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Tax Guide
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Expat tax obligations

U.S. Income tax obligation while living abroad

As a U.S. citizen/green card holder residing abroad, you still owe U.S. taxes each year on your worldwide income. The U.S. has tax treaties with many countries which allows the federal government to exchange data on its citizens living in other countries for tax purposes. Under same treaties, residents or citizens of the United States are taxed at a reduced rate, or are exempt from foreign taxes, on certain items of income they receive from foreign income.

Tax position of U.S. Citizens overseas

The IRS applies taxation rules on the basis of the taxpayer nationality and not on the basis of their residence. US expatriates who meet the Physical presence test or meet the Bona fide resident test may be able to take advantage of the Foreign earned income exclusion and or the Foreign housing exclusion.

You are considered physically present in a foreign country (or countries) if you reside in that country (or countries) for at least 330 full days in a 12-month period. You can live and work in any number of foreign countries, but you must be physically present in those countries for at least 330 full days. The qualifying period can be any consecutive 12-month period of time. A "full day" is 24 hours; days of arrival and departure are generally not counted in the physical presence test.

A person is considered a "bona fide resident" of a foreign country if they reside in that country for "an uninterrupted period that includes an entire tax year." A tax year is January 1 through December 31. Brief trips or vacations outside the foreign country will not jeopardize status as a bona fide resident. If the foreign government concerned has determined that a person is not subject to their tax laws as a resident, the Exclusions will not be available.

US citizens and resident aliens who are outside the United States (and its possessions) have the same requirements to file tax returns as anyone living in the United States. Income from worldwide sources must be considered when determining if a federal tax return must be filed. In general, foreign earned income is income received for services performed in a foreign country.

If you pay foreign taxes, it may be possible to offset these against US taxes if there is a double tax treaty with the country in which you are resident. The concept of 'tax home' is used in connection with foreign residence. Generally, a person's tax home is the general area of her main place of business, employment, or post of duty where she is permanently or indefinitely engaged to work. A person is not considered to have a tax home in a foreign country for any period during which their abode (the place where they regularly live) is in the United States.

Foreign earned income exclusion

If you are a full time resident abroad for a full calendar year, or live there for 330 days out of any consecutive 12-month period, you can exclude up to $91,500 of earned income from U.S. Income Taxation for 2010. If you are married, and both of you earn income and reside abroad, you can also exclude up to another $91,500 of your spouse's income from taxation. These exclusions can only be claimed by filing a tax return and are not automatic if you fail to file your Form 1040 for the applicable year (as well as the appropriate forms claiming this exclusion). Earned income is income you earn for your work or services and does not include rental income, dividend or interest income, or other types of income that are not paid for your own personal efforts. You can also claim an additional exclusion or deduction for your foreign housing expenses exceeding a standard amount established by the Federal Government.

A person who claims the Exclusion cannot claim any credits or deductions that are related to the excluded income, for instance a foreign tax credit or deduction for any foreign income tax paid on the excluded income. The earned income credit is also unavailable. Furthermore, for IRA purposes, the excluded income is not considered compensation and, for figuring deductible contributions in an employer retirement plan, is included in modified adjusted gross income.

The IRS confirmed that: "Effective for tax years beginning after 2005, the amount of foreign earned income (and foreign housing costs) excluded from an individual gross income will be used for purposes of determining the rate of income and alternative minimum tax (AMT) that applies to his or her non-excluded income." The Tax Increase Prevention and Reconciliation Act of 2005 (P.L. 109-222) addded a new section 911(f) to the Internal Revenue Code. An individual tax will be the excess of the tax that would be imposed if his or her taxable income were increased by the amount(s) excluded, and the tax that would be imposed if his or her taxable income were equal to the excluded amount(s).

"For this purpose, the excluded amount(s) will be reduced by the aggregate amount of any deductions or other exclusions otherwise disallowed. In many cases this will have the effect of increasing an individual U.S. federal income tax to an amount greater than it would have been under prior law."

Beginning with tax year 2006, a qualifying individual claiming the foreign earned income exclusion, the housing exclusion, or both, had to calculate the tax on the remaining non-excluded income using the tax rates that would have applied had the individual not claimed the exclusions.

Generally, a qualifying individual's initial choice of the foreign earned income exclusion must be made with one of the following income tax returns:

  • A return filed by the due date (including any extensions),
  • A return amending a timely-filed return. Amended returns generally must be filed by the later of 3 years after the filing date of the original return or 2 years after the tax is paid, or
  • A return filed within 1 year from the original due date of the return (determined without regard to any extensions).

Foreign income exclusion is not an excuse for non-filing

It is a common mistake to believe you do not have to file a tax return if you make less than the foreign earned income exclusion. You can only take the exclusion by filing a return. If you are caught for not filing, you may not be allowed to use the exclusion.

Foreign tax credits

Foreign taxes paid by a US taxpayer can often be credited against US tax liability or deducted in figuring taxable income on a US income tax return. It is often better to claim a credit for foreign taxes rather than to deduct them. Whereas a credit reduces US tax liability, with any excess able to be carried back and carried forward to other years, a deduction reduces taxable income and may be taken only in the current year. All foreign income taxes must be given the same treatment; it isn't permitted to deduct some foreign income taxes and take a credit for others.

In order to take a foreign tax credit, Form 1116 should be filed with Form 1040. Form 1116 is used to figure the amount of foreign tax paid or accrued that can be claimed as a foreign tax credit. The foreign income tax on which a credit can be claimed is the amount of legal and actual tax liability paid or accrued during the year.

A foreign tax credit cannot be claimed in respect of tax that would be refunded by the foreign country if applied for, or if the foreign country returns tax payments in the form of a subsidy. Credits cannot be claimed in respect of foreign taxes paid on income that is excluded from a US tax return.

Foreign tax credits are limited to a proportion of total US tax liability equal to the proportion formed by taxable income from sources outside the United States of total taxable income. Foreign tax credits are figured separately in relation to different types of income, including: passive (investment) income; financial services income; shipping income; dividends from a domestic international sales corporation (DISC); lump-sum distributions from employer benefit plans; and section 901(j) income.

Expenses (such as itemized deductions or the standard deduction) not definitely related to specific items of income must be apportioned to the foreign income in each category in the proportions that the various types of income form of total income.

The foreign tax credit and deduction, their limits, and the carryback and carryover provisions are discussed in detail in IRS Publication 514, Foreign Tax Credit for Individuals. Taxes for Expats can help you claim Foreign Tax Credits that can be used to partially or completely offset U.S. taxes that accrue on this same income. In higher tax countries, you will accrue such tax credits faster than you will ever be able to apply them; in lower tax countries, you will likely be able to apply most or all such tax credits against U.S. tax liability on this same income.

U.S. Tax treaties with over 60 countries

The U.S. has Tax Treaties with over 60 other countries. A Tax Treaty is complex and includes many provisions that can benefit any U.S. taxpayer. Tax Treaties codify the objectives of reducing or eliminating double taxation of your income by both countries via reciprocal foreign tax credits (see previous section). Individual tax treaties also address tax issues specific to the two countries involved. If you file your tax return each year while living abroad, the statute of limitations for IRS audits will expire three years after you file those returns. That means the IRS cannot go back (unless there is evidence of fraud) and attempt to audit or change those returns later. You may want to consider filing your return even if you have no income or don't owe taxes in order to force the statute of limitations to run out, thereby eliminating any future problems when you decide to return to the U.S.

U.S. Social security, medicare, and self-employment taxes

If you are an offshore employee of a U.S. corporation, that employer will normally withhold Social Security and Medicare taxes on your W-2 earnings. If you are working for a U.S.-based employer in one of the 20-plus countries with which the U.S. has established a Social Security Totalization Treaty, you may cite a closer connection to the foreign country and participate in that country social insurance system, and not have U.S. Social Security and Medicare taxes withheld from your U.S. pay.

If you are a bona fide employee of a foreign employer and are subject to foreign laws governing their social security tax, you are not required to pay U.S. Social Security tax. If you are self-employed (an independent contractor), you are obligated to pay, in addition to your income tax, a U.S. Self-Employment tax that is both employer and employee share of Social Security and Medicare taxes. You must file a Schedule C with your U.S. tax return and pay U.S. Self-Employment Tax on your net earnings by filing a Schedule S-E. The Self-Employment Tax rate is 15.3% of net Schedule C income before any foreign income exclusion and the taxable net self-employment rate is not reduced by the previously mentioned foreign tax credits. Net earnings are income after all legal business expenses are deducted and include the income earned both in a foreign country and in the United States.

Due date of tax return

If you have your personal permanent residence abroad on April 15th of any year, you get an automatic extension to file your tax return for the previous calendar year until June 15th. If you need more time, you can file further extension requests which can extend the due date of your tax return until October 15th. If you owe taxes, and fail to pay the estimated taxes by April 15th, you will be subject to interest and penalties for that underpayment. However, those penalties are not as severe as those imposed for failing to file your tax return in a timely manner. It is therefore advisable to always file an extension if you are going to file your return later than April 15th, even if you do not have the money to pay your estimated taxes at the time.

Avoiding penalty and interest on tax due

Even if you file an extension to October 15th, instead of April 15th, to file your US Income Tax Return, be aware that interest and underpayment penalty are charged as of April 15th. Further, the IRS can assess underpayment penalty (and interest) if the tax due is paid by April 15th, but no (or insufficient) estimated tax payments or withholding were made prior to paying the balance due on April 15th. This is because tax law requires sufficient regular payment or withholding (or combination) to be done through out the tax year in order to avoid ALL underpayment penalties.

Do you have additional questions?

Taxes for Expats can help you with any additional questions you have about your particular situation. Contact us today for a no-obligation consultation!

Below we enclose the IRS paper that provides further detail on this topic.

Tax guide for US citizens and resident aliens abroad