Dummies Guide -- US Taxes Abroad Introduction and Overview You're a US citizen or a green card holder and you live somewhere outside the USA (i.e., in a "foreign" country). You may have US tax filing obligations if you have personal income such as wages, salary, commissions, tips, consultancy fees, pension fund, alimony, US or foreign social security, interest, dividends, capital gains, rental property, farm income, royalties, inheritance, or payment-in-kind, whether from the US or abroad. You may have US tax filing obligations even if you haven't been to the USA or left several years ago and all your income is from "foreign" (non-us) sources. You may have US tax filing obligations even if some or all of your income was already taxed at source or is going to be taxed by a foreign country. You may have US tax filing obligations even if you aren't earning any money but are married to someone who did have income. Basically, you have to file a US tax Form 1040 for the previous year if your income was above a certain threshold. These thresholds are the same as for US residents. For tax year 2013 (filing in 2014) the thresholds (total yearly gross income) are: Under 65 65 or older You are single (unmarried) $10,000 $11,500 You are married filing jointly $20,000 $21,200 You are married filing separately $3,900 $3,900 You are filing as "Head of household" $12,850 $14,350 You are a widow or widower $16,100 $17,300 The Form 1040 is due April 15th, with an automatic extension to June 15th for Americans resident abroad. If any taxes are due, however, interest is calculated starting April 15th up to the payment date. Thus, tax obligations for US citizens and green card holders living and working in a foreign country continue even though they are no longer living in the USA. US tax issues become more complicated when an American moves overseas. Many Americans living abroad are married to non-us nationals, making their US tax situations even more complex. Here are some basics to help you navigate the US tax maze: Once above the gross income threshold discussed previously, any US citizen or any person holding a green card has the obligation to file US tax returns and to pay all US taxes. In the case of a green card holder, this remains so even if the green card has expired and the individual has not returned to the USA for many years. Any person wishing to abandon a green card must undertake certain steps from both a US immigration law perspective and a US tax perspective in order for the relinquishment to be recognised in the eyes of the law. In certain cases, the failure to do the right things required under the tax laws can mean continued US taxation as a US resident or imposition of very harsh tax consequences under the so-called expatriation rules. Proper tax advice should always be sought. It is very important that US (and if necessary, State) tax returns are properly prepared when overseas since so-called foreign exclusion amounts are involved. The tax return for the first year living in a foreign country is a bit more complicated and the use of a professional is highly advisable for return preparation for that first year overseas. The Internal Revenue Service (IRS) is now very rigorous in assessing tax penalties and auditing overseas Americans. Given the current US tax landscape, there is no room to make mistakes. Foreign Earned Income and Housing Exclusions 1
Individuals living and working abroad have two basic methods by which they can reduce US tax by a substantial amount. Both of these will be fully discussed us of the Foreign Earned Income Exclusion (FEIE), and /or use of the Foreign Tax Credit. Americans working abroad may be eligible to exclude certain foreign earned income (wages, compensation for services) from US taxable income under the rules governing the FEIE, and certain foreign housing costs paid by their employers. The exclusions apply regardless of whether any foreign tax is paid on the foreign earned income or housing amounts. These exclusion benefits can be claimed only if a US tax return is filed within certain time deadlines. Those who have dropped out of the tax reporting system risk losing these valuable tax benefits unless prompt action is taken to correct the filing situation. They are also at risk for very harsh penalties including so- called FBAR penalties. Professional advice should be sought in such a situation. Common mistakes: Not filing a tax return even if income is under the FEIE threshold Including non-earned income in the FEIE threshold calculation (for example, interest dividends) Not including in the calculation of income, contributions made by a foreign employer to an unqualified pension plan Making IRA contributions when there is no income or not enough income subject to tax because of the FEIE. The FEI Exclusion amount is adjusted annually for inflation. This amount for 2013 it is $97,600. Note: earned income means just that income that is earned for services performed. It does not include any other types of income, for example, such as dividends or interest. If a couple is married, each spouse can claim the full FEIE amount (e.g., for 2013, each spouse can exclude up to $97,600 of his or her earned income). If one spouse does not earn enough salary to fully utilize the exemption amount and has excess FEIE, this excess cannot be used by the other spouse to exclude amounts beyond his or her own exemption. Foreign Housing Exclusion A foreign housing exclusion (FHE) is available for certain amounts of overseas housing expenses paid or reimbursed by an employer. Allowable housing expenses are the reasonable expenses (such as rent, utilities other than telephone charges, and real and personal property insurance) paid or incurred during the year by the taxpayer and reimbursed by the employer, or paid on the taxpayer s behalf, for foreign housing (including those of the spouse and dependents if they lived with the taxpayer). The rental value of housing provided by the employer in return for services can also be covered by the FHE. Allowable housing expenses do not include the cost of home purchase or other capital items, wages of domestic servants, or deductible interest and taxes. The FHE is computed by calculating the difference between two numbers: 1. A ceiling amount which is generally 30 percent of the FEIE unless a higher ceiling amount applies because the taxpayer lives in a high- rent city designated by the IRS (there are many such cities listed by the IRS; IRS publishes the ceiling amounts annually) and 2. A base housing amount which is 16 percent of the FEIE. The difference represents the maximum amount of housing allowance that can be excluded from income. Note: the exclusion does not apply if you own your home and are paying a mortgage. Tax Home and Other Qualification Tests For an individual to qualify for the FEIE and FHE, a tax home must be maintained in a foreign country and either the Bona Fide Foreign Resident (BFR) or Physical Presence Test must be met. Generally, a tax home is the location of the main place of business, irrespective of where a family home is maintained. If the nature of a person s work means that there is no regular or main place of 2
business, then the tax home may be the place where the person regularly lives. A person is not considered to have a tax home in a foreign country if the person s household is maintained in the US. Temporary presence in the US (for example, for vacation or for employment), does not necessarily mean that the household is in the US during such time. The BFR Test To meet the BFR Test, a person must be a bona fide resident of a foreign country for an uninterrupted period which includes a full calendar year. A resident is one who, based on the facts and circumstances, has established a tax home and has in effect settled in that country. Green card holders living in a foreign country can also qualify under the BFR Test under certain circumstances, but they should obtain professional advice before claiming the FEIE as this may jeopardize the green card or future US citizenship under the US immigration rules. The first year overseas, it is common that the BFR Test criteria cannot be met because the taxpayer has not been living in the foreign country for an uninterrupted period which includes a full calendar year. In this case, a taxpayer might plan to satisfy the Physical Presence Test to maximize the exclusion, or apply for an extension of time to file the tax return until the taxpayer has stayed in the foreign country for a full calendar year in the following year. The Physical Presence Test To meet the Physical Presence Test an individual must be a US citizen or a resident alien, who is physically present in a foreign country or countries for 330 days in any 12 consecutive months. The 330 days do not have to be consecutive, but they must be whole days present in a foreign country. Travel time does not count toward the requisite 330 days if the travel is in the US or its possessions for periods of 24 hours or more, or takes place over international waters. Recordkeeping is critical. The Physical Presence Test often helps an individual on short assignment. It also enables an individual to come back to the US for short periods (generally up to one month) in any consecutive 12- month period and still qualify for the exclusions. Filing a Tax Return and Claiming Exclusion Benefits The exclusion benefits can be claimed only if a federal tax return is filed within certain time deadlines. Many Americans are under the mistaken belief they do not need to file returns if their income is below the exclusion thresholds. They risk losing the benefits completely unless corrective action is taken. The IRS website has all the relevant tax forms and other useful information: Click here Delinquent taxpayers may claim the exclusions even if they did not file their tax return within the certain mandatory time period after the due date if a special simple procedure is followed. This is generally possible for any tax year, no matter when the delinquent return is filed so long as the IRS has not taken the first step and notified the taxpayer of their delinquency and that tax is owed. If this happens, the IRS can completely deny the exclusions (meaning higher tax will be owed, thus, higher interest and penalties). It is best to remedy matters before being notified by the IRS since such notification means there is a very likely possibility of being prevented from taking the tax beneficial exclusions. Professional tax advice is the best course of action; back returns can be prepared quickly and correctly. Filing is generally required by 15 April of the year following the tax year in question (for example, for the 2013 tax year the return is due on 15 April 2014). Americans living and working overseas are generally entitled to an automatic two month extension, so returns are due 15 June. If tax is owed, interest will be assessed for the two month extension period. For this reason, many taxpayers pay a projected amount of tax by the April due date in order to stop interest from accruing. Using The Foreign Tax Credit As discussed above, use of the "Foreign Earned Income and Housing Exclusions" can be very beneficial. For those living in a country where tax must be paid, there is another possible method through which one can reduce US tax liability this is thorough use of the "Foreign Tax Credit." Remember, however, neither of these methods excuses you from filing if your income was above the filing thresholds discussed above. 3
Here's a simple example illustrating use of both methods. Using Foreign Earned Income Exclusion Suppose you live in France and you and your spouse together earned the equivalent of $150,000 (about EURO 110,000) from your French employer(s). You are married filing jointly, have two children and you take the standard deduction. The US tax on this income is calculated as follows: US tax on $150,000: $22,408 Subtract US tax on $97,600 (the exclusion): $ 9,578 Net US tax payable: $12,830 While this is only an approximate calculation, it gives you an idea of how the system works. Using Foreign Tax Credit The other method for reducing your US tax bill is the foreign tax credit, using IRS Form 1116. If your income was taxed by a foreign country, you can subtract that tax from your US tax, in most cases substantially reducing your US tax bill. But be careful, you cannot claim a foreign tax credit for foreign taxes on income excluded on Form 2555. In other words, you can only claim a foreign tax credit for foreign taxes on the same income that the US is taxing. The fraction of your foreign taxes that can be taken as a tax credit is determined by the ratio of excluded income to total income. Here's an example, using the same figures as above. French taxes on $150,000 (EURO 110,000) are EURO 14,567: $19,936 Fraction for excluded income ($97,600/$150,000): 0.65 Fraction of foreign taxes that can be taken as credit: 0.35 Net French tax that can be taken as credit (0.35 x $19,936): $6,977 In this particular example, you would actually be better off by just using the foreign tax credit alone and not even claiming the FEIE. If you do this you would only have to pay $2,472 in US taxes ($22,408 - $19,936). So you see that by judiciously combining the FEIE with the foreign tax credit or by applying only the foreign tax credit you can substantially reduce or even get your US tax bill down to zero. Again, this is only an approximate calculation to serve as an example of how the system works. There are many other aspects to be considered when figuring your US taxes. Among these are the handling of un-earned (passive) income such as interest and capital gains, earnings of a non-us spouse, self-employment taxes, business expenses, possibility of itemizing deductions instead of applying the standard deduction, etc., etc., but they go beyond the simple explanation that this article is intended to be. If you need to consider any of these elements, you would be well-advised to consult an international tax expert. Running a Business Through a Foreign Corporation or Other Entity Common misunderstandings about tax consequences often arise in cases involving US ownership of a foreign corporation when the US shareholder is employed by the company he owns (whether owned alone or in conjunction with others). The shareholder-employee often believes he will be taxed only on the salary income he earns from the entity. Unfortunately, this type of arrangement is very complicated from a US tax perspective and often results in unexpected tax consequences. First, aside from taxation of any compensation earned by the shareholder-employee, due to certain anti-deferral tax law provisions, the US shareholder can be currently taxed on some or all of the income earned by the corporation even though the corporation has not made any dividend distributions to him. This will depend on various factors, including the precise ownership structure as well as the kind of income 4
earned by the corporation and how and where it transacts its business. Second, highly detailed information reporting requirements are imposed on US shareholders of foreign corporations and significant penalties are imposed for non-filing. Sometimes a non-corporate structure is used to run the business. Different tax consequences and reporting obligations will arise depending on the structure for example, a partnership or sole proprietorship. The owner must fully understand how the US tax authorities will treat the structure he has chosen and tax planning is an absolute must. Paying Estimated Taxes The payment of estimated tax is the method used to pay tax on income that is not subject to withholding. Americans working in the US are familiar with their employers withholding from their wages a certain amount of income tax (and so-called FICA and FUTA taxes, too). Most Americans working overseas are employed by non-us employers and no withholding of tax is undertaken; likewise if they are self-employed working in their own business no withholding tax is drawn. In these cases, the tax payer must make sure to pay the correct amount of estimated tax and at the proper times. If enough tax is not paid through withholding or estimated tax payments, a penalty may be charged. If enough tax is not paid by the due date of each estimated tax payment period, a penalty may be charged even if a refund is due when the tax return is filed. To download Form 1040-ES for payment of estimated tax from the IRS: Click here (PDF) For general information about estimated tax from the IRS: http://www.irs.gov/businesses/small-businesses-&-self-employed/estimated-taxes Selfemployed persons must also pay a Self-Employment Tax. This tax is on the entire amount of net self- employment income; it is not reduced by the FEIE. For information from the IRS on Self-Employment Tax for Businesses Abroad: http://www.irs.gov/businesses/small-businesses-&-self-employed/self-employed-individuals- Tax-Center Paying taxes Follow the instructions on the Form 1040 for the easiest way to file and pay the taxes due. Many people preparing their own returns or, using professional tax return preparers, use the e-file method. Tax Information Reporting Requirements A very critical part of the US tax system involves the filing of tax information returns. Information reporting multiplies when one is working and living overseas. There are many information reporting forms; they cannot all be listed. An information return does not mean that tax is owed with regard to the transaction. Failure to file it, however, can result in harsh penalties. Qualified tax assistance should be sought if you believe you have any information reporting duty. Here are some examples in the foreign context of when an information return must be filed: Ownership of an interest in a non-us entity (foreign corporation, foreign partnership, foreign mutual fund) Creation of a foreign corporation Creation of a foreign trust Receiving benefits or distributions from a foreign trust Receiving gifts from foreign persons or bequests from foreign estates Liability for filing so-called boycott reports (for example, if one is running a business in the UAE or any other country named on the boycott list) Having foreign bank and / or financial accounts, including foreign life insurance or a foreign annuity with cash surrender value 5
Form 8938 Form 8938 is a fairly new reporting form - effective for tax return filings for the tax year 2011. The requirement for this new form was introduced by the Foreign Account Tax Compliance Act ( FATCA ). The requirement to file Form 8938 was enacted in 2010 in order to improve tax compliance by US taxpayers with offshore financial assets. Form 8938 ( Statement of Specified Foreign Financial Assets ) must be filed by taxpayers with specific types and amounts of foreign financial assets or foreign accounts. Taxpayers must determine whether they are subject to this new reporting requirement because the law imposes very harsh penalties for noncompliance. For form 8938: Click here (PDF) Individuals having a possible duty to file Form 8938 are US citizens and residents, non-residents who elect to file a joint income tax return and certain non-residents who live in a US territory. Form 8938 is not required of individuals who do not have an income tax return filing requirement. Form 8938 is required when the total value of specified foreign assets exceeds certain threshold amounts. For example, a married couple living in the US and filing a joint tax return must file Form 8938 if their total specified foreign assets exceed $100,000 on the last day of the tax year or more than $150,000 at any time during the tax year. The filing thresholds for taxpayers who reside abroad are higher. Generally, a married couple residing abroad and filing a joint return is required to file Form 8938 if the value of specified foreign assets exceeds $400,000 on the last day of the tax year or more than $600,000 at any time during the year. The detailed instructions to the Form explain in greater detail the thresholds for reporting as well as the meaning of certain terms, including what constitutes a specified foreign financial asset. The instructions also address how to value the assets in question; what assets are exempt, and what information must be provided. There are still many ambiguities in the instructions and professionals themselves are asking numerous questions. The new Form 8938 filing requirement does not replace or otherwise affect a taxpayer s obligation to file a so-called FBAR, which is more fully discussed below. Failure to file the Form 8938 or failure to report a specified foreign financial asset on the Form can result in the statute of limitations for the relevant tax year remaining open until the proper filing is made with the IRS. This is very significant because it puts taxpayers at great risk that their tax matters will not have any closure. Foreign Bank Account Reporting Failure to properly file any of the necessary information reports can result in significant financial cost. The most recent focus has been on the so- called Foreign Bank Account Reporting (FBAR) FinCen Form 114 which can be accessed here: Download the Individual FBAR (FinCEN Form 114) The FBAR must be e-filed. No submissions are permitted by post / paper filings. Make sure you carefully read the instructions about how to sign the form electronically and about obtaining an acknowledgement of receipt. All of these records are very important and it is highly advisable to keep both hard and soft copies. The FBAR filing process is complete when you receive an email acknowledgment containing a BSA Identifier within a few days of filing your FBAR. Please retain these email notifications for record keeping purposes. See: http://bsaefiling.fincen.treas.gov/noregfbarfiler.html You will need to convert any foreign currency (such as British pounds sterling) to USD. In order to do this you need to use the official Treasury Department exchange rates. The December 31, 2013 rates were recently posted and can be found here http://www.fms.treas.gov/intn.html#rates. Rules regarding FBAR Persons required to file a FBAR: US persons who have ownership or control (for example signature authority) of foreign accounts with an aggregate value of over $10,000 in the calendar year 6
Accounts required to be disclosed: Bank, securities, financial instruments accounts Accounts held in commingled funds (mutual funds) and the account holder holds an equity interest in the fund Individually owned bonds, notes, stock certificates, and unsecured loans are not "accounts" Foreign life insurance or annuities with cash surrender value are "accounts" Many mistakes are made with FBAR filings, the most common being: Many persons are under the mistaken belief that if one has several overseas accounts and a particular account is not over $10,000 then that account does not have to be reported. This is incorrect. Remember if the highest aggregate value of all of the foreign accounts on any day in the tax year is over $10,000, then all accounts must be reported on the FBAR. Another common mistake arises when an account beneficially belongs to another person. In this case it is often erroneously believed that the nominee does not need to report that account on an FBAR. This is incorrect; the nominee must still file the FBAR if the dollar threshold is met by the nominee. Other mistakes involve an improper understanding about what must be disclosed on the FBAR for example, foreign pension plans, foreign mutual funds or foreign life insurance / foreign annuity with a cash surrender value. Note: US taxpayers filing Form 1040 are required to check a box on Schedule B, Part III, indicating whether they have an interest in or signature authority over a financial account in a foreign country. Make sure this question and its follow-up are answered both accurately and completely. The FBAR form must be filed by 30 June following the calendar year for which the interest in a foreign account is reported. The FBAR form may not be extended; therefore, 30 June is always the deadline regardless of whether the taxpayer's income tax return is extended. The FBAR form is not to be attached to any tax return. It is important that you remain current in your US tax filing obligations. Under the recently enacted FATCA legislation, foreign financial institutions (such as brokerage firms and banks) are required to report to the IRS, either directly or indirectly, information on all accounts owned by US persons. If the IRS learns that you have foreign accounts before you file your US taxes and FBAR, you may be very harshly penalized and, in fact, may also risk criminal tax exposure. IRS Publication 54 provides full details on filing US taxes from abroad. Go to:http://www.irs.gov/pub/irs-pdf/p54.pdf Disclaimer: The information provided does not constitute tax or legal advice and is of a general nature only. The information provided is current as of February 2014. The US tax system is extremely complex; users are cautioned that they should obtain professional tax advice. Karl Jauch Board Member and Webmaster, ACA, Inc. Retired and living in France Virginia La Torre Jeker, J.D. American Attorney, living and practicing in Dubai 7