Now that the U.S. tax season is well under way, tax preparers all over the country are doling out appointments to those that live within our borders. But just what are the tax obligations and tax breaks, for U.S. citizens or green card holders living abroad?
Let’s completely dispel a common misconception at the outset: that if you’re a U.S. citizen or resident (what the Tax Code calls a “U.S. person”) and reside permanently in another country, you don’t have to file or pay U.S. federal taxes. That’s untrue, and in fact, U.S. persons living abroad have the same and in some cases enhanced tax and reporting obligations in comparison to U.S. residents.
That’s not the whole story. There are a few tax breaks existing for U.S. persons living abroad, such as the Foreign Earned Income Exclusion, the Foreign Housing Exclusion or Deduction, and the Foreign Tax Credit. But there are also numerous foreign reporting requirements with which U.S. persons must comply, and their impact is especially magnified for those living abroad.
Foreign Earned Income Exclusion
The Internal Revenue Code contains an “escape clause” for U.S. persons living abroad that allows you to earn up to $97,600 annually tax-free (2013, adjusted annually for inflation). If you’re married and your U.S. spouse accompanies you overseas, you can double this exemption and jointly earn up to $195,200 annually, free of U.S. income tax.
To qualify for the FEIE, you must still file a tax return, along with an extra form (Form 2555) even if you earn less than the maximum FEIE threshold.
Another FEIE limitation is that applies strictly to earned income, meaning wages, salary, self-employment income, tips, etc. The FEIE doesn’t let you exclude passive income, such as dividends, interest, capital gains, and so forth.
An essential element in the FEIE is where you perform a service. You might qualify for the exclusion, but you must meet one of two requirements.
1) You meet the “Bona Fide Residence Test” if you are a resident of a foreign country for an uninterrupted period that includes an entire “tax year” (generally, a calendar year). This qualification gives you greater freedom to return to the United States without jeopardizing the FEIE, but most filers don't meet this requirement in their first year abroad.
2) You meet the “Physical Presence Test” if you’re physically present in a foreign country or countries for 330 days in a 12-month period. The 12-month period does not have to be a calendar year, but you must count days traveling to and from the United States as U.S. days.
Foreign Housing Exclusion/Deduction
Another tax benefit for U.S. persons living abroad is the Foreign Housing Exclusion/Deduction. To qualify, you must again meet the Bona Fide Residence Test or the Physical Presence Test. If you’re a bona-fide employee working abroad, you may qualify for the exclusion, but self-employed U.S. citizens or green card holders can only receive a deduction. You apply the exclusion/deduction to earned income only, and the qualifying expenses are items such as rent, utilities, insurance, and the like.
To calculate how much income you can exclude or deduct, you must first calculate a number the IRS calls the “base housing amount.” This is 30% of the maximum FEIE for the tax year, computed on a daily basis for the number of days in the qualifying period that fall within the tax year. For instance, the maximum exclusion/deduction in 2013, where the FEIE was $97,600, would be $29,280. However, there is a higher limit in locations with a high cost of living, such as, say, Paris.
From this amount you must deduct something the IRS helpfully calls the “base housing amount.” For 2013, that number is $15,616, resulting in a “foreign housing cost amount” of $13,664.
Foreign Tax Credit
The Foreign Tax Credit (FTC) is a dollar-for-dollar credit against your U.S. income tax liability for income taxes paid while living or investing abroad. Unfortunately, U.S. persons living abroad can’t use the FTC for amounts excluded under the Foreign Earned Income Exclusion or the Foreign Housing Exclusion/Deduction.
On the plus side, though, you can carry back unused credits one year and or carry them forward 10 years. Also, if you live in a high-tax country such as Canada, the FTC can actually save you more in tax than the FEIE, but make sure you do the math before you choose one or the other.
Unfortunately, there are strict limits to the FTC. For instance, it doesn’t apply to social security taxes you pay in another country though some relief may be available if the country in which you reside has a Social Security “Totalization Agreement” with the United States. You’ll need a certificate of that coverage to qualify under such an agreement.
Foreign Reporting Obligations
U.S. persons, wherever they live, must report signature authority over, or financial interest in, foreign financial accounts, as well as report certain transactions and relationships with many types of foreign entities, including foreign corporations, foreign partnerships, foreign disregarded entities, foreign trusts and offshore mutual funds, which the IRS helpfully calls “Passive Foreign Investment Companies.”
Failure to comply with these reporting obligations can result in significant penalties. If you’re lucky, you might just get hit with a $500 “negligence” penalty, but in other cases, penalties start at $10,000 per failure to file, plus possible criminal sanctions. Also, don’t forget that there is no statute of limitations for failure to file any type of U.S. tax or reporting return.
Foreign Account Tax Compliance Act (FATCA)
Are we having fun yet? I certainly hope so, because I’ve saved the best (or worst, depending on your perspective) for last.
It’s called “FACTA,” and it became law on March 18th, 2010. FATCA creates a separate and overlapping reporting regime in addition to the one described in the previous section. It applies only to foreign financial assets, such as bank accounts, foreign securities, ownership interests in foreign entities and financial instruments or contracts with a foreign issuer or counterparty. The penalties for failing to comply with these requirements start at $10,000 per failure to file and as much as $50,000 if the failure continues after IRS notification. There’s a 40% penalty based on underpayment of tax attributable to unreported foreign assets.
Obviously, just because you live abroad in no way absolve you of your U.S. tax and reporting obligations., Given the current political climate “at home,” U.S. taxpayers living abroad can count on the government coming after each penny it feels it's owed. The complexities of reporting while living abroad can be difficult to sort through, as exampled illustrated in this brief survey. Make sure you have a team of tax professionals in place to sort through the details and make sure the taxpayer is in compliance.
(The Nestmann Group, Ltd. and its strategic partners can assist U.S. persons living abroad to set up a plan to exclude earned income to the applicable maximum, and insure compliance with all U.S. tax and reporting obligations. Contact us at info [at] nestmann.com for more information.)
Copyright (c) 2013 by Mark Nestmann