U.S. Tax of Foreign Income Explained
U.S. Tax of Foreign Income: The United States is one of the few countries in the world that follows a worldwide income tax and reporting model. This means that U.S. Persons are subject to tax on their worldwide income, and must report their global assets to the IRS each year on a myriad of different international information reporting forms.
To be a considered a U.S. person (Individual), there are three main categories:
- U.S. Citizen
- Legal Permanent Resident
- Foreign National who meets the Substantial Presence Test (SPT)
We will summarize the U.S. Tax of Foreign Income tax and IRS reporting requirements.
U.S. Citizen or U.S. Person?
While the distinction between U.S. Person and U.S. Citizen may be important for immigration and other related purposes, from an IRS perspective it’s pretty straightforward.
A Legal Permanent Resident/Green-Card Holder is subject to the same tax rules as a U.S. citizen.
Both U.S. Citizens and Legal Permanent Residents are taxed on their worldwide income regardless of where they reside, and regardless of where the income was earned.
There is also a third “catchall” category of individuals who are also required to pay tax on their worldwide income and reporting their foreign asset. It is referred to the substantial presence test, and it requires non-citizens and non-permanent residents to suffer the same tax fate as their resident/citizen counterparts — unless they can qualify for the Closer Connection Exception (8840 Form).
Reporting Foreign Income
When it comes to reporting foreign income in the U.S., there are various limitations, exception and exclusions.
Here are a few tips to keep in mind:
The United States has entered into tax treaties with many countries. Common types of tax and reporting treaties, include:
- Income Tax Treaties
- Estate Tax Treaties
- FATCA Agreements
- Totalization Agreements
For example, you may have a retirement plan in a country of where there is no tax treaty, and therefore the accrued but non-distributed income might be presently taxable, even if it is non-taxable (aka growing tax-free) in the country of origin (example CPFs in Singapore).
Conversely, if there is a tax treaty in place as with the UK, then typically the non-distributed retirement funds will be tax deferred until they are distributed, and even the contributions may be tax deductible.
Foreign Earned Income Exclusion (Form 2555)
If you work overseas, and meet the Tax Home test as well as either the Physical Presence Test or Bona-Fide Resident test, you may qualify to have upwards of $105,900 excluded from your income, along with a portion of your housing deduction. This will jump to nearly $108,000 for 2020.
If you are married filing jointly, you can each take the exclusion, although you cannot double dip the housing exclusion.
Foreign Tax Credit (Form 1116)
If you already pay taxes in a foreign country on the income you earned abroad, you may be able to apply those taxes you paid towards your US tax liability. This is referred to as the “Foreign Tax Credit.”
Typically Individuals will use form 1116 to claim the credit for different categories.
While exceptions apply, usually you cannot mix earned income credits against investment income credits, although there are some highly technical rules, which sometimes may allow you to use a hybrid method.
Offshore Reporting Requirements
In addition to tax liability, you may also have offshore/foreign/international reporting issues for accounts, assets, income and investments that you have overseas.
FBAR (FinCEN 114)
The FBAR is used to report “Foreign Financial Accounts.” This includes investments funds, and certain foreign life insurance policies.
If on any day of the year, a person’s (not just individual) aggregated maximum balances of all of their foreign accounts exceeds $10,000, they will likely have to file the form.
The most important thing to remember is that a person does 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 $16,388
- 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.
Contact our firm today for assistance with getting compliant.