This caveat is often overlooked by some self-preparers and even a few new professionals. This exception to the rule has been the source of audits in recent years.
So you’ve been thinking about taking that dream position in an exotic, foreign country for some time now, and you’re wondering how your tax situation will be affected. Welcome to the bewildering world of international tax. Since this is generally a specialty in tax preparation, my first recommendation would be to find yourself a qualified tax preparer who is familiar with the territory. Taxes for US Citizens living abroad are fairly complicated, so here are the basic concepts.
For starters, if you meet the IRS’ physical presence test and are living in a foreign country for at least 330 days over the course of a year, you may be eligible to exclude up to $101,300 in 2016 of earned income from foreign sources on your US tax return. However, to qualify for the exclusion, you also need to have moved your tax home. Your tax home is generally defined as the place where you have your main business, employment and social life. This means that this exclusion typically pertains to those that have taken longer term roles in foreign countries; but, with a little bit of planning and foresight, individuals on short-term assignments may be able to take advantage of the exclusion as well. If, for example, your position turns into something a little bit more permanent, you would be wise to try to solidify your tax home as the country you are in so that you can pass any IRS scrutiny that you might be subject to. As an aside, you should know that a lot of expat returns are prime targets for audits.
One’s tax home can be determined by various factors including things like:
1. Filing for an extended visa,
2. Applying for residency in a foreign country,
3. Setting up new banking arrangements in your new country, or
4. Filing foreign tax returns
In addition to meeting the physical presence test, the aforementioned items serve as evidence of your being in a new tax home. It’s common for people to get so caught up in the thrill of being in new surroundings that they forget that they need to file US tax returns so long as they maintain their US citizenship. As it turns out, filing your US taxes is pretty important.
And if you were still thinking that you could skate on by, you should know that the IRS and other international tax authorities share information with each other including travel dates. The IRS is using modern database technologies to uncover audit targets.
Now, under the recently re-enacted PATH legislation, tax issues can interfere with the renewal of passports when there are serious tax deficiencies that remain uncorrected. Filing your US taxes is something that should not be left to chance; or the last minute for that matter.
There are many tax returns filed every year that claim the foreign earned income exclusion in error. Individuals claim the exclusion even though their home was clearly in the US. Since the IRS monitors these erroneous claims very closely, you would be well-advised to seek the help of a qualified tax professional.
If all this talk of the risks of failing to file a tax return while you’re away isn’t enough, there may also be tax implications associated with your home state. Just be cognizant of this. If you retain the services of an experience professional, they should know enough to inquire about your home state and know the filing requirements that pertain to it.
In addition to federal and state income taxes, there are also social security tax implications for those of you that are self-employed or working as independent contractors. As someone who is self-employed or working as an independent contractor, you are responsible for paying social security taxes at the rate of 15.3% on income up to around $120,000 and 2.9% on beyond that. The foreign earned income exclusion does not apply to social security or self-employment taxes.
This caveat is often overlooked by some self-preparers and even a few new professionals. This exception to the rule has been the source of audits in recent years.
For employees working for a US company, this usually isn’t a problem and they’ll continue to withhold these taxes unless they have reason to believe that you’ll be permanently reassigned overseas. In that case, they would have to fill out form 673 and pay foreign social security taxes. This changes significantly in the event that you should start working for a foreign company. Things get very complicated, very quickly if you’re working for a foreign firm. One must first determine whether or not the country you’re working in has a tax treaty with the US. The treaty will determine how social security and medicare taxes are to be treated. The general rule though, is that the ex-patriot should only pay social security taxes to one country. In the event that you are working in a country that does not have social security of medicare taxes, you should consider filing your taxes as being subject to US medicare and social security taxes.
High income earners who do meet the IRS physical presence test and have effectively moved their tax home away from the US, may exceed the foreign earned income exclusion and will need to pay US income tax on amounts earned in excess of the exclusion. However, to the extent that you pay income taxes in the foreign country, you are entitled to a dollar for dollar credit on your US income taxes. In other words, if you owe $10,000 in income taxes in the US, but you paid your new country of residence $7,000 in taxes, you would only owe $3,000 to the US.
Now in case you’re a foreign worker who is assigned or living on a visa in the US or are a permanent resident, you’ll have a slightly more complicated situation to deal with. If you should be so unfortunate to have to deal with this tax situation, I would advise you to visit the IRS website (www.irs.gov) or consult with a tax professional that specializes in filing form 1040-NR. Resident alien taxpayers are generally subject to the same tax rules as Citizens, the IRS website has excellent information on this topic. Green card holders generally are required to file a U.S. income tax return and report worldwide income no matter where you live per the IRS. If these individuals are still claiming foreign residency such as a dual resident status, they may need to refer to the complex rules contained in tax treaties to be able to claim offset credits for any taxes paid overseas; but in general US tax would still apply if they hold a valid green card. See IRS Publication 519 for a much more detailed explanation on this subject. With the US holding certain passport renewals hostage; these days, it is best for green card holders to pay close attention to US tax filing requirements if they hope to be able to travel freely between countries in the future.
Foreign non-resident aliens who are living temporarily in the US on certain types of visas are also taxed on their income from sources within the US or from their trade or business income that is effectively connected with the US. These individuals would generally file form 1040NR and pay income taxes under most circumstances but are often exempt from US self-employment and social security taxes and may be able to claim the foreign tax credit to offset their US income tax if they pay foreign income taxes as well on these earnings.
On a final note, in regard to expat taxation, one must include a cautionary reminder about the FBAR (foreign bank reporting filing requirements). As a US citizen living abroad, you are required to file the FBAR form if you have signatory power over a foreign bank account which held more than $10,000 at any time during the course of the year. With the penalty for failure to report on these accounts being so high, I would caution you to make sure that you know what’s expected of you with respect to this form; and if you’re unsure, make sure to seek professional help.
So there you go, optimistically, you now have a basic understanding of this complicated area of tax and should be aware that you cannot escape US tax laws based on your location. In a nutshell, there is no free lunch as they say and the grass is not always greener on the other side when it comes to taxes, taxpayers who are thinking of making such a move or might already be living their dream but now have this nagging feeling that they might have overlooked their US tax filing requirements and should probably seek the advice and assistance of a qualified tax pro.
Todd Conrow CPA, SoCal Native, Father, Diver, Survivor!
