Why is Foreign Income that is Tax Free Subject to U.S. Tax - Voluntary Disclosure Options

Why is Tax-Free Foreign Income Subject to U.S. Tax – Voluntary Disclosure Options

This is a question we receive often.

Here is an example of a common scenario: Jessica is originally from Hong Kong. She resides in the United States as a Legal Permanent Resident with every intention of becoming a U.S. citizen.

Thus, at this time, Jessica is not a US citizen but still a citizen of Hong Kong.

Jessica came to the United States when she was 43 years old; thus, she had already amassed significant earnings in Hong Kong before relocating to the United States. In fact, she has two million ($2,000,000) dollars in foreign accounts throughout Hong Kong and China. (By Foreign, we simply mean accounts located outside of the United States.)

Since that income is not taxed in Hong Kong or China, she earns about $40,000 a year tax-free, which has been accumulating in the accounts overseas.

She has not brought any of that money to the United States and has not transferred any of her US earnings to the foreign bank accounts; in her mind, the Hong Kong in Chinese income stays abroad, and the US income is subject to US tax.

Worldwide Income

Unfortunately for Jessica, that is not how the US tax system works. In the United States, taxes are generally based on citizenship (including Legal Permanent Residence and Substantial Presence).

The United States taxes individuals on their worldwide income. It does not matter if an individual resides in the United States or abroad in a foreign country – if they have a responsibility to file a US tax return (as Green Card Holders do), they have a responsibility to report their worldwide income.

Even though Jessica resides in the United States and pays tax on all of her US source income, she is also required to pay tax on all of her foreign sourced income as well. If she was paying tax in a foreign country on foreign earnings, then she would usually receive a Foreign Tax Credit to ensure she is not doubled-tax. But, since the foreign countries identified above generally do not tax individuals on passive income such as bank account interest, Jessica has not paid any foreign tax on the earnings.

Therefore, Jessica is subject to US tax.

Green Card/U.S. Citizenship Status

In order to become a U.S. Citizen and/or continue being a Green-Card Holder/Legal Permanent Resident, person must stay within tax compliance. Since Jessica has not been paying any U.S. tax on her foreign source income, she is out of tax compliance — which may impact her ability to renew the green card or obtain citizenship in the United States.

In order to get into compliance, Jessica may consider entering into IRS Offshore Voluntary Disclosure in order to get herself into tax compliance before she is audited or examined by the U.S. government — which may potentially result in Jessica being subject to excessively high fines and penalties.

Golding & Golding, A PLC

We have successfully represented clients in more than 1,000 streamlined and voluntary offshore disclosure submissions nationwide and in over 70-different countries. We have represented thousands of individuals and businesses with international tax problems.

We are the “go-to” firm for other Attorneys, CPAs, Enrolled Agents, Accountants, and Financial Professionals across the globe.