OVDP Lawyers – Earning Foreign Income | Reporting Foreign Accounts
Generally, whether you are a U.S. Citizen or Legal Permanent Resident you are required to file a 1040 each year and disclose all of your U.S. and foreign income (unless you do not meet the minimum threshold for filing a tax return). In addition, if you have a foreign accounts, you have to disclose the information on a 1040 Schedule B, and possibly other forms such as a Schedule B, FBAR, 3520, etc.
As if filing US tax is not complex enough, when a person is a US citizen or legal permanent resident of the United States and works in various different countries during the tax year, tax filings become nearly overwhelming.
The following is a primer on tax filing requirements for individuals who work in multiple different foreign countries:
U.S. Tax Filing Requirements
The tax filing requirements for individuals with foreign income will be determined by their US status.
Citizens/Legal Permanent Residents
When a person is a citizen or legal permanent resident of the United States there required to file a US tax return for each tax year. Despite all the misinformation you will find online, fact of the matter is these are the requirements. In other words, if a person is a legal permanent resident of the United States who is not relinquished their residency, then they reside in Japan and earn money in Japan, China, Brazil, and Nicaragua – they are still required to file US tax return.
Depending on the amount of money they make, as well as whether they paid for taxes and any or all of these jurisdictions, the taxpayer may be entitled to either a foreign tax credit for foreign earned income exclusion on a portion of the foreign income; nevertheless, they still have to file a 1040 tax return.
Non-Citizens/ Non-Legal Permanent Residents
It is not as if every person on the planet has to file a US tax return – even if it seems that way. Rather, if a person is a non-US citizen and non-legal permanent resident of the United States than their only required to file a US tax return if they have US Income. This is generally called ECI (Effectively Connected Income) and instead of filing a 1040, the individual can file a 1040NR (which means Non-Resident)
United States will still require taxes to be paid (absent treaty relief or other relief) for the income that the individual earned in the United States and/or from a US company.
Foreign Income – Multiple Jurisdictions
Since our firm is commonly called upon to represent individuals who earn income in several different countries, we put together the following case study to try to explain the process
Case Study: Jeff: Jeff is a non-US citizen of the United States but a legal permanent resident of the United States. Jeff also has citizenship in China. Jeff is an international consultant for many different large companies around the globe . As a result, Jeff earns income from many different sources, which would depend on the number of different companies he consults for in any given year. Even though Jeff does not reside in the United States is not relinquished his legal permanent resident card (which can lead to other immigration issues involving living outside of the United States for more than six months, but are not of consequence for this example).
- Each year, Jeff receives 1099s and W-2s and equivalent from multiple different employers. That is because depending on which jurisdiction he is working in, sometimes is considered a contract employee and other times he is considered an independent contractor.
- Therefore, Jeff pays taxes in nearly 8 jurisdictions for tax year 2015. Jeff has not yet filed his US tax return because he was under the false impression that because he did not earn any income in the United States he does not need to file a tax return in the United States.
- After speaking with an experienced international tax attorney, Jeff realizes that in fact he is required to file a 1040 tax return in the United States and pay tax on his income. One of the luxuries of being a legal permanent resident and/or US citizen is that the United States taxes individuals on their worldwide income.
- Luckily, Jeff was informed that he qualifies for the foreign tax credit in the majority of jurisdictions it works in and therefore at the end of the day even though Jeffrey is required to file a US tax return, he does not have any outstanding tax liability.
Foreign Tax Credit & Foreign Earned Income Exclusion
The United States is not in the business of seeking double taxation. In fact, the United States has entered in the tax treaties with several countries to try to reduce the headaches of double taxation – in addition to the double taxation prevention clauses of the Internal Revenue Code.
The two main methods individuals use to avoid duplication of taxes is the foreign tax credit and the foreign earned income exclusion, which are described below:
Foreign Earned Income Exclusion
U.S. taxpayers (U.S. Citizen, Legal Permanent Resident, Foreign Nationals subject to U.S. tax) are required to pay tax to the United States on their worldwide income. If a US taxpayer works overseas and has already paid tax in a foreign country they will usually be entitled to either take a foreign tax credit or a foreign earned income exclusion.
Unlike the Foreign Tax Credit, the foreign earned income exclusion essentially excludes up $100,000 of overseas earnings from any tax liability – along with roughly $15,000 of housing expense.
How do I Qualify for the Foreign Earned Income Exclusion?
In order to qualify for Foreign Earned Income Exclusion, there are a few main requirements:
- The taxpayer must be employed or generate self-income (in other words, the taxpayer cannot be employed by the US government).
- The taxpayer must have employment income (unlike the foreign tax credit, the Foreign Earned Income Exclusion refers to “earned” income – as opposed to passive income)
- The taxpayer must meet either the bona fide residence test or the physical presence test.
- The taxpayer must call the foreign country his or her tax home.
Foreign Tax Credit
The Foreign Tax Credit is a tax “Credit” against foreign taxes already paid.
The Taxpayer Must Show Proof of the Foreign Tax Paid
If a U.S. taxpayer can show proof that they have already paid a tax in a foreign country on income that they would have to pay tax on in the United States they can usually obtain a credit. To qualify, the US taxpayer must be able to prove that they paid tax – this is usually done by providing copies of foreign tax returns and/or a stamped document (which most countries provide) that shows proof the taxes were received by the taxpayer in the foreign country.
- While the taxpayer is not required to include this proof when they file their US tax return, if they do have is proof it will only help to substantiate their claim and may assist to avoid a possible IRS audit.
The Taxpayer must Differentiate between Different Types of Income
As a general rule, the taxpayer can only use the tax credit for distinct types of income (there are some complex rules which may allow for “mixing the pots” but they are well beyond the scope of this article”). For example, if a taxpayer has overseas passive income as well as domestic passive income, then they can apply the foreign passive income tax credit to the foreign income tax liability.
- The taxpayer may have multiple buckets of tax credits that can be applied to different types of income. With that said, for the most part you cannot use one bucket of income and apply the tax credit to a different bucket of income.
- In other words, you must use your foreign tax credit the passive income only for passive income and not employment income; otherwise you are asking to be audited.
Foreign Account Disclosure And Passive Income
One way many US taxpayers are getting into trouble is by failing to disclose their foreign bank accounts and other foreign accounts as well as failing to report passive income from these accounts in foreign countries. Under the new FATCA (Foreign Account Tax Compliance Act) and other international tax laws, individuals may find himself subject to extremely high penalties, if not worse, for failing to disclose and report foreign accounts and foreign income.
The following is a brief summary of the most common foreign tax rules impacting taxpayers:
What is FATCA?
In accordance with FATCA (Foreign Account Tax Compliance Act), hundreds of foreign financial institutions (FFIs) are reporting foreign income, assets, bank and financial accounts U.S. citizens and Legal Permanent Residents.
And, if the IRS gets wind of your overseas assets and catches you (e.g. tax audit) before you have a chance to enter the program, then you cannot enter any of the offshore voluntary disclosure programs. Moreover, depending on which bank or financial institution you have accounts at, the IRS can penalize upwards of 50%. Also, FFI’s are starting to freeze the accounts of U.S. citizens and Legal Permanent Residents if they cannot prove compliance.
For example, if you enter the standard OVDP Program, then your penalty amount would be 27.5% of the highest year’s annual aggregate total for the highest year going back 8 years. Sounds high, right? But, if you do not enter the standard OVDP program and get caught by the IRS, it could be a 100% penalty for the balance of your accounts during the audit period – including several other penalties as well.
What is an FBAR?
In accordance with international tax law compliance, taxpayers who meet the threshold requirements are required to file an FBAR.
An FBAR, is a “Report of Foreign Bank and Financial Accounts” form. It is a form that is filed online, directly with the Department of Treasury. Unlike the tax return, the form must be filed by June 30th of the tax year and there are no extensions available for filing it late. If you attempt to file it late, there can be serious repercussions, including fines and penalties.
**UPDATE: Starting in 2016 (for filing 2015 FBARs) the FBAR rules have changed.
Who is Required to File an FBAR?
Not everyone who has foreign accounts is required to file an FBAR. Rather, it is required to be filed by all U.S. Taxpayers with accounts overseas that reach an “annual aggregate total” that is more than $10,000. What that means is that if a U.S. Taxpayer (including Legal Permanent Residents “aka Green Card Holders”) maintains foreign accounts, including banks accounts, financial accounts, income-producing property, or insurance policies that have a combined value of more than $10,000, then that person is required to file an FBAR statement
Does that Mean if I have less than $10,001 in a Bank Account I am not required to File an FBAR?
No. It is important to remember that the threshold is the Annual Aggregate Total value. This means if you have 11 banks accounts with $1000 each in them, you are STILL required to file the FBAR and list all the accounts on it. In other words, you are required to report the total value of all your foreign accounts located in any foreign country, once you exceed the $10,000 annual aggregate total threshold.
There are various accounts and other assets (insurance policies) which may or may not be included in your FBAR analysis. Please contact one of our experienced FBAR Lawyers for further assistance.
OVDP (Offshore Voluntary Disclosure Program Requirements)
OVDP stands for the Offshore Voluntary Disclosure Program, which came into effect in 2009 and was modified again in 2011, 2012 and 2014.
Before the implementation of the modified streamlined program (which is strictly for individuals who were non-willful in their failure to report their overseas assets and income) the penalty structure was generally (and continues to be for willful participants) 27.5% of the highest years annual aggregate total and 50% if any of your money was held in one of the identified “bad banks.”
In other words, if you have foreign accounts that were unreported to the IRS and Department of Treasury, then to determine your penalty structure you would need to total up all of your unreported overseas and accounts for each year, for the last eight years, and then take the highest year’s highest balance and multiply it by 27.5% to arrive at the penalty amount due. (A complete breakdown of OVDP requirements can be found on our OVDP Page, by Clicking Here)
What is the Modified Streamlined Program?
In order to avoid “non-willful” applicants from having to go through the entire OVDP process before opting out, the IRS and Department of the Treasury modified a small program in existence, called the streamlined program, which was very limited. The IRS expanded the program to basically allow anyone who was non-willful to enter the program.
The program reduced the amount of documentation that applicants were required to file to only three years of amended tax returns and six years of FBAR (Foreign Account Reporting Statements). In addition, there was no penalty on the tax amount that was due, no penalty on the value of foreign real estate that was not previously disclosed, and the 27.5% penalty was reduced all the way down to 5%, or completely waived if the foreign residence requirements were met.
Penalty Waiver: there is a small facet of the modified streamlined program called the Modified Foreign Offshore Program. If a person qualifies for the modified stream of program (which means they acted non willfully) and they can prove they lived overseas in any number of different countries for a total of 330 days out of the tax year in any year within the last three years, then they may qualify to have the penalty waived.
The Streamlined Programs sounds great, right? Well it is, unless you are attempting to wrongfully evade the 27.5% penalty by entering the program when you knew you were willful.