If you’re a U.S. citizen living abroad, you may have assumed that you are not beholden to Uncle Sam and his taxes.
Unfortunately, the United States is one of only two countries (the other being Eritrea) that taxes its citizens regardless of where they reside. Here’s how the government explains it (straight from IRS.gov):
“If you are a U.S. citizen or resident alien, the rules for filing income, estate, and gift tax returns and paying estimated tax are generally the same whether you are in the United States or abroad. Your worldwide income is subject to U.S. income tax, regardless of where you reside.”
The IRS doesn’t care where you live. As long as you’re a U.S. citizen, you’re required to file a tax return and report 100% of your worldwide income. The only exception is if you otherwise wouldn’t have to file a return (because, for example, your income is low or zero).
Reducing or Eliminating Your U.S. Income Taxes
As an expat, you’re required to report all your income. However, you are entitled to certain credits and exclusions that could reduce, or potentially eliminate, your U.S. income taxes. These include:
- The Foreign Tax Credit
- Exclusions from income
The Foreign Tax Credit
The U.S. is not so overbearing that it enjoys forcing its citizens to pay their international tax as well as their taxes in the U.S. That’s where the foreign tax credit comes into play.
This tax credit is designed to minimize the event of a double taxation. It provides you a tax credit for all or part of the amount you paid in foreign taxes. Only foreign income taxes (and excess profits taxes) qualify. So, for example, when you go shopping overseas, you won’t get credit for paying the foreign value-added taxes or any sales taxes.
And, if you buy a home abroad, you won’t get credit for paying the property taxes.
Instead of taking the credit for foreign income taxes, you could deduct these taxes as an itemized deduction on a Schedule A form. However, from our experience, most expats are better off by taking the credit.
Exclusions From Income
Expats may have another option. If you qualify, you can elect to exclude the following from gross income:
- Foreign-earned income of up to an annual threshold (as of 2016 it was $101,300)
- Foreign housing costs that exceed a base equal to 16% of the foreign-earned income exclusion and subject to a cap equal to 40% of the foreign-earned income exclusion (note: self-employed expats can’t claim the foreign housing exclusion; rather, they must claim the foreign housing deduction)
For example: Anna lived in Australia during 2016. She earned $150,000 and paid $30,000 in rent on an apartment in Melbourne. She can exclude $101,300 of her foreign earnings from her U.S. taxable income, plus claim a $13,792 housing cost exclusion: $30,000 for rent - $16,208 (which is 16% of 101,300) - $13,792.
Her taxable income is reduced by $115,092.
Expats can elect to use either or both exclusions, and they’re available to each expat taxpayer. In other words, if eligible, each spouse can claim the exclusions if a couple files a joint tax return.
To qualify for income exclusions:
- You must have foreign-earned income
- Your tax home must be in a foreign country
And, you must be one of the following:
- A U.S. citizen who is a resident of a foreign country for an uninterrupted period that includes an entire tax year;
- A U.S. resident alien, who is a citizen or national of a country with which the U.S. has an income tax treaty, and who is a resident of a foreign country for an uninterrupted period that includes an entire tax year; or
- A U.S. citizen or U.S. resident alien who is physically present in a foreign country for at least 330 full days during any consecutive 12-month period.
Why Use the Income Exclusion?
Expats choose the income exclusions instead of the foreign tax credit because they can use these exclusions regardless of whether they're subject to income tax in a foreign country.
As a result, these exclusions can be more beneficial than the foreign tax credit, if their foreign tax obligation is small.
Overdue Tax Returns: Understanding Streamlined Filing Compliance Procedures
As an expat, filing taxes online isn’t always feasible. If you’re in transit, in an area that makes it difficult to file, or didn’t realize you owed taxes, you might benefit from relief.
The streamlined filing compliance procedure is available to taxpayers whose failure to report foreign financial assets, or who did not pay all the taxes due on those assets, was not a willful act.
In other words, you have to prove that your error wasn’t something of which you were aware or that you purposely avoided your tax obligations.
If you want to participate in the streamlined procedures, you need a valid Taxpayer Identification Number (for U.S. citizens and resident aliens, this would be your Social Security Number).
If you complete the streamlined filing compliance procedures, you will be expected to comply with U.S. law for all future years and file returns.
Filing U.S. Taxes as an Expat Who Owns a Foreign Business
There are numerous factors to consider if you own a foreign business.
You may need to make estimated tax payments to the IRS if you file as a self-employed individual (such as sole proprietor, partner, or S Corp shareholder) and you expect to owe $1,000 or more in taxes.
Social Security / FICA Taxes
Do you need to pay Social Security or FICA taxes for your overseas business? It depends on how your company is structured and where you’re located.
If you’re a sole proprietor (thus no business entity) and have a U.S.-based business, you’ll likely need to pay U.S. FICA taxes. These taxes apply before you can use the foreign-earned income exclusion.
If you have a foreign-based business entity, you are likely not liable for U.S. Social Security or FICA taxes. However, if you live in a country that has a tax treaty with the U.S., then you should consult with the treaty to see how (and to whom) these taxes apply.
U.S. expats may also experience new U.S. tax reporting including, but not limited to, the reporting of foreign bank accounts, foreign assets, and healthcare coverage exemptions.
Reporting Your Earnings
There are many systems in place designed to reduce an expat’s likelihood of double taxation for earned income. That being said, it is your duty, as a U.S. citizen, to report your income and file your taxes in the U.S.
Any treaties your current country has with the U.S., coupled with your unique situation, can very well eliminate your need to pay taxes, but reporting is still your responsibility.
If you are living abroad and need help with your tax preparation, we are here to make things easy for you. Click below to schedule a free consultation.
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