Tax Planning

Another “Tax Attack” on U.S. Citizens Living Abroad

The United States is one of only two countries, and the only major country, that taxes its citizens, no matter where they live. If you haven’t lived in the United States in decades, you must pay tax on your worldwide income as if you never left. Even “accidental” U.S. citizens born overseas with at least one U.S. parent, who never set foot in the United States, must file U.S. tax returns. These laws affect every one of the more than 6 million U.S. citizens living abroad.

Ridiculous? Yes. But fortunately, the Tax Code contains an escape clause that allows you to earn up to $92,900/year tax-free (2011, adjusted annually for inflation) if you live and work outside the United States. If your spouse accompanies you overseas, you can double this exemption and jointly earn up to $185,800 annually, free of U.S. income tax obligations. You can also exclude or deduct some of your housing expenses from your gross income earned abroad.

These provisions are called the “foreign earned income exclusion” (FEIE), the “foreign housing exclusion (FHE),” and the “foreign housing deduction (FHD),” respectively. And, if the IRS and Congress have their way, they’ll soon be made more restrictive, if not eliminated altogether.

Our overseers in Washington, D.C. don’t view these provisions as a protection against double taxation—which is what they are. After all, nearly all U.S. citizens working abroad pay taxes on the local income they earn. Instead, Congress and the IRS perceive the FEIE as just another tax break, forgetting that most of these citizens have already paid foreign tax on the “excluded” amount.

A recent proposal for eliminating the FEIE came in the otherwise excellent “Back in Black” plan introduced by Senator Tom Coburn (R-OK) earlier this year. The Coburn initiative claims that the FEIE “subsidizes employers sending employees overseas” and “may work against U.S. domestic interests by encouraging highly compensated U.S. citizens to work overseas… expatriating U.S. intellectual capital and reducing U.S. tax revenue.” The report quotes a Congressional Budget Office study estimating that ending the exclusion would result in more than $70 billion in additional taxes over ten years. According to the CBO,

“One rationale for eliminating the exclusion for foreign earnings is that U.S. citizens with similar income should incur similar tax liabilities, regardless of where they live or what services they receive from the government. That principle is violated if people can move to low-tax foreign countries and escape U.S. taxation while retaining their U.S. citizenship. In addition, the existing exclusion represents an implicit subsidy to corporations that employ U.S. citizens abroad, because those companies can pay their employees less than they would if the income were fully subject to U.S. taxes. Moreover, ending the exclusion for foreign-earned income would lessen some of the complexity of the tax code.”

This so-called rationale ignores the fact citizens of every other major country need not pay tax on their earned income outside that country if they don’t live there. And it arrogantly asserts that the FEIE provides a tax subsidy to corporations employing U.S. citizens abroad. In reality, the FEIE merely helps level the playing field for U.S. citizens working abroad compared to citizens of any other country. In addition, wherever they live and work, U.S. citizens must also comply with the draconian reporting requirements for their foreign investments and businesses imposed by Congress summarized here. All these factors combine to penalize U.S. citizens living abroad, and make U.S. citizens—and by extension, the United States itself—less competitive internationally.

Without the FEIE, U.S. citizens working abroad only receive a tax credit for most income taxes paid to other governments. However, the foreign tax credit has numerous qualifications and exceptions. Many foreign taxes aren’t eligible for a tax credit, including property taxes, excise taxes, payroll taxes, and value-added taxes. While you can deduct most of these taxes from your taxable income, deductions are inherently less valuable than tax credits

But facts and logic may not stop Congress from eliminating the FEIE. In 1962, Congress first began taxing the earned income of non-resident U.S. citizens. It created the FEIE to partially offset the additional tax and compliance burden on those citizens. Ever since, in almost every congressional session, one or more bills are introduced to end or restrict it. Getting rid of the FEIE was part of the Wyden-Gregg bill in the last Congress. The Joint Committee on Taxation classifies the FEIE as a “tax expenditure,” and like the CBO projects huge but unrealistic tax revenues with its elimination.

In the meantime, the IRS is cracking down on taxpayers claiming exclusions or deductions from their income earned abroad. It’s set up five separate initiatives to find taxpayers who don’t qualify for part or all of the FEIE.

In a FEIE audit, the focus is often on whether you have a “U.S. abode.” Naturally, there’s no hard-and-fast definition. In general, the more connections you retain to the United States while living abroad, the more likely it is the IRS will conclude that you have a U.S. abode. This is particularly true if you have permanent U.S. ties, such as a dwelling or a spouse and children remaining in the United States while you work abroad. Unless you can demonstrate stronger ties to the country where you’re working than to the United States, the IRS may deny all exclusions or deductions from your earned income abroad!

There’s only one way to escape the insane dilemma that U.S. citizens working abroad face. That’s to legally and permanently end your future U.S. tax and reporting obligations via a legal process called “expatriation.” This process requires that you give up your U.S. citizenship and passport if you’re a citizen or your green card if you’re a permanent resident.

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