US Citizens Living Abroad & US Tax
US Citizens Living Abroad: When a U.S. Person resides overseas in a foreign country, they are still subject to US tax on their worldwide income. This is different than when a person actually expatriates from the United States. If a person actually expatriates, then they are no longer subject to US Tax and Reporting on worldwide income (covered expatriates may require additional tax payments). But, when a person is an expat — they are still a US person who resides overseas and therefore still subject to US Tax and Reporting requirements — although tax minimization strategies such as Foreign Tax Credits and Foreign Earned Income Exclusion may be used to further lower their US Tax Liability.
Let’s look at 15 important Tax and Reporting Requirements for US Citizens Living Abroad:
1. Worldwide Income for US Citizens Living Abroad
The United States taxes US persons on their worldwide income, no matter where they live and where the income is sourced from. This is different than most countries in which they tax their citizens differently depending on whether they reside in the country or in a foreign country. It is also important to note that a US person is different than a US citizen. A US person includes a US citizen, legal permanent resident, or foreign national who meets the substantial presence test. Therefore, it is very important for legal permanent residents who are leaving the United States for good to properly relinquish their green card and consider whether or not they have to file formal expatriation papers such as Form 8854.
2. Worldwide Account and Asset Reporting
In addition to reporting worldwide income on a tax return, US persons also have to include their global assets on a myriad of different international information reporting forms. This is true, even if the assets are acquired after they move outside of the United States. There are various different forms and requirements depending on the type of asset and category of income — which we will summarize below.
3. Foreign Tax Credit (FTC)
Even though a person may have to pay US tax on their worldwide income, they may qualify to apply foreign tax credits to their US tax liability in order to reduce or eliminate there US tax on that income.
There is an equation that is used to calculate the credit and while it does not always result in a dollar-for-dollar credit — it is a great way to reduce tax liability.
Not all taxes qualify for the foreign tax credit.
4. Foreign Earned Income Exclusion (FEIE)
When a US person resides outside of the United States and has a different country tax home, they may qualify for the foreign earned income exclusion and foreign housing exclusion.
The taxpayer must meet either the physical presence test or the bona fide residence test. By doing so, the taxpayer can eliminate more than $100,000 of income from their tax return — as well as a portion of their housing. Another great benefit to the foreign earned income exclusion is that spouses can each use their own exclusion amount for the income they earn.
A few important tips: while you can use FEIE along with the foreign tax credit together for the same source of income, you cannot double-dip on the same dollar income. In addition, FEIE is used for earned income and not passive income and generally contributions to pension are not included in the foreign earned income exclusion either.
5. Totalization Agreement
The foreign earned income exclusion does not apply to self-employment tax. But, the United States has entered into totalization agreements with about 25 different countries in which the expat would only have to pay into the Social Security system in the country they are residing and not the US — in order to avoid double payment.
It is important to note that there are only 25 countries that have Totalization Agreements.
For example, there is a Totalization agreement with Australia but New Zealand does not.
6. Foreign Tax-Free Income
It is important to note that even though foreign income may be tax-free in the country of source (especially with foreign pension contributions), that does not mean it is tax-free in the United States. For example, if a person is earning interest income in a country that does not tax interest income, the expat would still have to include the interest income on their US tax return.
Taxpayers should always check the treaty if one is applicable to see if there is an exception, exclusion, or limitation to the tax rules.
In general, many countries — especially Asian countries — do not tax dividends. Unfortunately, those rules usually do not crossover into the US tax laws. Therefore, an expat that earns dividend income in a foreign country would still have to include that dividend income on their US tax return — along with any applicable tax credits.
While a nonresident alien may escape tax on U.S. borne interest income, a US expat who has not formally expatriated but simply resides outside of the United States does not enjoy those same tax benefits — the foreign interest income is also taxable in the US.
9. Capital Gains
Nonresident aliens are exempt from US capital gains with certain exceptions and limitations. Since a US expat who resides overseas is not a nonresident alien but rather a foreign resident (with US person status), these rules do not apply. Capital gain earned outside of the United States by a US person expat is still taxable to the expat on their US tax return.
10. Foreign Account Reporting & FBAR (FinCEN Form 114)
When a US person has foreign bank accounts and other financial accounts with an annual aggregate total that exceeds $10,000 on any given day in any year, they have to report the accounts on the FBAR (aka FinCEN Form 114). The form is filed electronically directly on the FinCEN website.
11. Foreign Asset Reporting on Form 8938
Expats with specified foreign financial assets may have to report the assets each year on a Form 8938 if they meet the threshold requirements for filing.* The Form 8938 is submitted with the tax return. There may be some overlap between the Form 8938 and FBAR — as well as other forms such as Forms 5471, 8621, and 8865.
*The threshold for filing form 8938 is much higher for foreign residents than it is for US residents.
12. Foreign Real Estate Rental and Reporting
When a person owns foreign real estate that generates income, the income must be included on the US tax return, Schedule E — this is true, even if the income nets a loss after expenses are accounted for. If the real estate is owned by an individual, then it is not an asset that is reported for FATCA Form 8938. Conversely, if the asset is owned in an entity such as a sociedade anonima, then the S.A. includes the value of the real estate on the Form 5471 or other form.
13. Foreign Investments
Expats have to report their worldwide investments to the US on their tax return. There are many different flavors of foreign investments — and many different international information reporting forms that may be required to be filed. It is important for the expat to ascertain the specific type of investment in order to evaluate what form is includable on the US tax return. It is also very important to consider that just because the asset grows tax-free overseas such as a UK ISA or a French Assurance Vie does not mean it will grow tax-free in the United States as well — because usually it is not treated as tax-deferred in the US.
14. Foreign Mutual Funds
Expats who own foreign mutual funds are typically reported both on the FBAR and Form 8621 — the latter which is used to report PFIC or “passive foreign investment companies.” There are many complicated rules involving the reporting of PFIC and excess distributions. Keep in mind that the rules changed a few years back and unless an exception applies, the Form 8621 is still required even if there is no excess distributions.
15. Foreign Corporation & Form 5471
When an expat has ownership over a foreign corporation, especially in a year that they acquired the interest in the company — they may have to file the Form 5471. The form is relatively complicated and requires a general understanding of accounting and bookkeeping principles. For some expats who want to try to avoid the 5471 reporting requirement, they may be able to disregard the entity and instead file a Form 8858/Schedule C — which can be less severe and easier to prepare.
US Citizens Living Abroad Should Consider Their Options
When a person is a US expat who resides overseas but has not formally expatriated, they are still subject to US tax and reporting. There are many pitfalls to be aware of and possible penalties for noncompliance — but the IRS has multiple offshore disclosure/tax amnesty programs in place to assist Taxpayers.
Golding & Golding: About our International Tax Law Firm
Golding & Golding specializes exclusively in international tax, and specifically IRS offshore disclosure and compliance, including taxes for expats.
Contact our firm today for assistance.