New law retroactively hikes taxes for Americans working abroad - Don D. Nelson, Attorney, CPA

Code Sec. 911 , as amended by Tax Increase Prevention and Reconciliation Act § 515

While it's true that the Tax Increase Prevention and Reconciliation Act (TIPRA, P.L. 109-222 ) prevents various tax increases from occurring this year and defers others due to apply in future years, its title is a misnomer when it comes to certain Americans working abroad. That's because TIPRA has made retroactive changes to the foreign earned income and housing cost exclusions that can drastically increase the tax bills of Americans working abroad. The changes apply retroactively for tax years beginning after 2005.

Background. The U.S. generally taxes its citizens and residents on their worldwide income. An election applies to exclude earned income of a qualified individual who has his tax home in a foreign country and is either (i) a U.S. citizen who is a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year, or (ii) a U.S. citizen or resident present in a foreign country or countries for at least 330 full days in any 12 consecutive month period. This is called the foreign earned income exclusion. Under pre-Act law, the maximum exclusion amount was to have been $80,000 for 2006 and 2007 and indexed for inflation after 2007.

A qualified individual also may elect to exclude certain foreign housing costs paid or incurred on his behalf (or claim a deduction where the costs are not paid by the employer). Under pre-TIPRA law, the amount of the housing cost exclusion was equal to the excess of a taxpayer's housing expenses over a base housing cost amount. Housing expenses include the reasonable expenses paid or incurred during the tax year for a taxpayer's housing (and a spouse's and dependents' housing if they live with the taxpayer) in a foreign country, including expenses attributable to housing such as utilities and insurance, but not interest and taxes. If the taxpayer maintains a second household outside the U.S. for a spouse or dependents who do not reside with the taxpayer because of dangerous, unhealthful, or otherwise adverse living conditions, the housing expenses of the second household also are eligible for exclusion.

Under pre-TIPRA law, the base housing cost amount above which costs were eligible for exclusion in a tax year was 16% of the annual salary (computed on a daily basis) of a grade GS-14, step 1, U.S. government employee, multiplied by the number of days of foreign residence or presence in the tax year. For 2006 this salary was $77,793, with the result that the 2006 base housing amount was to have been $12,447 for a taxpayer entitled to the exclusion for the entire year.

The combined foreign earned income exclusion and housing cost exclusion cannot exceed the taxpayer's total foreign earned income. In addition, the taxpayer's foreign tax credit is reduced by the amount of the credit attributable to the exclusions.

A taxpayer with excludable income under Code Sec. 911 was subject to tax on his other income, after deductions, starting in the lowest tax rate bracket.

Acceleration of inflation adjustments to foreign earned income exclusion. Under the Act, the $80,000 maximum foreign earned income exclusion amount is adjusted for inflation after 2005. ( Code Sec. 911(b)(2)(D)(ii) , as amended by Act § 515(a)) As a result, the maximum 2006 exclusion is $82,400.

OBSERVATION: While this $2,400 increase in the maximum exclusion for 2006 could theoretically save taxes for some taxpayers, it must be viewed in the context of the other changes made by TIPRA, which can serve to increase taxes for Americans working abroad, as explained below.

Changes to exclusion for housing costs . TIPRA also amended the housing cost amount so that the base housing cost amount is 16% (computed on a daily basis) of the maximum foreign earned income exclusion (the $80,000 amount adjusted for post-2005 inflation) for the calendar year in which the tax year begins ( Code Sec. 911(c)(1)(B)(i) ), multiplied by the number of days of bona fide residence or presence for which the qualified individual is eligible for the exclusion.

OBSERVATION: Thus, the base housing cost amount is $13,184 ($82,400 × 16%) for 2006.

In addition, TIPRA limited the housing cost exclusion to 30% of the maximum foreign earned income exclusion (computed on a daily basis) for the calendar year in which the tax year begins, multiplied by the number of days of bona fide residence or presence for which the qualified individual is eligible for the exclusion. ( Code Sec. Sec . Code Sec. 911(c) ) For 2006, the maximum amount of the foreign housing cost exclusion is $11,536: [($82,400 × 30%) − $13,184] for a taxpayer entitled to the exclusion for the entire year.

IRS has issued other guidance providing for the adjustment of the 30% limit on the basis of geographic differences in housing costs relative to housing costs in the U.S. ( Code Sec. 911(c)(2)(B) ). That Notice 2006-87 can be downloaded by clicking this line in .pdf format.  It contains five pages of cities and areas in which the maximum housing expense is greater thant the standard one set forth above. Notice 2006-87 has been further modified and expanded by Notice 2007-25, 2007-12  which has established additional higher limits for other cities in the world.

Exclusions no longer save tax at taxpayer's highest brackets. Where a taxpayer excludes income under the foreign earned income exclusion or the housing cost exclusion for any tax year, then, notwithstanding the regular income tax or alternative minimum tax rules, the following rules apply under TIPRA. The taxpayer's regular tax is equal to the excess (if any) of:

... the regular tax that would be imposed for the tax year if his taxable income were increased by the amount of these exclusions for the tax year ( Code Sec. 911(f)(1)(A) ) over

... the tax that would be imposed for the tax year if his taxable income were equal to the amount of these exclusions for the tax year. ( Code Sec. 911(f)(1)(B) )

ILLUSTRATION : For 2006, Andrew, a single taxpayer, is entitled to the foreign earned income exclusion and the foreign housing cost exclusion for the entire year. He is entitled to the maximum foreign earned income exclusion of $82,400 and a foreign housing cost exclusion of $10,000. (Andrew has actual housing cost expenses of $23,184 which is $10,000 more than the base housing cost amount of $13,184.) He has taxable income of $17,600 after taking the exclusions into account. Without the exclusions, Andrew's taxable income would be $110,000 ($17,600 + $82,400 + $10,000). Andrew's income tax for 2006 equals the excess of $25,132 (the tax on total taxable income of $110,000) over $20,204 (the tax on the total exclusion of $92,400). Thus, his total tax for 2006 is $4,928.

Under pre-TIPRA law, Andrew would have been entitled to a foreign earned income exclusion of $80,000, and a foreign housing exclusion of $10,737 (housing cost expenses of $23,184 less the base housing cost amount of $12,447). His taxable income would have been $19,263 ($110,000 less the total foreign exclusions of $90,737). The tax on $19,263 would have been $2,520, or $2,408 less than it is under TIPRA.

Similar rules apply in computing the tentative minimum tax for AMT purposes. ( Code Sec. 911(f)(2) )

OBSERVATION: The changes made by the Act will have the most adverse impact on Americans working abroad in low tax areas, such as Bermuda, Hong Kong, the Middle East and Singapore. On the other hand, because of the continued available of the foreign tax credit, they will have far less impact on Americans working abroad in high taxed European countries.

2006 ESTIMATED TAXES AND PLANNING: You should review your estimated taxes for 2006 and may wish to make revisions based on the new tax law. We can assist you with revised estimates and with planning for these new tax increases for U.S. expatriates working abroad.