Two Ways for US Expats to (Legally) Reduce or Eliminate Their Tax Liability
When you’ve been in the US expat tax business for a while, some conversations begin to repeat themselves. Here are some answers I get from potential CPAs For Expats clients when I ask them why they never filed taxes as a US expat:
“I never had to because I make less than $100,000.”
“I fall under the exemption limit so I don’t have to file.”
“I pay tons of tax to [the UK/Australia/Canada/the Netherlands/wherever] so I don’t have to file with the US—they have a tax treaty, don’t they?”
When I get one of these responses, it is all I can do to resist quoting the immortal words of Luke Skywalker: “Impressive. Every word of that sentence was wrong.”
Filing Requirements for US Expats
We’ve discussed previously in this space (but it’s worth repeating) that the US taxes its citizens and Green Card holders on their worldwide income, no matter the source, and no matter where the taxpayer lives. If you earn more than the minimum required for your filing status, then you are required to file a return. Period, end of story, finito, done.
The amount of tax you owe, however, is quite another matter.
As we tell our clients to put their minds at ease, the vast majority of US expats do not actually have to pay income tax to the United States. However (and this is a big however), it is up to the taxpayer to prove to the IRS that they do not owe tax, and the way they accomplish that is by filing one of the following forms:
Form 1116, Foreign Tax Credit (FTC); or
Form 2555, Foreign Earned Income Exclusion (FEIE).
Let’s go through these methods one at a time, and we will discuss the advantages and disadvantages of each.
The Foreign Tax Credit
The tax code allows you to take a credit against your US tax for foreign income taxes paid to the vast majority of countries. Boiled down to its most essential function, the FTC allows you to only pay tax to the US if the US tax rate is higher than that of your country of residence.
For example, if your US tax bill is $2,000, but you already paid $3,000 in tax to the UK, then you wouldn’t have to pay any tax to the US. The unused tax credit can be rolled forward to future years for up to 10 years.
The FTC can get complicated in some situations because you can generally only take Foreign Tax Credits against the same category of income it was paid on—wages and business income are categorized as “General Limitation Income”, and interest, dividends, capital gains, and rental income are characterized as “Passive Income”. Take the following example:
Mike (a US citizen married to a nonresident alien) earned $70,000 in wages from a British company and $500 in dividends in tax year 2018. He paid £9,300 ($12,400) in income taxes on his wages to Her Majesty’s Revenue and Customs, but nothing on his dividends. Mike’s US tax bill on his wages is $8,600, which is completely wiped out by the Foreign Tax Credit, with the remaining unused credits carried forward to tax year 2019 and beyond. However, he would owe $110 in tax on his dividends, which are passive income and cannot be covered by the taxes he paid on his wages.
For US expats who live in high-tax jurisdictions (e.g., Australia, most of Europe, Canada, and Japan, among others), this is a nearly foolproof way to avoid paying tax to the IRS.
However, what about if you happened to not pay a lot of foreign tax? Maybe you work in a qualified startup industry (India), or you got a special exemption for being a new immigrant (Israel), or you live in a country that doesn’t have an income tax to begin with (The Bahamas, The United Arab Emirates, or Monaco) or a relatively low tax rate (Saudi Arabia, Switzerland, or Hong Kong). Or, just maybe, you just don’t want to go through the paperwork of keeping track of carryovers, different categories of income, and how much each government gets to squeeze you for?
Good news, my friend, because there is still…
The Foreign Earned Income Exclusion
Remember the guy earlier that thought he didn’t have to file because he made less than $100,000? He was wrong, but he wasn’t completely off base (but don’t tell Master Luke—he’s gotten ornery in his old age and needs to tee off on a young Padawan occasionally).
Our friend earlier was referring to the Foreign Earned Income Exclusion (FEIE, Form 2555), which a US expat can use to exempt (or exclude) foreign wage or business income from US tax. For 2019, the exclusion amount is $105,900—the amount is adjusted for inflation every year.
To qualify for the FEIE, a taxpayer needs to satisfy the following two tests:
His or her “tax home” must be in a foreign country for at least 330 days out of a twelve-month period; AND
He or she must satisfy either the “bona fide residence test” or the “physical presence test”.
Part 2 here is one thing that throws people off. Let’s go through the two tests one at a time:
Bona Fide Residence Test
If you are a bona fide resident of a foreign country for an entire year, you may take the FEIE. The term “bona fide resident” is left nebulous in the tax code, and the term is subjective by nature. Suffice it to say that if you maintain a home in the US, if you know that your stay in the foreign country is temporary, or if your family remains in the US while you are abroad, then you are not a bona fide resident.
Example: John is sent by his company to Germany for technical training for six months. His family stays in the United States because he did not want his children to have to switch schools. John fails the Bona Fide Residence Test.
Physical Presence Test
The Physical Presence test does not need details of when or if you plan to leave the foreign country to be satisfied. You will satisfy the Physical Presence Test if you are in the foreign country for 330 days out of a twelve-month period.
Example: John is sent to Germany for two rounds of training: January 2 through July 15, and August 5 through January 1. John is physically present in Germany for 345 days, and thus satisfies the Physical Presence Test.
Claiming the Foreign Earned Income Exclusion
If both the tax home test and either the Bona Fide Residence test or the Physical Presence Test are satisfied, then the taxpayer can use Form 2555 to exclude his income up to the exclusion amount. Only foreign earned income can be excluded, so wages earned while in the United States are ineligible (because they are not foreign) and interest, investment income, and pensions are also ineligible (because they are not earned income).
The FEIE must be actively claimed on a timely filed return or on an amendment to a timely filed return. If you are filing a form 2555 more than one year late, you must include the words “Filed Pursuant to Section 1.911-7(a)(2)(i)(D)” on your return, or the IRS may deny your claim for the exclusion.
Foreign Earned Income Exclusion vs. Foreign Tax Credit
So, you ask, why would I use the FTC if I can just exclude my income and be done with it?
Good question, and thank you for asking. There are several reasons why a taxpayer would not want to file Form 2555 or why he or she might not be able to. For example:
· If you file Form 2555, you are automatically barred from taking the Additional Child Tax Credit, which could result in a $1,400 refund per child being lost. You also would not be allowed to take the Earned Income Credit, but that is usually not available to US expats anyway.
If you don’t satisfy the bona fide residence test or the physical presence test, then you would not be allowed to use the FEIE, but if you paid foreign tax, the credits would still be available.
If your foreign income is mostly unearned (pensions, investments, and interest), then that income is not excludable under the FEIE, as discussed above.
Whether you use the Foreign Earned Income Exclusion or the Foreign Tax Credit, your accountant should make sure that you are taking advantage of all of your rights as a US expat.
Looking to file US taxes at an affordable rate? Contact CPAs For Expats for a quote!