The United States is one of the very few 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. Beneficiaries of a deceased U.S. citizen living abroad must prepare a U.S. estate tax return and possibly pay estate tax, even if they're non-U.S. citizens who have never lived in the United States.
Ridiculous? Yes. But fortunately, the Internal Revenue 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. This provision is called the "foreign earned income exclusion" (FEIE).
Don't have an overseas job? You may still qualify for the FEIE if you have sizeable liquid assets that you can manage offshore in the appropriate foreign entity and pay yourself a salary as a portfolio manager out of the income those assets generate.
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.
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. If you're self-employed, you can only take a deduction for housing expenses.
In most cases, the maximum housing exclusion is $13,006 (2011 limit), although the exclusion is higher in certain high-cost locations. If you're married and both you and your spouse are working offshore, only one spouse can exclude housing expenses, unless you maintain separate households. Still, in combination with the FEIE, that gives you nearly $200,000 of income each year you can legally exclude from U.S. taxation.
To qualify for the FEIE, you must prove that you have a new "tax home" outside the United States; i.e., a jurisdiction that can tax your income on the basis of residence or other ties. There is no requirement that you live in a country that actually imposes an income tax. You must also file a U.S. tax return, along with IRS Form 2555.
In addition, you must qualify under one of two tests to be eligible for the FEIE:
* Physical presence test. You qualify under this test if you're physically present in a foreign country or countries for at least 330 full days during any period of 12 consecutive months.
* Bona fide residence test. If you have established legal residence in another country for an uninterrupted period of at least one calendar year (January 1-December 31), you qualify under this test. You must also be either a U.S. citizen or a U.S. resident alien who is a citizen of a country that has an income tax treaty in effect with the United States.
If you qualify for the FEIE under the bona-fide residence test, you must not spend so much time in the United States that your intention to be resident in another country isn't clear. According to the instructions for IRS Form 2555:
No specific rule determines if you are a bona fide resident of a foreign country because the determination involves your intention about the length and nature of your stay. Evidence of your intention may be your words and acts. If these conflict, your acts carry more weight than your words. Generally, if you go to a foreign country for a definite, temporary purpose and return to the United States after you accomplish it, you are not a bona fide resident of the foreign country. If accomplishing the purpose requires an extended, indefinite stay, and you make your home in the foreign country, you may be a bona fide resident.
While U.S. Social Security and Medicare taxes don't generally apply to wages for services performed outside of the United States, if you're self-employed or work for an "American employer," you're subject to Social Security and Medicare tax on the same proportion of your earned income as you would in the United States. You also may be subject to these taxes if you work in a country with which the United States has signed a "totalization agreement."
If you don't qualify for the FEIE, you can take either a tax credit or a deduction for income taxes imposed on you by a foreign country. However, you can't credit or deduct foreign income taxes on income exempt from tax under the FEIE or the foreign housing exclusion. If the taxes are higher in a foreign country than what you would pay on the same income in the United States, you can only take a credit for the equivalent tax you would pay in the United States. In that event, the foreign tax credit will be more valuable than the FEIE.
Confused? We can help. Please contact The Nestmann Group, Ltd. if you believe you might qualify for the FEIE.
Copyright (c) 2011 by Mark Nestman