“Internal Revenue Service” is a bit of a misnomer—sometimes “Universal Revenue Service” might seem more fitting. Contrary to popular belief, moving to a tropical island will not relieve you of your U.S. tax liabilities. Your tax responsibilities remain no matter where you temporarily or permanently relocate. Paying taxes while living abroad can be confusing and it’s important to have a clear understanding of what’s expected from you in order to fully enjoy your experience overseas. There are even some surprising perks to paying taxes abroad, so if you are considering a foreign move, you will want to be aware of how to redeem all of your deductions and credits.
Fortunately for California taxpayers, the Tax Attorneys, CPAs and EA’s at The Tax Law Offices of David W. Klasing can provide all the guidance you need to comply with your tax obligations both domestic and overseas. Call us at (800) 681-1295 today or contact us online for a reduced-rate consultation.
What is the Foreign-Earned Income Exclusion?
Generally, U.S. citizens and resident aliens are subject to a federal income tax on worldwide income. The FEIE (Foreign-Earned Income Exclusion) allows qualified taxpayers to exclude from taxable income up to $101,300 of earned income subject to two requirements:
- The taxpayer must establish a “tax home” in a foreign county (or several foreign countries); and
- The taxpayer will need to satisfy the “bona fide residence test” or the “physical presence test.”
We will discuss these tests in detail a little later on. It is important to keep in mind that the income must be earned from working (either as an employee or as an independent contractor) and some sources of income are not eligible to be included in the exclusion.
What is Foreign Earned Income?
The IRS defines foreign earned income as income you receive for services performed in a foreign country during a period your tax home (defined below) is in a foreign country and during which you meet either the bona fide residence or the physical presence test.
Earned income is pay for personal services performed, such as wages, salaries, or professional fees. Income is generally classified into three categories—variable; earned and unearned. Unearned income, like dividends, interest, capital gains, gambling winnings, alimony, social security benefits, pensions and annuities, cannot go towards a person’s foreign earned income.
There are even more exclusions from earned income foreign taxpayers need to keep in mind:
- The previously excluded value of meals and lodging furnished for the convenience of your employer;
- Pension or annuity payments including social security benefits;
- Pay you receive as an employee of the U.S. Government;
- Amounts included in your income because of your employer’s contributions to a nonexempt employee trust or to a nonqualified annuity contract;
- Recaptured unallowable moving expenses; and
- Payments received after the end of the tax year following the tax year in which you performed the services that earned the income.
Needless to say, this is an extensive list that is easy to misunderstand. In order to fully understand which items contribute to earned income, it is important to contact an experienced Tax Attorney or CPA.
How Do I Establish a “Tax Home”?
A tax home for the purposes of redeeming the FEIE essentially requires cutting ties with the U.S. This would mean breaking your lease or selling your home, and selling your car or office space if you rent one. Documentation of these sales will show your intent to leave the U.S. In IRS terms, your tax home is the place where you are permanently or indefinitely engaged to work as an employee or self-employed individual. Having a “tax home” in a given location does not necessarily mean that the given location is your residence or domicile for tax purposes.
What About My Moving Expenses?
Earned income may include reimbursement of moving expenses. You must include as earned income:
- Any reimbursements of, or payments for, nondeductible moving expenses;
- Reimbursements that are more than your deductible expenses and that you do not return to your employer;
- Any reimbursements made under a nonaccountable plan, even if they are for deductible expenses; and
- Any reimbursement of moving expenses you deducted in an earlier year.
Also, make sure you’re referring to the right “move”—a foreign move is a move in connection with the start of work at a new job location outside the United States and its territories. A foreign move does not include a move back to the United States or its territories.
What is the Bona Fide Residence Test?
In order to pass the “bona fide residence test,” you must be a bona fide resident of a foreign country (or countries) for an uninterrupted period that includes an entire tax year. You’ll need to prove your intention to live outside the United States full-time. The test is not an exact formula, but the following are factors that are usually considered:
- Establishment of a temporary home in a foreign country for an indefinite period (usually by lease or proof of home ownership).
- Marital status and residence of the family.
- General assimilation; participation in communities on the social and cultural level. (This would include a gym membership or library card.)
- Physical presence in the foreign country.
- Assumption of economic burdens and payment of local taxes.
- Other documentation such as health insurance, local bank account info or a driver’s license.
What is the Physical Presence Test?
The physical presence test is a little simpler. To pass this one, all you need to do is be physically present in another country for 330 full days over the course of a 12-month period. The 330 days need not be consecutive and need not be in the same country—as long as they are outside the U.S. This test is not so much concerned with the type of residence you establish or your intentions to return to the U.S., but more so with the simple fact that you spent enough time in another country. Nevertheless, your intentions with regard to the nature and purpose of your stay abroad will be considered in determining whether you have established a “tax home.” Remember that you need only pass the bona fide residence test or the physical presence test to claim the FEIE, and that your other aspects of your finances may be affected depending on which you qualify under.
What About My Tax Obligations in Foreign Countries?
This is where the bona fide residence test will yield different consequences than the physical presence test. The general rule in most countries is that if you are spending more than 183 days in the country, you are considered a fiscal tax resident of that country, requiring you to pay income taxes in that country as well. This would be an issue for someone who has taken up a bona fide residence, but not necessarily for someone passing under the physical presence test. A taxpayer claiming the FEIE under the physical presence test could potentially be spending less than 183 in any given foreign country, as long as they are outside the U.S. for the 330 days.
Different countries have different rules when it comes to issues like territorial tax systems (where you are only required to report income earned within the country’s borders) and permanent residency requirements. Some territories like the Bahamas, the Cayman Islands and Monaco have no income tax system in place at all. It can be an overwhelming decision if you are picking your location strictly for tax purposes.
Should I Take a Foreign Tax Credit or Deduction?
As a general rule, you must take either a credit or deduction for all qualified foreign taxes. If you choose to take a credit for qualified foreign taxes, you must take the credit for all of them and cannot deduct any. Conversely, if you choose to deduct qualified foreign taxes, you must deduct all of them and cannot take a credit for any. The IRS advises that taxpayers take the foreign tax credit and provides the following reasons a taxpayer would be better-advised to take a credit rather than a deduction:
- A credit reduces your actual U.S. income tax on a dollar-for-dollar basis, while a deduction reduces only your income subject to tax;
- You can choose to take the foreign tax credit even if you do not itemize your deductions. You then are allowed the standard deduction in addition to the credit; and
- If you choose to take the foreign tax credit, and the taxes paid or accrued exceed the credit limit for the tax year, you may be able to carry over or carry back the excess to another tax year.
The choice is still yours as to which to claim, but a credit might be in your best interest since it is intended to relieve the double tax burden when foreign-sourced income is taxed by both the U.S. and the foreign country. As always, consulting with an experienced tax attorney and CPA is the best way to maximize your tax benefits.
When and Where Should I File?
As you might expect, taxpayers living abroad have a slightly different filing process. U.S. Citizens or resident aliens residing overseas and those on military duty outside the U.S. are allowed an automatic 2-month extension (until June 15) to file their returns. If you qualify for this 2-month extension, penalties for paying any tax late are assessed from the 2-month extended due date of the payment (June 15 for the calendar year taxpayers). Keep in mind that even if you are allowed an extension, you will have to pay interest on any tax not paid by the regular due date of your return (April 15 for the calendar year taxpayers). As for local U.S. taxpayers, the option to request an extension until October 15 is still available through filing Form 4868.
U.S. citizens and resident aliens living in a foreign country can mail their U.S. tax return to the address provided on the IRS website. Taxpayers with an adjusted gross income within a certain threshold can file for free using an IRS program called Free File. One last thing foreign taxpayers need to remember is that you must express the amounts you report on your U.S. tax return in U.S. dollars. If you receive all or part of your income or pay some or all of your expenses in foreign currency, the foreign currency must be translated into U.S. dollars.
Contact an Experienced Expat Tax Attorney Today
The U.S. income tax process is complicated in general, but much more so if you are an American taxpayer living abroad. If you have been living overseas and failing to comply with U.S. tax regulations, it is essential to contact an experienced Expat Tax Attorney. Tax evasion is a serious crime with serious penalties. The professionals at the Tax Law Offices of David W. Klasing have decades of experience handling both international and domestic tax issues. Whether you are considering a move abroad or facing an audit or criminal investigation involving international or domestic issues, we can provide the skilled advocacy you need. Call us at (800) 681-1295 today or contact us online to schedule a reduced-rate initial consultation.
