I do not live or work in the U.S. therefore, I do not have to file a U.S. return
When Americans move overseas, they logically expect to file a tax return in their new country of residency. What they often do not realize is they are still required to file returns in the United States. The U.S. is one of two countries in the world that taxes based on citizenship rather than residency. As such, the American tax law requires U.S. citizens and permanent residents to file a tax return irrespective of where they reside. If you are single and make over $10,000, you have a U.S. tax filing obligation.
I don’t owe any U.S. tax, therefore I do not have to file a U.S. return
As we pointed out above, a U.S. person making over $10,000 has a U.S. tax filing obligation. The U.S. has provisions to alleviate double taxation. These include the Foreign Earned Income Exclusion, foreign tax credits and tax treaties. The Foreign Earned Income Exclusion, for instance, allows eligible expats to exclude up to USD 100,800 of income earned abroad from being taxed in the US. However, this exclusion is not automatic and must be made on a timely filed tax return. Many expats mistakenly believe they do not need to a file a tax return as long as their income is below the exclusion limit.
The foreign tax credit, on the other hand, gives expats the opportunity to use the taxes they paid in a foreign country to offset their US taxes. However, if the foreign exclusion is taken, then the foreign tax credits are reduced (or even eliminated) proportionally for the amount of income that was excluded.
While the exclusion may eliminate all earned income for you, it may not be the best tax planning option. Depending on the tax rate in your country of residency, it may be more beneficial to use foreign tax credits, as they can be carried forward for up to 10 years. It is important to analyze your specific situation to see whether it is better to take the exclusion or foreign tax credit.
The U.S. has tax treaties in place with countries around the world. These treaties mitigate the effect of double taxation by providing provisions to reduce or eliminate taxation in either the source or resident country. However, the treaties are legal instruments and often difficult to interpret and apply. Talk to your tax advisor regarding the best approach for your specific situation.
Disregarding the FBAR, FATCA, and other information return filings
Aside from the above-mentioned tax return filings, expats also have additional compliance requirements related to their foreign financial assets that can sometimes easily be neglected. Americans with foreign bank and financial accounts with a combined value of over USD 10,000 during the year are obligated to file Form FINCen114, commonly known as FBAR. In addition to that, some expats owning foreign stocks and offshore financial assets may be required to file Form 8938 related to the recently talked about in the news Foreign Account Tax Compliant Act (FATCA). However, the FBAR and Form 8938 require more than just “accounts” to be reported. See the IRS comparison chart to see what types of assets are required to be reported. https://www.irs.gov/Businesses/Comparison-of-Form-8938-and-FBAR-Requirements
In addition, if an expat owns an interest in a foreign corporation, partnership or is the owner or beneficiary of a foreign trust, additional reporting is required.
Even though these forms are simply informational and do not result in any tax, the filing obligations should not be taken lightly as the penalties for not complying are severe. For instance, the IRS can impose a USD 10,000 penalty for non-willful failure to file an FBAR, while a willful violation can reach the greater of USD 100,000 or 50 percent of the account value.
To summarize, it is important to take an inventory of all your financial assets and inform your tax adviser.
Investing in foreign mutual funds, pensions, and life insurance policies
U.S. expats investing in a non-U.S. financial institution need to understand the concept of a Passive Foreign Investment Company (PFIC). The definition of a PFIC is tedious and beyond the scope of this article. However, PFICS include “pooled investments” registered outside the United States. This includes mutual funds, insurance products and pension plans established outside of the U.S.
PFIC rules generally apply to investments held inside a foreign pension or foreign life insurance policy. Some tax treaties (such as the UK) allow for pensions to receive favorable “qualified’ tax treatment under the terms of a double-taxation treaty between the U.S. and the host country. However, investments in a foreign life insurance policy will likely always be deemed a PFIC, subject to additional reporting.
The tax treatment of PFICs is extremely punitive compared to similar investments established in the U.S. In addition, there is extensive reporting requirements, Form 8621, for each PFIC that is owned.
U.S. expats should consult their U.S. tax adviser and investment adviser before investing abroad. A thorough analysis of the tax and cost of tax and reporting compliance often results in a complete erosion of any earnings and leads to a conclusion that U.S. individuals should only be invested in U.S. based products.
Not considering your state return filing requirements
State return filing requirements can often be overlooked because of the complexity and the uniqueness of the residency rules that some states employ. Some states determine residency based on physical presence and do not require taxpayers who have lived out of the state for over a certain period of time, typically six months, to file a tax return.
Other states, however, follow complex domicile rules that can make it challenging for someone to break residency when moving abroad. Under this type of law, the presence of ties such as family members, real estate property, driver’s license and voting registration may continue to connect a taxpayer to a certain state and require him to file a state return even years after the person has moved away.
In addition, many states do not allow any exclusions or foreign tax credits, which means you may end up owing state tax on your foreign earnings.
Misunderstanding the self-employment tax intricacies
©2017 SDC, LLC www.sdcglobalcpa.com
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult tax, legal and accounting advisors before engaging in any transaction.