American residents abroad are often out of touch with U.S. laws and regulations, but it has become increasingly important for taxpayers to familiarize themselves with U.S. tax laws and filing requirements due to the IRS's recent crackdown on Americans abroad. Here are five things you should know about taxes for Americans overseas:
1. American residents abroad are still subject to U.S. taxes have to file a U.S. income tax return reporting all worldwide income. Even Americans who live outside of the United States need to file U.S. income tax returns if they are U.S. citizens or green card holders who has not formally surrendered their green cards. Tax returns must report all compensation, self-employment income, and rental and investment earnings to the IRS, even if the account is non-taxable or tax-advantaged in the taxpayer's country of residence. The general rule is that all income is taxable in the United States unless the IRS specifically says it is not, and many foreign tax-free accounts do not meet the IRS's strict definitions of US tax-advantaged accounts.
2. Gross compensation is taxable in the U.S., not net wages. In many European countries, high social taxes are withheld from salary at the source, and these amounts that were already paid are not subject to income tax on the foreign country's tax return. Not so for the IRS. On a U.S. income tax return, gross compensation must be reported before income and social tax withholding, and any fringe benefits or housing allowances must also be reported as income. In countries where social charges can be 20% or more of salary, it can certainly hurt. However, if the IRS finds out that a taxpayer has been reporting "net" salary rather than gross compensation, the penalties for tax fraud, late payment, and accuracy related fines are severe.
2. The first $91,500 of earned income (e.g., salary, not unemployment or investment income) is excluded from U.S. taxation if you meet certain qualifications. This special rule, known as the Foreign Earned Income Exclusion, was created to encourage American companies to create American jobs overseas and thus expand the American economy, and the benefits from the exclusion can be claimed in one of two ways. First, the Physical Presence Test requires that the taxpayer be outside of the U.S. for at least 330 days in a 365-day period (not necessarily a full calendar year). The second, known as the Bona Fide Residence Test, can be used by taxpayers who reside abroad after they have spent one full calendar living outside of the U.S. In both cases, the taxpayer must file a tax return in order to claim the exclusion, or risk forfeiting the exclusion if audited.
3. For salary over $91,500, foreign income taxes can be claimed as tax credit. American residents abroad can claim income taxes paid in their country of residence as a dollar-for-dollar credit against their U.S. income tax liability. The taxes must be pro-rated against the amount excluded using the foreign earned income exclusion, and only income taxes - not social charges - are eligible. If the taxpayer's country of residence has a higher tax rate than the United States, the taxpayer will generally owe no U.S. income taxes. If it's lower, a balance of the difference will be due.
4. If the taxpayer's country of residence doesn't have an income tax treaty with the United States, the taxpayer must file as a U.S. resident. Many European countries have tax treaties with the United States, allowing the countries to share information on taxpayers, especially potential tax frauds. Besides the fact that this system makes it difficult to evade taxes, it also establishes which country has the right to tax which type of income first. However, Americans living in countries that have no tax treaty with the U.S. (or countries with no income tax) must file their taxes as if they were U.S. residents, often paying Social Security taxes on their income. Americans in these countries also don't get the benefit of an automatic extension of time to file until June 15, or of an extension request to December 15.
5. American residents abroad need to report foreign bank accounts and financial assets to the IRS. Every year, U.S. citizens or green card holders with more than $10,000 in foreign bank and financial accounts must declare the accounts' existence to the IRS on a form known as the FBAR, or Report of Foreign Bank Accounts (Form 90.22.1). This form must be filed by June 30 (there's no extension) and include the highest balance of each and every account held by the taxpayer during the previous tax year, even if it only had $1 in it.
Potential penalties are steep - $10,000 per account per year for willful failure to report - and since 2008, the IRS is cracking down hard on Americans overseas. Starting in 2012, the FBAR will be complemented by another form, Form 8938, which will report all foreign financial assets as part of the taxpayer's income tax return and demonstrate where the income from each account is reported. And if the taxpayer isn't a resident of Switzerland, Lichtenstein, or other countries notorious for their tax secrecy laws, the IRS will be very suspicious of any bank accounts held there.
These are just some of the things American residents abroad should know about the IRS. To learn more, visit irs.gov or the IRS satellite office in your country of residence, or consult with a tax professional familiar with international tax returns.