses overseas. Whether or not international travel is incidental to the liberty interest in the Fifth Amendment, such travel cannot practically occur without passports or other travel documents. In other words, you cannot permit broad passport restrictions and maintain that there is a fundamental right to international travel. The two are incompatible.
And don’t think that this decision will only affect tax cheats. By holding against a fundamental liberty interest in international travel and allowing the federal government’s revocation of a delinquent taxpayer’s passport to be subject only to rational-basis review (citing, among others, Cold War–era cases involving passport restrictions for national-security reasons, including membership in Communist Party organizations), the majority in Maehr has opened the door to the IRS preventing Americans from traveling abroad — or restricting their travel while abroad — for myriad reasons beyond a deliberate failure to pay back taxes. What if a taxpayer made an errant, but immaterial disclosure or omission in a tax filing from years ago? What if that same taxpayer, still residing in the U.S., seeks entry into a complex overseas joint-venture, funding, or investment arrangement involving funds from another taxpayer who failed to report them to the IRS, exposing that taxpayer and that arrangement to penalties? Could the IRS, relying on existing law or utilizing new legislation from Congress, notify the State Department to revoke such taxpayer’s passport — whether for his errors, investment in the arrangement, or to pressure the offending taxpayer into compliance? The list of possibilities is long.
As renunciations reach new records, Maehr could not have come at a worse time. As a matter of policy, the U.S. government should use this opportunity to stop its tax war on American expats and those in the U.S. looking to transfer assets, or to start or expand businesses abroad — the overwhelming majority of whom are not tax cheats. Congress should pass new legislation either removing the IRS’s authority to compel the revocation of Americans’ passports in the FAST Act altogether or narrowing its scope. The harmful slippery slope created by Maehr should give greater impetus to efforts to repeal the FATCA, as a first step to ending citizenship-based taxation altogether in favor of the residence-based system used by virtually the entire world. The need to act has never been more urgent.