U.S. citizens living abroad are painfully aware of the thicket of information about expat tax rules, and it can be a struggle sorting the truth from the most common myths about compliance. Olivier Wagner at 1040 Abroad punctures myths and provides guidance below:
Myth #1: Individuals living outside of the U.S. and filing tax returns with a foreign government don’t have to file annual U.S. tax returns.
This is incorrect. The U.S. requires its citizens and permanent residents to file annual tax returns no matter where they live or earn income, unless they’re under the standard filing requirements. This is true even for expats who have never lived in the U.S. or who moved from the U.S. when they were young.
This is incorrect. The IRS taxes expats on their worldwide income. Regardless of where a U.S. citizen works, they must report all of their income as if they are living within the U.S. However, they can take advantage of certain expat tax rules and benefits such as the Foreign Earned Income Exclusion (FEIE) and Foreign Tax Credit (FTC). The Foreign Earned Income Exclusion affords an expat the ability to reduce their employment income by up to $100,800. This amount can even be increased if the expat is renting a home in their foreign country, and paying the expenses for renting that home. In addition to the exclusion, the expat will also retain their standard deduction and exemption amounts ($10,300 for a single taxpayer in 2015) to apply against other income. Expats with employment income below the exclusion amount and with higher investment income will find this option beneficial. While the investment income cannot be excluded, the expat will still have the standard deduction and exemption amounts to apply against the investment income. The exclusion is also an attractive option for expats living and working in low tax or no tax locations like Hong Kong, Singapore, UAE, and parts of Switzerland. The reason the exclusion may work better for expats in these regions, is that the foreign taxes they are paying in those locations may not be enough to cover the full U.S. tax liability if the Foreign Tax Credit is used rather than the exclusion.
If an expat is living in a higher-tax jurisdiction, they may find the Foreign Tax Credit to be a better alternative. Any Foreign Tax Credit that isn’t used in the current year can be carried back one year and forward 10 years. This can make it a good option for someone who may receive an untaxed severance payment or employer pension distribution in the future. So long as the income is in the same type of category as the income that produced the carryover, those carryovers can apply against that untaxed income in a future year.
Myth #3: If their foreign income is below the Foreign Earned Income Exclusion (FEIE), expats don’t need to file a U.S. tax return.
This is incorrect. Although the FEIE allows expats to exclude up to $100,800 in gross income from their 2015 taxes, they must file a U.S. tax return to claim this benefit. The Foreign Earned Income Exclusion is an affirmative election that must be made by an expat by filing a tax return and including a completed Form 2555. Try to file your tax return — and claim the exclusion — on time; late filers are sometimes able to claim the exclusion but it’s safest to file in a timely manner.
Myth #4: Work performed by an expat within the U.S. but paid by an expat’s foreign employer is foreign income because it’s paid by the foreign employer and not issued on a W-2.
This isn’t the case. The U.S. determines the source of income from employment based on where the services are performed rather than by who’s paying for the services. That means any work performed in the U.S. by an expat for their foreign employer will actually be considered U.S. income. This amount is based on the number of actual work days in the U.S. compared to an expat’s total work days throughout the year. The reason why this is so important is that an expat can’t claim the Foreign Earned Income Exclusion or Foreign Tax Credit on U.S.-sourced income. So this will sometimes leave an amount of income that is double-taxed. Luckily, if the expat is from a country that has an income tax treaty, the treaty may give them the ability to treat that income as if it were from foreign sources — and to claim a tax credit on that income — so the double-taxation burden is remedied.
Myth #5: Expats’ non-U.S.-based pension plans have the same tax treatment in the U.S. as they do in their country of residence.
Not the case. Only a handful of countries have rules in place that afford U.S. expats the ability to treat their foreign pension much the same as they would a 401(k), for instance. The typical non-U.S.-based retirement plan is taxed on employer contributions in the year the contributions are made, rather than when distributions are made. U.S. expats also don’t get a tax deduction for their own contributions as they would in a typical 401(k) type of plan, up to the yearly limit. In addition to taxing contributions, some expats may even have to be taxed on the earnings the plan accrues each year. The differences in retirement plan tax rules in the U.S. and the expat’s country of residence can cause issues with tax liabilities on the U.S. return when no offsetting credit is available because tax hasn’t been paid on the income in the foreign country yet.
Myth #6: When expats receive certain items of income, they’re only taxable in their country of residence under the rules provided for in the income tax treaty the foreign country has with the U.S.
Not so fast. While the tax treaty may indicate that the income is only taxed in the expat’s country of residence, there are usually other articles of the treaty that will come in to play. Specifically, an article typically referred to as the ‘savings clause’ will reserve the U.S. the right to tax their citizens as if the treaty weren’t in effect, save for a small amount of exceptions. This will then give the IRS all the right in the world to tax an expat’s income even when it’s taxed in their country of residence as well. In order to then prevent double taxation, an expat would look to claim an offsetting credit/deduction either on the foreign tax return or the U.S. tax return, depending on which country the treaty specifies the offset is available.
Myth #7: An expat’s foreign investments are treated the same as they are in the foreign country.
This isn’t true in all instances. While income from stock of foreign corporations in the form of dividends or sales, and interest from savings and CD type accounts are typically treated the same, other investments receive much harsher treatment. For instance, non-U.S. based mutual fund-type investments don’t receive the same tax treatment as their U.S. counterparts. Instead, they likely fall under a tax regime known as Passive Foreign Investment Company (PFIC). While the tax rules for PFICs are quite complex, the main point to take away is that an expat shouldn’t expect the same favorable capital gain tax rates as they would with a U.S. mutual fund. Instead, the tax on non-U.S. based funds is typically quite unfavorable, with high tax rates and even an interest charge applied. To avoid the pitfalls of these types of an investments, it’s best for the expat to first discuss with a U.S. tax adviser the U.S. tax consequences and the options they have available before purchasing the investments.
To add to the already disadvantageous tax consequences to these types of investments, you may often find these funds tucked into foreign tax-advantaged investment accounts or unqualified individual retirement plans that don’t receive the same tax treatment in the U.S. This adds to the overall tax liability on the U.S. side, because there is no Foreign Tax Credit to help offset the liability.
Before making a decision on working abroad or investing in non-U.S. investments, it is best to consult an adviser who specializes in the complex U.S. expat tax rules. The U.S. is one of only a handful of nations to tax its citizens on their worldwide income, which makes the tax rules unique for U.S. expats. Not only that, but foreign institutions may have different reporting requirements or timelines than the U.S. government, making it more difficult for U.S. expats to obtain the necessary documentation to file their tax return. Retirement and investment accounts can also be structured differently abroad, complicating their tax treatment at home.
Fact: U.S. citizens and permanent resident visa holders in general must file a U.S. income tax return, Foreign Bank and Financial Account reports (FBAR) and possibly state income tax returns.
Expat tax rules and the myths surrounding them can trip up Americans living abroad. But even if they’ve honestly overlooked their filing obligations over the past several years, U.S. expats can take advantage of the IRS’s non-penalty disclosure programs to come into compliance. Now’s the time to tackle those myths and get up-to-date with the IRS.