Does the IRS think you’re American?

Ronald,* a 31-year-old journalist, never thought that having an American mom would mean the tax authorities in the U.S. would be interested in him.

Here’s his dilemma: Ronald’s parents were Korean immigrants who became Canadian citizens. His mother obtained dual U.S.-Canadian citizenship when the family settled in Texas before eventually moving to Ottawa where Ronald was born. Under the advice of his parents — who believed it would open up job prospects — Ronald also got dual citizenship in his 20s, although he’s never lived or worked in the U.S.

“My only tie to the U.S. was a U.S. passport that I used to make it easier to travel to the U.S. for vacation,” he says. “I never worked there.”

So he was surprised to learn that any “U.S. person,” even a citizen of another country, needs to comply with tax obligations to the IRS. The U.S. is one of only two countries that taxes based on citizenship. That means that, even if you’ve never set foot on U.S. soil, you must still report to the IRS and potentially pay U.S. taxes if you’re considered a U.S. person.

“I was floored,” Ronald says. “I think of myself as a Canadian, and I didn’t realize that having that dual citizenship would make my tax situation so much more complicated.”

After consulting with his accountant, he began filing a U.S. tax return each year, complete with extensive reporting on each of his financial holdings. Moreover, because he had spent some time working in Europe, he was also duty-bound to report any previous income and financial information from his time overseas.

Who are U.S. Persons?

According to the U.S. State Department, an estimated nine million non-military U.S. persons are currently living abroad.¹ Many of these individuals acquired U.S. citizenship at birth because their parent was a U.S. citizen. No application was required — it happened automatically as a function of law. Others may have been born in the U.S. but moved away as young children. You may even be considered a U.S. person for tax purposes simply because you’ve spent a substantial amount of time there over the past few years.

“Many people, like Ronald, simply aren’t aware that you can still be considered a U.S. person even without significant ties to the U.S.,” says Nicole Ewing, Director, Tax and Estate Planning, TD Wealth. “If you’re unsure about whether or not you’re considered a U.S. person for tax purposes, you should speak to a tax specialist as soon as possible.”

What to do if you’re considered a “U.S. person”

If you do have to file a U.S. tax return, it may not necessarily mean that you will have to pay out more in taxes than you already do. The U.S. permits a foreign-earned income exclusion, which allows you to exclude approximately US$120,000 of earnings (in 2023) from income or self-employment income.² You can also earn a tax credit for taxes already paid in Canada. However, even if you don’t have to pay any additional tax, be prepared to spend considerably more time on your tax filings in the future.

If you are considered a U.S. person by the IRS, you may also want to adjust your tax planning strategies. Ewing says that there can be further complications for U.S. citizens on the Canadian side as well: “For example, under the U.S. taxation regime, U.S. persons may have U.S. tax issues investing in Canadian mutual funds or using a Tax-Free Savings Account (TFSA). With mutual funds it’s a burdensome compliance process but with TFSAs it’s additional tax since money that is tax-sheltered here may not be tax-sheltered in the U.S. Further, as a U.S. person, you are subject to U.S. estate and gift tax, so it may be wise to consult a cross-border tax specialist.”

What are the consequences if you don’t file?

Many people who aren’t sure about their U.S. person status might choose to ignore any possible responsibilities to the IRS, believing that the IRS won’t be the wiser. However, Canadian banks are required to report account information to the IRS for U.S. persons. If you fail to comply with tax filing and account reporting requirements, the IRS can enact harsh criminal penalties, says Ewing. A person who willfully fails to file a tax return could be subject to a prison term of up to a year, and a hefty fine if criminally convicted.³

Fortunately, as Ewing points out, you may utilize a voluntary disclosure process whereby U.S. tax filings and any other missing information can be filed with the IRS to account for any lapses in previous years. “It’s always best to become tax compliant with the IRS before they find out. That way, you can avoid penalties you may otherwise incur,” she says.

What happened to Ronald?

After Ronald realized he was responsible for filing a U.S. tax return each year, he decided that he might as well utilize his U.S. citizenship and started taking on work in San Francisco. But he still holds investments here in Canada and is concerned that tax planning and estate planning are going to be difficult. “At one point, I considered renouncing my U.S. citizenship,” Ronald says. “But then, I realized that U.S. citizenship does come with some advantages.”

Ewing cautions that renouncing U.S. citizenship might not be for everyone. “It’s a complicated process involving filing fees and a potential punitive exit tax,” she says. “It may be best to speak to cross-border tax and legal professionals about whether it makes sense for you before you do anything drastic.”

Ultimately, for people who are concerned about their tax status, the first step is to discover whether or not the IRS considers you a U.S. person. If you’re at all unsure, best to speak with your advisor or a tax professional who can guide you toward next steps.

*Ronald is a pseudonym