This article will explore in brief U.S. federal tax issues concerning expatriates. When discussing expatriate U.S. taxation, you must know who an expatriate is. One noted authority describes an expatriate as a person who voluntarily abandons or renounces his or her country and becomes a citizen or subject of another country. However, when used in this article, an expatriate is defined as an individual who has U.S. citizenship but who is living in a foreign country for a period of time. Such expatriates usually plan to return to their home country eventually, although some never do. Thus, for the purposes of this article, an expatriate is defined as a U.S. citizen temporarily living in a foreign country and working in that foreign country, but who plans on returning to the United States.
Tax and other ancillary issues to be explored in this article are: (1) what is the current foreign earned income exclusion associated with expatriates; (2) what are applicable foreign tax credits associated with that individual; (3) what are the reporting requirements to the U.S. Internal Revenue Service (IRS) concerning foreign bank accounts of U.S. citizens; (4) what are the U.S. filing requirements unique to expatriates; and, to a limited extent, (5) federal tax and ancillary issues associated with an expatriate who dies in a foreign country.
Current Foreign Earned Income Exclusion
If an expatriate has full-time residence abroad for a full calendar year, he or she may exclude $91,500 (the 2010 threshold amount) of foreign earned income for the year. If the expatriate is married and both spouses earn income abroad and reside and work abroad, the expatriate’s spouse can also exclude $91,500 (the 2010 threshold amount) of additional income from U.S. taxation. Certain excess foreign housing costs also can be excluded or deducted. These exclusion amounts only can be claimed on a properly filed 1040 Form if elected and are not automatic; the expatriate must file an income tax return for the year the income applies as well as the appropriate forms claiming this exclusion. The United States has income tax treaties with a number of foreign countries. Both the IRS and foreign taxing authorities exchange information on their citizens living in the other’s country. The U.S. government usually has individuals working in foreign countries in the U.S. embassy or consulate in that foreign country to assist citizens and to report to the IRS information for citizens who may not be filing U.S. tax returns. These issues are complex, but U.S. citizens living in a foreign country need to check with their tax professionals concerning all applicable filing requirements and applicable income exclusions.
It is very important for an individual who temporarily moves out of the United States not to ignore the tax claims of his or her previous state on income abroad. Many states, such as Massachusetts and Virginia, make it difficult to give up tax residency in that particular state. Some states require the expatriate to file state income taxes and pay state income taxes even if he or she does not move back to that state for several years. This issue should be researched for the particular state of residency prior to relocation into a foreign country. As indicated, state tax issues are not the gist of this article, but never forget that although the federal government might have applicable exclusions, the state of residency might not have the same applicable exclusions or credits.
Foreign Tax Credits
The foreign tax credit is intended to reduce the double tax burden that would otherwise occur when foreign-source income is taxed by both the United States and the foreign country from which the income is derived. To claim the foreign tax credit, individual expatriates who have paid or accrued certain foreign taxes to a foreign country or U.S. possession should file IRS Form 1116. Generally, the following four tests must be met for any foreign tax to qualify for the credit: (1) The tax must be imposed on the individual; (2) the individual must have paid or accrued the tax; (3) the tax must be the legal and an actual foreign tax liability; and (4) the tax must be an income tax (or a tax in lieu of an income tax). Note that foreign taxes paid on income excluded under the foreign earned income and housing exclusions are not eligible for credit.
A third issue to be explored here regards the reporting requirements to the U.S. Department of Treasury concerning foreign bank accounts of U.S. citizens. As many of you are aware, there has been a recent case against the Swiss bank UBS regarding such accounts. The U.S. Department of Justice has pursued UBS as well as thousands of additional situations involving U.S. citizens evading taxes through offshore bank and foreign accounts, and, when appropriate, it has sought criminal prosecution.
Expatriates must report all income earned in foreign accounts on their U.S. tax returns and must file Form TD F 90-22.1 for each calendar year by June 30 of the following year, if the highest balances in all accounts during the year when combined together exceed $10,000 any time during the year. If expatriates own investments in a foreign corporation or own foreign mutual fund shares, they are required to file the IRS form for owning part of a foreign passive investment company. It is our understanding that the IRS may now be matching expatriates’ U.S. passports with their U.S. tax records and now knows if they have not been filing all required U.S. tax returns while living in Mexico. Also, the U.S. government has recently sent agents to Australia and China to locate bank accounts owned by U.S. citizens who are not reporting income and ownership on the required IRS forms. In addition, the IRS has hired many new agents to audit, investigate, and discover U.S. citizens living abroad who have failed to file all necessary income tax forms and to pay appropriate taxes.
On IRS Form 1040, the individual annual income tax return form, on Schedule B, Part 3, there are questions concerning foreign accounts and trusts. In general, expatriates must complete this form if they (1) had more than a certain amount of taxable interest or ordinary dividends, (2) had an interest in or signature authority over a foreign account for which a Form TD F 90-22.1 is required, or (3) received a distribution from, or was a grantor of, or transferor to, a foreign trust. The instructions to Form TD F 90-22.1 indicate that if at any time during the taxable year the expatriate had an interest in or was a signatory to or had other authority over a financial account in a foreign country such as a bank account or other account, the expatriate must complete said form. However, there are certain exceptions to the filing of this form if the combined value of the accounts was $10,000 or less during the year, the accounts were with a U.S. military banking facility operated by a U.S. financial institution, and other exceptions.
Expatriates who had their tax home abroad on April 15 of any year get an automatic extension to file their 1040 tax return for the previous year until June 15. Taxpayers needing still more time can file further extension requests, which can extend the due date of the return until October 15. If they owe taxes and fail to pay the estimated tax by April 15, they may be subject to interest and penalties for that underpayment. However, those penalties are not as severe as those imposed for failing to file a tax return in a timely manner. It is therefore wise for taxpayers always to file an extension if they are going to file their return later than April 15, even if they do not have the money to pay their estimated taxes.
The complexity of the taxation code and the U.S. tax imposition for U.S. citizens living abroad has caused some U.S. expatriates to turn in their U.S. passports. Permanently ending U.S. citizenship is a very difficult decision and an irrevocable step; the fact that U.S. citizens are willing to take this step is a testament to how onerous the burdens have become. Relinquishing U.S. citizenship is generally not a difficult process administratively. The individual takes an oath, files several forms, and may be subject to an exit tax and related trailing tax requirements. The former citizen then receives his or her canceled passport to complete the process.
Estate Taxation of Expatriates Who Die Abroad
Generally speaking, if an individual owns assets in the United States and is living abroad on the date of his or her death, complexities arise regarding estate tax laws and asset-passing provisions. It is imperative that a U.S. citizen living abroad have a U.S. will and preferably a trust, and also have a local lawyer in the foreign country prepare a local will and/or trust, if applicable, for that country. Surprises occur if there is not proper preparation. Typically, foreign governments tax real estate owned in that country by the decedent on the decedent’s date of death. If the expatriate wants U.S. estate laws to apply, estate planning experts suggest keeping as much wealth as possible in the United States and as little as possible in the foreign country. However, given foreign heirship rules and owner’s inheritance taxes in some countries, this preparation may not be enough. If an expatriate has large amounts of assets, foundations and corporate entities and especially trusts can help to minimize these estate and inheritance taxes. Trusts are a more flexible way of accomplishing goals. However, trusts are not surefire. Some countries with forced heirship rules tend not to recognize trusts. Expatriates should concentrate on the country in which they have most of their assets and also should consider the estate tax treaties.
Expatriates residing abroad when they die do not escape federal estate taxes. This is just one final reason to consult a tax specialist who is knowledgeable about international tax affairs when moving abroad.
IRS Circular 230 Disclaimer: If the foregoing includes any tax advice, while we maintain our responsibility to you with respect to such advice, it is neither written nor intended to be used, and cannot be used, for the purposes of avoiding Federal tax penalties. A formal opinion meeting specific requirements set forth in the new U.S. Treasury guidelines may be required to avoid Federal tax penalties. This article was written in September 2010, and therefore all tax issues are researched as of September 2010, and no later-date tax changes are incorporated. Therefore, the reader of this article needs to make sure all law stated herein is applicable after September 2010. The author researched for this article the Internal Revenue Code and Regulations and reviewed IRS government publications and articles on the Internet concerning expatriates, as well as the U.S. Master Tax Guide.