Common Misconceptions about Expat Tax Rules
U.S. citizens and those of certain other countries working and living in foreign lands are no strangers to the painfully byzantine jumble of tax rules. Without professional help or an innate knowledge on this opaque subject, it can be a huge battle determining what is truly helpful (and legal) and what is to be discarded as misinformation regarding tax compliance. Below are a few potential traps for which to be leery.
Some Examples of Misunderstandings and Downright Fallacies
Filing U.S. Taxes
That American citizens or legal residents working and living outside of the U.S. who already file tax returns with their host country don’t also need to file their U.S. tax returns is a common yet risky and erroneous assumption to make. In the vast majority of cases, the U.S. mandates that all its citizens and legal residents file their yearly tax returns regardless of where they may reside or make their living.
U.S. income is only for U.S. tax returns
This is an easy assumption to make (and hope for) but indeed expats must report all income on a U.S. tax return. Uncle Sam taxes all global income in the case of a taxpayer working overseas, no matter where the U.S. citizen may live and work. Keep in mind, though, that one in this situation can exploit certain expat taxation rules and enjoy some benefits, like those afforded by the FEIE or “Foreign Earned Income Exclusion” and the FTC or “Foreign Tax Credit.”
The FEIE allows the expat the choice of reducing his or her employment income to the tune of just over $100,000 and can even be increased should the expat be paying to rent a dwelling in his or foreign locale. Also, the expat can enjoy his or her usual deduction and exemptions, which is presently just over $10,000 for those of the single taxpaying status, (applied toward other income earned). Those making amounts below the exclusion level but who have higher income derived from their investments will certainly like this option too. Income from investments cannot be excluded, but the taxpayer will still enjoy the aforementioned standard deduction and exemptions that can be applied against whatever investment income they earn.
Work Paid by a Foreign Employer in the U.S.
“My employer is foreign and so is my income, right?” Not so fast there Chief! Work that is undertaken by an expat within the U.S. but compensated by a foreign employer is NOT foreign income, no matter if it be provided by an employer from Timbuktu or whether it even shows up on a W-2 form.
Uncle Sam doles out his employment designations by virtue of where the services are offered and not by who is paying for said services. In other words, any work undertaken in America by an expat for his or her foreign employer is deemed U.S. income. The amount taxed is determined by how many days worked in the U.S. balanced against the expat’s total work days for the whole year. This is not something to blithely ignore as an expatriate worker is not allowed to claim the Foreign Tax Credit on any income sourced from the U.S. The problem is that this can sometimes end up leaving some income that is taxed twice. Fortunately, should the expat work in a country that shares an income tax treaty with his home country, this may allow him or her to deem the income as foreign sourced and hence have the ability to claim a tax credit on it, thereby alleviating the burden of the double taxation.
Foreign Earned Income Exclusion (FEIE) & Filing U.S. Tax Returns
Many expats are under the false assumption that, should their foreign income be below the Foreign Earned Income Exclusion (FEIE) level, they will not be compelled to file a U.S. tax return.
Nope, again this is not true. The FEIE does allow expats to write off just over $100,000 from their gross income on taxes (for 2015), however they still are obligated to file a U.S. tax return in order to enjoy this benefit. Note that the FEIE must be elected by the expat when he or she files a tax return, (it is not automatically instated), and he or she must also include Form 2555 as well.
Income Tax Treaties Limit Taxation to Income Earned in an Expat’s Resident Country
Here is where another red flag must be raised. Though many will infer from a bilateral tax treaty that income is to be taxed only in the expat’s resident country, there are more often than not other treaty aspects that can supersede this. For instance, there is a part of many typical treaties in which a so-called “savings clause” is inserted. This reserves the right of Uncle Sam to tax their citizens just as if there were no treaty at all, though there are some exceptions and I suggest contacting a tax professional for help in this area. In short, the IRS can tax an expatriate’s income along with any additional taxation by the country in which they reside. The way to mitigate this is for the expat to claim a credit or deduction on either his or her foreign or American tax return.
Foreign Pension Plans are Taxed at the Same Levels in the U.S. as in an Expat’s Country of Residence.
Again, this is erroneous. For example, just a few countries allow U.S. expats to treat their foreign pension as they might a 401(k) plan. Normally the foreign retirement plan is taxed via an employer’s yearly contributions as opposed to when the distributions are doled out. U.S. expats will not enjoy a tax deduction on their own usual 401(k) additions either. Some will even likely be taxed on the earnings they accrue annually with their plan as well. The often vague differences in retirement plans between the U.S. and an expat’s resident country can also lead to complications over tax liabilities with one’s U.S. return. Again, one is wise to seek out professional help on this one.
If you have been offered an opportunity to work in some exotic foreign locale, you would be wise to first meet with a tax professional that is well versed in the often convoluted and complex rules regarding expat workers. Just a few countries, the U.S. being notable as one among them, tax their citizens on global income. This means that tax rules, as they apply to these expats, are unique. On top of it all, many foreign institutions will have their own unique set of reporting requirements and timelines, adding ever more complication to an already byzantine situation. Meeting with a tax pro to discuss these and a myriad of other relevant subjects cannot be stressed enough.
If you go away from reading this with at least one fact sticking in your mind, it would be that U.S. citizens and permanent residents must pretty much all file a U.S. income tax return along with the FBAR.
And one more thing: If you know you have committed some errors and feel the shadow of Uncle Sam’s boot over your head, you, as an expat, may wish to cry “uncle” and seriously look into the IRS’s non-penalty disclosure program so as to get yourself into compliance. Remember, as Ben Franklin once said, “in this world nothing can be said to be certain, except death and taxes.” I’d opt for the latter as opposed to the former…
Source: LinkedIn (Eric la Cara, Capital Tax & Accounting Serviced Ltd. Profile)