Other than Hungary, the United States is the only major country that taxes its citizens, no matter where they live. 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.
Fortunately, the Internal Revenue Code contains an escape clause that allows you to earn up to $95,100/year tax-free (2012, 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 $190,200 annually, free of U.S. income tax obligations. This provision is called the “foreign earned income exclusion” (FEIE).
You can also exclude or deduct some of your housing expenses from your gross income earned abroad. The exclusion applies to housing expenses paid for by your employer. Non-taxable fringe benefits to a U.S.-based employee are also non-taxable overseas. Your employer can pay for your health insurance, or contribute to a retirement plan, with no additional tax liability. For more information on the FEIE, see this post.
Unfortunately, the FEIE doesn't reduce the compliance burden non-resident U.S. citizens face in dealing with U.S. reporting requirements. Nor does it make it any easier to deal with the increasing barriers they face in banking or doing business offshore.
In addition, in almost every congressional session since the FEIE came into existence in 1962, proposals have emerged to scale back or eliminate this supposed "tax break"—which wouldn't be necessary at all if Congress didn't impose citizenship-based taxation on U.S. expats. In 2011, the Congressional Budget Office estimated that ending the FEIE would reduce the U.S. deficit by more $70 billion over a 10-year period.
Now, in negotiations over the "fiscal cliff," the FEIE is once again in the spotlight. The latest proposal is H.R. 6474, which calls for a five-year phase-out of certain "tax expenditures," including the FEIE. Basically, income excludible from U.S. tax under the FEIE would fall 20% annually from 2012 and end permanently in 2017.
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.
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.
There’s only one way to escape the insane dilemma that U.S. citizens working abroad face. That’s to end legally and permanently 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. Obviously, it requires that you have a passport from another country other than the United States.
If you're interested in expatriation, we can help. My firm has helped dozens of clients acquire second passports and subsequently expatriate. For more information on expatriation, see my special report, The Billionaire’s Loophole, available here.
Copyright © 2012 by Mark Nestmann