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US TAXATION OF AMERICANS LIVING ABROAD
 

by Don D. Nelson, Attorney at Law, CPA.
 

[Print This Out For Your Later Reference]

 

Your U.S. Income Tax Obligation While Living Abroad
 


 

As a U.S. expatriate residing in abroad, you still must file a US Income Tax Return each year on your worldwide income!  The stories you hear from the fellow American  expatriate sitting next to you at the bar that once you leave the U.S., you no longer owe any taxes or have to file tax returns , are about as true as most bar room tales.  Its against the law to give up your U.S. citizenship in order to avoid U.S. taxes!  Therefore, if you aren't filing your U.S. tax return,  the statute of limitations on tax collections will not run out and your tax return obligation (and perhaps the taxes you owe) only grows greater as each year passes.
 

US Tax Treaties with over 42 Countries


 

The US has income tax treaties with over 42 other countries. Now, both the IRS and the foreign taxing authorities can exchange information on their citizens living in the other country.  Both the Internal Revenue Service and taxing authorities in foreign countries use these treaties regularly to exchange information on their residents living in the other's country.  The IRS usually has several agents attached to the U.S. Embassy in each country to assist U.S. Citizens and to search out and report to the IRS citizens who may not be filing their U.S. tax returns.
 

A Tax Treaty is quite complex, but includes many special provisions which can benefit an American living and working outside of the US.  It attempts to reduce or eliminate any double taxation of your income by both countries by allowing credits for foreign income taxes you pay while living in outside the U.S. against your U.S. income taxes.  This credit more often than not will totally offset any U.S. tax you might owe on your worldwide income in the U.S.  The credit is not automatic, you must file a US return to claim it.
 

Statute of Limitations

 

If you fail to file that return for any tax year (whether a return is required or not), the statute of limitations on tax assessments for that year will never run out.  Therefore, if you live abroad for 10 years, and then return to the United States, the IRS may question your failure to file returns for those ten years and later  can make assessments based on their best estimate of your income.   The interest and penalties on any old tax amounts owed grows faster than you can imagine and after 4-5  years may exceed the amount of the original taxes owed.
 

If you do file your tax return each tax year while living abroad,  the statute of limitations in most situations for IRS audits will expire three years after you file those returns. That means the IRS cannot go back (absent fraud) and try to audit or change those returns later.  Therefore, you should file your return  even if you have no income or don't owe taxes in order to force the statute of limitations to run and eliminate future problems when you decide to return to the U.S.
 

Foreign Earned Income Exclusion
 

If you have your full time residence abroad for a full calendar year (bonafide residence test) or do not return to the US more than 35 days in a consecutive 12 month period (physical present test), you can exclude up to $91,500 of earned income from U.S. Income Taxation for 2010 and lesser amounts in earlier years.  If you are married, and both of you earn income and reside and work abroad, you can  also exclude up to another $95100 (for tax year 2012) and less amounts for earlier years of your spouses income from taxation.  These exclusions can only be claimed on a filed tax return and is not automatic.  Late filed returns more than 18 months late may not be eligible for the exclusion if any taxes are owed on those late filed returns. This is a fantastic advantage for people who live and work  outside of the U.S.  Earned income is that paid you for your work or services and does not apply to rental income, dividend or interest income, or other types of income that is not paid for your own personal efforts.
 

You can also claim an additional  exclusion from your U.S. taxes in excess of the $95,100 (2012) or $97,600 (for 2013), if  the rent, utilities, etc. you pay on your residence abroad and other living expenses exceed a standard amount (which is currently approx $14,400 per year) established by the IRS. This exclusion only comes into play when your earnings are in excess of the   foreign earned income exclusion.  Note There is a maximum allowable housing deduction (before deducting the $14,400) and the IRS allows even higher amounts in over 100 cities in the world which have higher housing costs. See the instructions to Form 2555 to see that list of cities with the higher allowable cost of housing.
 

U.S. Self Employment Tax
 

If you are a bonafide  employee of your foreign employer (which can mean your own foreign corporation) and have foreign  social security and other payroll taxes withheld from your wages, and you are considered an employee under local foreign law, you do not have to worry about paying any social security taxes to the U.S. The IRS then considers you a foreign employee. However, if you are self employed by contract, and no foreign social security  or other payroll taxes are being withheld from your earnings  ( in other words  an independent contractor) you must file a Schedule C with your U.S. tax return and pay U.S. self employment tax (social security taxes by the self employed) on your net earnings ( after deducting your expenses).   The self employment tax rate is 15.3%  and is not reduced by the previously mentioned foreign earned income exclusion or foreign tax credits.

An exception to paying social security on your foreign self employment income occurs if you reside in a country which has a social security agreement with the US.  In that event you can elect to have your earnings covered by the foreign country's social security (only if they have a social security agreement with the US), and not have to pay US self employment tax (social security). A list of the countries that have such an agreement with the US is here. (click to go to list)
 

Forms Which Must be Filed With IRS to Avoid Severe Penalties
 

If  you own more than a 10% ownership interest in a foreign corporation you are required to file  a special form with the IRS reporting that interest.  In many cases, if that foreign corporation is making profits, it will be a "controlled foreign corporation" and you may also owe U.S. tax on its earnings.  If you are the beneficiary or trustee of a foreign trust (such as a Fideicomiso which holds title to your residence in Mexico) you must file  a special form with the  IRS.  Another a special form must be filed with the U.S. Treasury  if you have ownership or signature authority over a  Mexican bank account which anytime during the year has a balance of more than $10,000 US or more.  If you fail to file any of these forms as required by law, you will be subject to penalties up to $10,000 or more.  These penalties might be assessed many years from now  when the U.S. IRS and the Mexican Hacienda finally start sharing information on a regular basis.  If you do not file these forms when required, it will be very difficult to later avoid those penalties.
 

Taxes on World Wide Income

U.S. Permanent Residents (green card holders) as well as U.S. Citizens must report each year their income earned anywhere in the world. That means your U.S. income tax return must include:

  • Foreign dividends

  • Rental Income Earned Abroad

  • Foreign pension income

  • Foreign capital gains or losses on stocks, bonds, real estate

  • Foreign royalties

  • All other foreign income

Due Date of Tax Return
 

If you have your personal permanent residence is abroad on April 15th of any year, you get an automatic extension to file your tax return for the previous calendar year until June 15th.  If you need more time, you can file several further extension requests which can extend the due date of your tax return until October 15th using Form 4868.  If you owe taxes, and fail to pay the estimated taxes in by April 15th,  you will be subject to interest and penalties for that  underpayment.  However, those penalties are not as severe as those imposed for failing to file your tax return in a timely manner. It is therefore wise to always file an extension if you are going to file your return later than April 15th, even though you do not have the money to pay your estimated taxes at that time because that eliminates the larger late filing penalty which is 5% per month.
 

Avoiding  U.S. State Taxes
 

Do not assume just because you moved out of the U.S. that your previous state of residence has no claim on taxing your income. Many states such as California, Virginia, New Mexico and South Carolinamake it very difficult to give up your "tax domicile" in the state and require that you file state income tax returns (and pay the tax) even if you do not move back until  many years later. Some of the criteria that a state looks at to determine if you are a resident for state income tax purposes includes your driver license, if you register to vote there,  if you maintain an address there, the location of your bank accounts, if you own or rent real property there, the license plates on your cars, and if you still receive utility bills in that state.  There are many other factors used by state taxing agencies to determine if you are a resident, but they are too numerous to mention here. You must be careful to reduce or eliminate all indices of residency or your previous state of residency in the U.S. will come after you for state income taxes. You must carefully plan your departure from your previous home state by  reviewing your states tax residency  laws and taking the actual steps necessary to prove to that state you no longer have a "tax domicile" there after you move abroad.  If you do not, the taxes, penalties and interest later assessed by that state can be huge.
 

You do have to continue to  pay taxes in a state if you receive rental income there or receive income from a trade or business located there, even if you are no longer a resident.  Investment income  from stock sales, dividends, and interest are not subject to state tax unless you still have your tax domicile in there.  Generally you can only give up your tax domicile if you establish full time permanent residency abroad or in another state without any intent to return to your previous state.  The rules defining "tax domicile" vary significantly in the various states and should be reviewed.  Pensions are no longer taxable in the state in which you earned the pension if  you permanently leave that state and established a tax domicile abroad or in another state.
 

What About Returns Which Were not Filed for Years You Lived Abroad?

Though not required to by law, the IRS currently allows an expatriate to file past tax returns which were erroneously not previously filed and claim the foreign earned income exclusion and foreign tax credits as if the returns had been filed on a timely basis. That usually means most delinquent expatriates who file past returns owe little taxes or interest after claiming those benefits.  It can easily be determined if returns are owed for past years by ordering a transcript from the IRS.  This can be done by a tax professional without triggering any inquiry from the IRS concerning the taxpayer. However if certain foreign reporting forms for foreign corporations,  foreign partnerships, investment companies, foreign trusts, foreign financial and bank accounts, and foreign partnerships, LLCS, or investment companies are not filed in a timely manner the IRS may collect substantial penalties (often $10,000 or more) for not filing these forms unless the taxpayer can provide the IRS with a reasonable excuse for their previous failure to file. The IRS has not clearly defined what they will accept as a reasonable excuse.

The IRS currently has the 2012 Offshore Voluntary Disclosure Program in effect which may be useful to reduce penalties and eliminate possible criminal problems for those who have not filed their returns or reported their offshore assets and income for past years. Read more about it  those programs here

 Offers in Compromises and Payment Plans
 

If one of the reasons you are living abroad is that you owe the IRS or state taxing agencies Offer in Compromise programs which may allow you to settle the balance owed for pennies on the dollar.   When you do owe back taxes, the amount owed increases at a fast pace due to interest and penalties and therefore can get very large compared with the original amount of tax owed. In order to make an offer in compromise you must file returns for all of your past tax years
 

Many delinquent taxpayers have through the use of  an offer in compromise settled with payments of anywhere from 10% to 50% of the total amount owed.  The IRS statistics show that in the past year only 15 percent of the Offers in Compromise have been accepted and that the average compromise was 20 percent of the total amount due.
 

Recently the IRS liberalized the offer in compromise rules  which make it available to many more taxpayers and much more likely your offer will be accepted.

 The entire process usually takes three to six months and requires filing financial information with the IRS and the required forms. You can make an offer which allows you to pay off the amount agreed over a period of time.  The IRS has tightened up the procedures so less than 20% of applications for offers in compromise are accepted.  If you have assets or potential for future income large enough to pay off the tax debt it is doubtful that your offer in compromise will be accepted.

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Don D. Nelson,  US TAX Attorney & Certified Public Accountant
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