Top 10 reasons why US expats may owe tax to the IRS and what you can do about it
Ines Zemelman, EAJul-10-2016
Having to pay tax to the IRS after you already pay a high tax rate in your resident country is unpleasant. We get it. While we fight tooth and nail to ensure your tax position is optimized, sometimes there is no way to avoid paying tax. This may happen due to one of the following 10 reasons.
1) The most common reason is Net Investment Tax.
Affected individuals: taxpayers with high gross income.
You would owe tax if you have Investment Income from dividends, interest, stock transactions and your modified adjusted gross income is over the following thresholds. Modified Adjusted Gross Income (MAGI) is your gross income minus deductions and personal exemptions.
|Filing Status||Threshold Amount|
|Married filing jointly||$250,000|
|Married filing separately||$125,000|
|Head of household (with qualifying person)||$200,000|
|Qualifying widow(er) with dependent child||$250,000|
To avoid this tax you should either have a lower gross income or curtail your investment activity – both of which seem unproductive. So, you simply incorporate 3.8% net investment tax when you calculate your net return on investment.
2) The second most common reason is self-employment tax
Affected individuals: self-employed taxpayers living in the countries without the Social Security Totalization Agreement.
If you live in a country that has a Social Security Totalization Agreement with the U.S. then you are protected from duplicate contributions on net self-employment income. You pay only to the country of residence and get an exemption in the U.S. However - if your country of residence has not yet signed such agreement with the U.S., then you end up paying to both systems. In a positive twist, you will get a government pension in both countries when you reach retirement age, but while you work you will see the U.S. tax bill every year regardless of any exemptions, deductions and credits.
To avoid duplicate charge - consider incorporating your sole proprietorship. Then you will be considered an employee in your own company, and will no longer be subject to U.S. Social Security tax.
3) Difference in tax treatment of deferred compensation (contributions to foreign pension plan) in your country of residency and in the U.S
Affected individuals: taxpayers with employer-sponsored foreign retirement plans.
Again, rules are different depending on the tax conventions between the United States and the country where your pension plan is situated. If you have employer-sponsored retirement plan in the UK, Germany, Belgium, Netherlands or Canada – contributions to those plans are considered the IRS-qualified. Employer contributions to the plan as well as income accumulation are allowed for deferral as if those were U.S.-based plans. Retirement plan in any other country of the world is non-IRS qualified and therefore not allowed for deferral.
As a result, 5% or 10% or 20% of your earned income exempt from taxation in your country of residency is taxable in the U.S. This income is not allowed for the foreign earned income exclusion, although foreign tax credit still can be applied.
To avoid this you may switch your retirement investment goals towards the US-based plans. However, tax saving may not be substantiated by your long term investment goals.
4) Incidental high income (i.e. end-year bonus) with foreign tax payment not made and possibly not even assessed by the time of filing U.S. tax return
Affected individuals: recipients of lump sum income without tax withholding at source.
This tax is reversible, although this is a multistep process. First you have to file your tax return utilizing the longest possible extension through October 15. If by October 15th bonus tax has not been paid yet, file the return and pay U.S. tax due. Next year, you will file amended return and carry back foreign tax paid on that high income the following year. This is not a simple solution yet you will get back what you had overpaid. IRS will even pay you an interest on the money they “borrowed” for a year.
5) Alternative Minimum Tax (AMT)
Affected individuals: High income taxpayers with tax-preferenced income ( Capital gain or loss, depreciation; home mortgage interest, exercise of incentive stock options, net operating loss).
The AMT is what the name implies, an alternative method of tax calculation where certain tax benefits, i.e. reduced tax on capital gains are added back and tax saving turns into additional tax. Expats are rarely subject to AMT and most likely candidates are high earning individuals with filing status Married Filing Separately.
You can avoid AMT by using a different filing status if possible. Head of Household or Married Filing Jointly have much lower likelihood of AMT surcharge.
6) Liberal investment tax regime in your country of residence
Affected individuals: taxpayers residing in countries with no tax on certain types of investment income (Switzerland, Malaysia, New Zealand, Hong Kong).
Some countries apply high tax rates on earnings while investment income is tax free. If you paid 40% tax on earnings but 0% on dividends then you will owe tax in the U.S. even if you see that only part of the foreign tax available for credit was used. This happens because the principle of foreign tax credit – it has to be levied in the foreign country on the same income category. Therefore foreign tax levied on earnings cannot be used to offset U.S.tax on foreign dividends.
There is no double taxation here, you just cannot fully enjoy the liberal investment regime in your country of residency while having U.S. tax obligation.
7) Different tax legislation with regard to certain income types
Affected individuals: taxpayers realizing over $250K capital gain upon selling primary residence ($500K if filing married jointly).
In many countries, if you sell a house and buy another house within a short period of time, the capital gains are entirely tax free. In the U.S., capital gains from selling primary residence are exempt up to $250K per person. The time when you buy a new house does make a difference. Hence, if you sell your foreign house, realize capital gains of $450K, and invest the entire proceeds immediately to buy a new house – you can only exclude $250K and must pay U.S. tax on $200K capital gains.
You could not avoid tax but this is a one-time taxable event not likely to repeat next year unless you sell another appreciated real estate property.
8) Phantom income
Affected individuals: taxpayers selling real estate with the remaining mortgage repayment denominated in local currency devalued vs USD.
For example - in 2007 you took a mortgage denominated in local currency. At that time the value of the loan in $USD terms was $100K. You paid off half of the mortgage and sold the house 7 years later. In local currency you owe to the bank ½ of the borrowed principal amount. At this time, the USD has appreciated and in $US terms the amount of money you returned to the bank was only $30K because of local currency depreciation. The $20K difference is phantom income that you never received but have to pay tax on it.
To avoid this unpleasant situation you may choose to secure a loan in $USD terms.
9) U.S. State tax refund will turn into a taxable income if you itemized your deductions in the prior year
Affected individuals: taxpayers getting refund from U.S. state and claiming itemized deductions on federal return.
This is U.S. sourced tax not eligible for foreign tax credit.
To avoid tax be careful using itemized deductions again. If you use standard deductions then state refund will not be taxable the following year regardless of the refund amount.
10) Unexpected tax penalties
Affected individuals: taxpayers making ROTH contributions prior to having the draft of tax return prepared.
If you over-contribute to ROTH IRA you will pay penalty on excess contributions. First you have to withdraw excess contributions before the due date of filing tax return including extension. Then this tax will be eliminated. If not withdrawn by the due date, the penalty will continue to be assessed each year.
To avoid excess contributions and penalties next year do not make contributions until you have a draft of tax return prepared. You have time until April 15th of the following year to make contributions to the prior year. Do not rush making contributions and you will avoid the redundant paperwork and never will pay those penalties again.