Regardless of where they might live and work, every United States citizen must file an income tax return each year. This practice is unique worldwide as most countries will only tax the income of their residents. The United States and Eritrea are the only two countries in the world that tax based on both citizenship and residency.
The overall rules on reporting foreign income can be a little bit complicated. The IRS allows various foreign tax credits and a foreign earned income exclusion that can potentially lower your tax obligation.
In order to avoid getting into trouble with the IRS, it might be worth consulting with an accountant. A tax professional can help you correctly fill out your return, file it on time, and take advantage of credits that might lower your overall tax payment.
What Types of Foreign Income Are Taxable?
The IRS considers all earned income and unearned income from foreign and domestic sources taxable. Essentially, you’ll have to pay taxes on any amount of money that you receive in any part of the world.
It’s a lot easier to calculate your earned income. Earned income is considered any amount of money you receive for work you have performed. The most common examples of earned income include wages, salaries, tips, commissions, and bonuses.
It can be a little bit more challenging trying to calculate unearned income. Government-provided benefits such as Social Security, Medicare, Veterans Affairs benefits, welfare, unemployment, and workers’ compensation are considered unearned income.
Living outside the United States can affect your eligibility to receive these benefits. You should be able to collect Social Security if you live in most countries, but the other government benefits might not be available.
The more common types of unearned income earned abroad are interest and dividend-related income. These types of income are typically subjected to the long-term capital gains tax rate. Other sources of unearned income might include retirement accounts, inheritances, alimony, and lottery winnings.
There are many more types of unearned income, and the taxation rates can vary significantly. It might be worth talking with a tax professional before filing. They can review your return and make sure that you pay the correct amount of taxes.
How Can You Reduce Your Foreign Income Tax Obligations?
It’s a bit frustrating having to file an income tax return despite living and working in another country. However, the IRS offers up a few options that can help lower your tax obligation.
Using these options can prevent you from being taxed too much or paying taxes to two different countries. There are two different ways to achieve these goals: the foreign tax credit and the foreign earned income exclusion.
The Foreign Tax Credit
The Foreign Tax Credit is a nonrefundable credit that can prevent you from paying taxes to two different countries. This credit is available for anyone working in another country or receiving investment income from a foreign source.
The Foreign Tax Credit is non-refundable because it can only reduce the potential tax obligation to zero. Living and working in another country will mean that you will have to pay taxes to their government.
Instead of being taxed twice, you would use the Foreign Tax Credit to show how much money you’ve paid in taxes to that government. Every dollar you pay in taxes to the foreign country can be deducted from the taxes you owe to the United States.
While you will only be taxed once on your income, the higher tax rate of the two countries is used. Let’s say that you’ve paid $10,000 in taxes in a foreign country. If the IRS calculates your tax obligation as only $8,000, then you wouldn’t receive a refund from them. On the other hand, if the IRS calculates your tax obligation as $12,000, you would owe them an additional $2,000 in taxes.
The Foreign Earned Income Exclusion
The Foreign Earned Income Exclusion is more difficult and requires certain eligibility requirements. This tax exclusion has a similar goal to the Foreign Tax Credit as it works to prevent you from being taxed twice. It will also go further and potentially protect some of your income from IRS taxation.
The maximum amount you could exclude from your income for 2021 is $108,700. The limit will increase to $112,00 for the 2022 fiscal year.
It’s important to note that this option only applies to countries with a tax treaty with the United States. Most countries have an active tax treaty with the United States, but you need to make sure before using this exclusion.
In order to qualify for the Foreign Earned Income Exclusion, you must meet all three of the following requirements:
- You must be a United States citizen or a resident alien. Resident aliens are individuals classified as permanent residents of a foreign country but aren’t granted citizenship.
- You must have a qualifying presence in a foreign country. Qualifying presence status is granted by meeting the Bona Fide Resident Test (BFRT) or Physical Presence Test (PPT). The BFRT is met if you are a resident of a foreign country for an uninterrupted period that includes the entire tax year. This period runs from January 1st through December 31st. You are permitted to leave the foreign country for temporary trips, but you must return to the foreign country in a reasonable time. The PPT requires that you are physically present in a foreign country for at least 330 days during 12 consecutive months.
- You must have earned income originating from a foreign country. You will specifically need to receive earned income from a source that operates in a foreign country. Working for an employer or being self-employed are the most common examples of earned income. Receiving unearned income from foreign sources such as a pension, retirement benefits, alimony, or gambling is not considered foreign earned income.
What Constitutes a Reportable Foreign Financial Account?
Every United States citizen is required to file a Report of Foreign Bank and Financial Accounts (FBAR) if they meet the following criteria:
- There is a financial interest in or authority over at least one financial account located outside the United States.
- The value of said financial accounts exceeds $10,000 in value at any time during the calendar year.
There is a somewhat broad definition of what constitutes a financial account, but it’s not too complicated. These are a few examples of the most common types of reportable financial accounts:
- Bank accounts like checking, savings, demand deposits, or any other type of account operated by a banking institution.
- Securities accounts such as activities that buy, sell, hold, trade stock options, or other business securities.
- Accounts that involve accepting monetary deposits as a financial agent, owning an insurance policy with a cash value or annuity policy, acting as a broker or deal for commodity transactions, and operating a mutual fund with a regular net asset value determination.
What Are the Penalties for Failing To Report Foreign Income?
Failing to file an FBAR in a timely and accurate manner may result in civil penalties being assessed by the IRS. If they determine this conduct to be “willful,” it could result in criminal penalties. The penalties are tied to inflation and will increase over time. In order to avoid these penalties, you should consult with a tax professional before filing your return. Otherwise, you could be at risk for the following penalties:
- A non-willful transaction violation, which is ruled to not be due to any reasonable cause, may result in a $12,921 fine for each violation.
- A willful transaction violation may result in a fine of $129,210 or 50% of the foreign account balance being seized for each violation. You may end up owing more money than the total amount of your foreign account.
- A negligent violation made by a trade institution or business may result in a fine of $1,118 for each violation.
- A pattern of negligent violations made by a trade institution or business may result in a fine of $86,976.
Additionally, there are potential criminal charges that might be applicable. Failing to pay the correct amount of your tax obligation relating to offshore accounts could lead to the following charges:
- Failure to file an income tax return comes with a fine of up to $100,000 and up to one year in prison.
- Filing a false return comes with a fine of up to $250,000 and up to three years in prison.
- Tax evasion comes with a fine of up to $250,000 and up to five years in prison.
As long as you are a registered citizen of the United States, you will be required to pay taxes and file an annual tax return. These requirements remain true even if you move halfway around the world. Fortunately, a few options are in place that can help prevent you from being taxed twice.
You should talk with a tax professional to make sure that you are following all United States tax laws. Coast One Financial Group experts can help review your tax information and apply all relevant credits and exclusions. Failing to pay your share of taxes can result in serious fines and potentially a prison sentence.