When it comes to the taxation of foreign income by the U.S. government, unfortunately the IRS standard practices are wildly divergent from almost every other country on the planet. The definition of U.S. Person is very broad, and extends to more than just U.S. Citizens.
What are U.S. Taxes on Foreign Income?
Typically, in most other countries, taxation is molded after the concept of Resident-Based Taxation (RBT).
In other words, if you are a resident of a foreign country then you pay tax in that foreign country on income you earned within that country. Typically (exceptions do apply) you do not pay taxes in the foreign country on income you earned outside of the country… Makes sense, right?
Citizen-Based Taxation (CBT)
Unlike almost every other country in the world, the United States utilizes a CBT model, otherwise known as Citizen-Based Taxation. Unfortunately, CBT is way more encompassing than the name implies. CBT goes far beyond taxing just U.S. Citizens; it also includes Legal Permanent Residents (Green-Card Holders) and even non-permanent residents who meet the Substantial Presence Test.
Under a Citizen-Based Taxation model, the United States taxes you on your worldwide income. It does not matter whether you reside in the United States or outside of the United States, and it does not matter if your income was earned from a U.S. source or foreign source – all of the income is reported on your US tax return.
With that said, there are a few key issues to keep in mind – so don’t give up hope just yet!
Foreign Earned Income Exclusion
If you meet the requirements of being a Foreign Resident under either the Physical Presence Test (PPT) or Bona-Fide Residence Test (BFR), then in accordance with the foreign earned income exclusion, you may be able to exclude up to $101,700 from your taxable income – along with additional money for housing allowance. The exclusion is claimed on IRS Form 2555.
Two things to keep in mind: First, the IRS is cracking down on people trying to claim this exclusion. Second, you have to claim the exclusion. In other words, just because you make less than $101,700 USD does not mean you are exempted from filing taxes. Stated another way, even if you earn less than $101,700 you cannot just not file the return (sorry for the double negative). Rather, you have to file the return and claim the exclusion. Otherwise, how will the IRS know what you earned?
In addition, due to increased enforcement through Foreign Bank Levies and Passport Revocation, compliance is a must.
Foreign Tax Credit
Depending on how much you have paid in foreign tax, and the type of tax — you may be able to claim a credit for the income you earned abroad against any taxes you owe on your US taxes, for the same income. The form you file is form 1116 (individuals). It is typically not a dollar-for-dollar deduction, because it is offset by your US tax status to avoid the artificial reduction of your non-foreign U.S. taxes — especially in situations in which foreign country may have an extremely high tax rate, such as Australia or Europe.
If you are a higher income earner, you may be able to apply both the Foreign Earned Income Exclusion and Foreign Tax Credit to the same category of income (but you cannot double dip).
Unlike the Foreign Earned Income Exclusion, which must be for earned income, the Foreign Tax Credit can be used for either Earned Income or Passive Income such as: Royalties, Dividends, Interest, or Capital Gains.
U.S. Income Tax Treaty Position
Depending on whether the United States has entered into a income tax treaty with a particular foreign country, may impact your U.S. tax liability. In fact, you may be able to avoid immediate taxation of certain retirement benefits (common with the UK) and/or you may be able to claim a qualified dividend (at a reduced tax rate), in situations in which at least there is a tax treaty with the foreign country (other restrictions apply)
International Reporting Forms
When a person is out of compliance with US tax related issues, it typically also includes matters involving reporting foreign accounts, investments, and/or assets on various international informational returns, such as:
- Form 3520
- Form 5471
- Form 8621
- Form 8865
- FATCA Form 8938
At Golding & Golding we focus our entire tax law practice on IRS offshore voluntary disclosure. We have helped thousands of individuals safely get into compliance, and we can assist you as well.
How to Avoid Non-Compliance with Offshore Tax & Reporting?
In order to stay in compliance, it is important to continue filing U.S. Tax returns, and reporting any foreign accounts, assets, investments, and income on the requisite International Informational Reporting Forms.
FBAR (FinCEN 114)
The FBAR is used to report “Foreign Financial Accounts.” This includes investments funds, and certain foreign life insurance policies.
The threshold requirements are relatively simple. On any day of the year, if you aggregated (totaled) the maximum balances of all of your foreign accounts, does the total amount exceed $10,000 (USD)?
If it does, then you most likely have to file the form. The most important thing to remember is you do not need to have more than $10,000 in each account; rather, it is an annual aggregate total of the maximum balances of all the accounts.
This form is used to report “Specified Foreign Financial Assets.”
There are four main thresholds for individuals is as follows:.
- Single or Filing Separate (in the U.S.): $50,000/$75,000
- Married with a Joint Returns (In the U.S): $100,000/$150,000
- Single or Filing Separate (Outside the U.S.): $200,000/$300,000
- Married with a Joint Returns (Outside the U.S.): $400,000/$600,000
Form 3520 is filed when a person receives a Gift, Inheritance or Trust Distribution from a foreign person, business or trust. There are three (3) main different thresholds:
- Gift from a Foreign Person: More than $100,000.
- Gift from a Foreign Business: More than $16,076.
- Foreign Trust: Various threshold requirements involving foreign Trusts
Form 5471 is filed in any year that you have ownership interest in a foreign corporation, and meet one of the threshold requirements for filling (Categories 1-5). These are general thresholds:
- Category 1: U.S. shareholders of specified foreign corporations (SFCs) subject to the provisions of section 965.
- Category 2: Officer or Director of a foreign corporation, with a U.S. Shareholder of at least 10% ownership.
- Category 3: A person acquires stock (or additional stock) that bumps them up to 10% Shareholder.
- Category 4: Control of a foreign corporation for at least 30 days during the accounting period.
- Category 5: 10% ownership of a Controlled Foreign Corporation (CFC).
Form 8621 requires a complex analysis, beyond the scope of this article. It is required by any person with a PFIC (Passive Foreign Investment Company).
The analysis gets infinitely more complicated if a person has excess distributions. The failure to file the return may result in the statute of limitations remaining open indefinitely.
*There are some exceptions, exclusions, and limitations to filing.
Golding & Golding: About Our International Tax Law Firm
Golding & Golding specializes exclusively in international tax, and specifically IRS offshore disclosure.
We are the “go-to” firm for other Attorneys, CPAs, Enrolled Agents, Accountants, and Financial Professionals across the globe. Our attorneys have worked with thousands of clients on offshore disclosure matters, including FATCA & FBAR.
Each case is led by a Board-Certified Tax Law Specialist with 20 years of experience, and the entire matter (tax and legal) is handled by our team, in-house.
*Please beware of copycat tax and law firms misleading the public about their credentials and experience.