TAXING ISSUES Tax

Considerations For American Families In The United Kingdom

The following is designed to provide general tax information for Americans living abroad or contemplating a foreign move. As with all tax and legal issues, seeking tailored advice from qualified counsel is advisable.

Complicating factors abound, but American families in the United Kingdom have options to ensure they keep financial plans heading in the right direction despite the added nuance. The approach includes optimising the annual US tax filings, maximising tax incentives collectively offered by both countries, and determining if there are ways to ease the pain for children who may love apple pie and the New York Yankees, but remain oblivious to the dark side of the blue passport.

Filing Status

With tax returns generally filed separately by spouses in the United Kingdom, the concept of combining family income will primarily focus on US tax attributes. Filing status is a straightforward determination for American families abroad when both spouses are US citizens or permanent residents. The same decision-making factors facing US-based families will predominantly apply with joint US tax returns often providing a more favourable outcome.

Yet, when only one spouse is a US citizen, limitations on the ability to optimise filing status will follow. By default, an American taxpayer married to a nonresident will be obliged to use the Married Filing Separately (MFS) filing status. Primary disadvantages for those using this status include:

1. Higher tax brackets. The top tax rate of 37% kicks in for MFS at $323,925, whereas single taxpayers do not hit this threshold until $539,000, and jointly filing taxpayers at $647,850 (2022).

2. Lower annual tax filing threshold. Taxpayers using MFS status must file a US tax return each year if total income is greater than $5. Other Taxpayers may not need to file unless their income is more than the standard deduction amount for that year, $12,950 for single Taxpayers and $25,900 for those filing jointly (2022). Different thresholds will apply to self-employed individuals and those over age 65.

3. Elimination of certain tax credits and deductions. Taxpayers using MFS status will generally be limited from claiming the Child and Dependent Care Credit or education credits, such as the American

Opportunity Credit or Lifetime Learning Credit. Deductions for tuition or student loan interest are also unavailable.

4. Lower threshold for Net Investment Income Tax. The threshold for the 3.8% NIIT, which cannot be offset by British taxes paid, is set at $125,000 for MFS taxpayers, whereas single filers do not pay until $200,000 and joint filers at $250,000.

5. Limitations on Roth contributions. MFS filers cannot contribute to a Roth IRA if income is greater than $10,000, thus rendering such accounts largely unavailable. Given that high rates of tax are assessed in the United Kingdom and incomes are not combined locally when determining tax liability, the true disadvantages of MFS filing status may be unimpactful to the bottom line. However, when one of the restrictions described above does prove problematic, two options may permit a more favourable filing strategy.

The Head of Household filing status is available for those who pay more than half the cost of maintaining a home for a dependent child. Generally, married taxpayers must be living apart from their spouse to use this filing status; however, when a spouse is nonresident during any portion of the year, the Taxpayer is “considered unmarried” for Head of Household purposes.

Determining which spouse is paying more than half of household support will often be a straightforward determination. In borderline cases, keeping good records and structuring finances to ensure that the American spouse’s support is being allocated directly to household expenses will be helpful.

Americans may also elect to file a joint US tax return with a nonresident spouse. The result of the election is that the nonresident spouse is subsequently classified as a US resident for tax purposes, taxable on his or her worldwide income. Given the notoriety as the most challenging tax status on planet earth, this may be a difficult sell and starting the conversation with some hard and fast numbers is likely to be the best approach here.

Every situation is unique but families in certain scenarios may be able to use such an election to bypass limitations or incremental tax liabilities created by MFS status, such as inability to make contributions to a Roth IRA or exposure to NIIT due to the lower threshold.

Making such an election requires careful consideration of future tax planning for the family. Importantly, many of the challenges American investors face with respect to stocks and shares ISAs and the dreaded PFIC tax exposure would thereafter be encountered by a nonresident spouse. For example, the election would undermine any strategy that would leverage a spouse’s nonresident status to pursue local savings incentives that would be toxic for a US taxpayer to maintain.

The election remains in effect in later years until revoked and can only be made once by both spouses. If made and subsequently revoked, the joint filing election will be eliminated from future tax planning opportunities that may arise as retirement approaches. A long-term view of this election should be taken.

US Tax Credits

As a general matter, the high rates of British tax and the ability to claim foreign tax credits will mean that the economic impact of any tax credit is often lost unless the credit is “refundable” and can be paid out as a cash outlay beyond the tax liability for the year. Notable credits available to American expats that contain this feature are the Additional Child Tax Credit and American Opportunity Credit.

Nevertheless, scenarios can arise where a nonrefundable credit reduces US tax exposure in a manner that does not drive an incremental UK tax liability. For example, though the amounts have been steadily reduced in recent years, the United Kingdom offers more generous specific exemptions for different types of investment income than may be available on the US side. An American opting for remittance basis taxation in the UK may also be in a better position to improve tax outcomes with nonrefundable US tax credits.

Examples of common nonrefundable credits include the Child and Dependent Care Credit, Credit for the Elderly and Disabled, Adoption Credit, Lifetime Learning Credit, and Saver’s Credit. Understanding the overall impact of these tax benefits from a cross-border perspective is important.

With nonrefundable credits often providing minimal benefit to those paying a high rate of British tax, determining eligibility for the Additional Child Tax Credit is crucial for American families abroad. This benefit was expanded significantly in 2017 and is currently available to those filing jointly with income below $400,000 and single taxpayers with income below

$200,000. The refundable payment totals $1,500 per child below the age of 17.

This refundable credit will reduce NIIT and any excess is paid out as a tax refund. Please note the higher income thresholds established in 2017 are to sunset in 2026 without legislative action.

Owning The Family Home

The US and UK tax systems incentivise ownership of a family home; however, the rules in place on both sides of the pond are not identical. The incentive gap can create scenarios for American families where tax is due in one country, but not the other.

In the United Kingdom, gain is fully excludable from capital gains tax, provided the property had been used as a main home during the entire period of ownership. The ownership period is allocated between time as a main home and the period of nonqualifying use, with only gain attributable to the nonqualifying period being subject to UK tax at a rate of 18% for basic rate Taxpayers and 28% at the higher rate.

In the United States, taxpayers may exclude up to $250,000 in gain ($500,000 for married taxpayers filing jointly) from the sale of a main home, provided they owned and used the home as a principal residence for two of the prior five years before the home sale.

Accordingly, if significant gain were to be produced from the sale of a British home or, alternatively, a home with a period of nonqualified use produces gains below the relevant US exclusion threshold, a one-sided tax liability could be produced.

Tax paid on the sale means less to reinvest in a new home. With the profound impact ownership of a family home can have on the ability to build wealth, taxes should not arise unexpectedly.

Education Savings And State Residency

State residency following a move from the United States will be a subjective and heavily nuanced issue for families that contemplates the length of the stay in the United Kingdom, specific attributes of the family and business, and the state where ties are maintained. Given the challenges faced in many states with reducing state-level tax on income earned abroad, efforts are often taken to break residency in the home state to avoid a continued tax liability on already highly taxed British source income or investment earnings.

A family moving to the United Kingdom on an indefinite basis, with no specific plans to return stateside, is often in a position to break residency in the state where they were living prior to the move. This change does have the potential to reduce overall tax exposure, but families who have been thinking about US colleges for their children would want to understand whether such a change could result in-state tuition rates becoming unavailable.

US education savings plans are generally ineligible for the same tax protection granted to pensions and ISAs in the United Kingdom, meaning the opportunity for tax-free growth on higher education savings could also be undermined. Furthermore, the deduction for contributions to these arrangements is claimed at the state level and would be neutralised if US state tax returns were no longer being filed. Following a mid or long-term move to the United Kingdom, strategies to change how contributions for education savings accounts are made in the United States and analysing the potential of converting such an arrangement to an IRA or leveraging it for pre-university education expenses may be worthwhile.

Accounts And Investments For US Children

Challenges with US-based education savings plans would logically lead to the pursuit of UK savings options for children, such as Junior ISAs or Childrens Bonds. Helping a child start saving for the future as early as possible does not need to be deterred by potential tax or reporting issues that would follow. As with all other decisions in this space, the approach will undoubtedly be a bit different than it will for US-based families.

US citizens can gift children up to $16,000 annually without triggering a gift tax return and even after that threshold is passed, gift tax is not due until the significant lifetime gifts are made. Similarly in the United Kingdom, a gift is not subject to any transfer tax unless the donor passes away within seven years of having made the gift. But keep in mind that a child receiving a gift from a nonresident parent or relative will be required to disclose it on Form 3520 if the amount received during the year exceeds $100,000.

Accounts and investments owned by US citizen children will encounter essentially the same tax and financial reporting obligations as those held by their parents. Moreover, tax rules will require in many situations that investment earnings of children be taxed at the respective tax rates of their US parents. An election can be made to include a child’s investment income on a parent’s tax return to avoid a separate filing being needed for their child. Otherwise, a US citizen child would need to file a tax return in the United States if their investment income is greater than $1,150 (2022) annually.

To complicate matters, as clarified by our friends with the Financial Crimes Enforcement Network (FinCEN), “… a child is responsible for filing his or her own FBAR report. If a child cannot file his or her own FBAR for any reason, such as age, the child’s parent, guardian, or other legally responsible person must file it for the child”. The notion of child being assessed FBAR penalties on their Junior ISA raises a single eyebrow for all, but the requirement to file is clear nonetheless.

Unlike with US tax return filings, there is not an option to include a child’s accounts on a parent or guardian FBAR. A minor child with title to accounts valued greater than $10,000 does need to file an independent report on Form FinCEN 114. In fact, US citizen parents who maintain signature authority over these same accounts may need to report them on their personal foreign bank account report as well so the account may need to be reported twice.

The long-term benefits of helping children to start saving early cannot be denied. Fortunately, optimising tax and reporting considerations in pursuit of this goal is a very real possibility.

Conclusion

The additional layer of complexity surrounding tax decision-making for families may lead parents to question whether to pass these complexities on to their children. While citizenship is often conferred automatically when a child is born abroad to US citizen parents, there are scenarios where parents may be faced with the choice of whether to proactively pursue US citizenship for children who are likely to maintain minimal ties to the country going forward.

Considering the difficulty in predicting how having a US passport may benefit or impact a child in the future, the normal expatriation rules provide relief for children until the age of 18 ½, thus giving them the flexibility to make the decision for themselves in the future without facing exposure to classification as a covered expatriate if they choose to relinquish their US citizenship status.

Despite the potential banking and savings challenges faced by US citizens in general, families who would benefit from child tax credits while living in the United Kingdom may not want to leave this support on the table. Ultimately, this decision is highly personal and must reflect on many details beyond simply tax matters.

Roland A.

Sabates Managing Member, Expat Legal Services Group

Expat Legal Services Group serves the American expat community in the areas of international tax, immigration law, and cross border business and estate planning, leveraging a suite of modern technology solutions.

Contact Expat Legal Services Group today at info@expatlegal.com or visit the website at www.expatlegal.com.

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