Under the citizenship-based taxation approach, a US citizen working or enjoying retirement in any country outside the US shall continue to be subject to US income tax. This rule signifies that individuals are taxed based on their citizenship irrespective of their place of residence. In other words, if an American is outside of the US at any time during the year and earned income abroad, US Federal law requires him to file his Individual Income Tax Return or Form 1040, to report his worldwide income, and to pay taxes to the Internal Revenue Services (IRS). This makes the US one of only two countries (the other being the African nation of Eritrea) implementing this tax regime; other countries tax worldwide income of residents, but not citizens living elsewhere. For American expats, this entails recurring tax obligations on top of evaluating the tax impact in the foreign country where they are assigned to work. So even if an American expat is working in a tax-free country, he or she is still required to file income tax returns with the IRS — an obligation which, surprisingly, some Americans working overseas seem to be unaware of.
Another trap among American expats is the false assumption of having escaped tax obligations due to the acquisition of citizenship of another country. Despite multiple citizenships, the same US tax rules will apply as long as the taxpayer remains a US citizen.
That being said, here are some important reminders on US tax filing of Americans residing abroad:
1. The tax filing deadline automatically extends to June 15. American citizens are allowed an automatic two-month extension to file their return without the need to request for an extension. For a calendar year return, the automatic two-month extension is from April 15 to June 15. The extension does not include the deadline for payment of taxes. Hence, payment of taxes after April 15 shall be subject to interest for late payment.
2. Americans can qualify to exclude all or a portion of their foreign earned income from US taxation. Although foreign earned income is required to be reported as part of the taxpayer’s gross income in the US, Section 911 of the US tax code allows the taxpayer to exclude these foreign earned incomes from taxation in the US. Generally, this rule aims to place US citizens abroad on equal footing with their foreign counterparts. The IRS allows a general exclusion of up to $104,100 in 2018 (or $102,100 in 2017), subject to annual adjustment of amount due to inflation. In addition, they may also either exclude or deduct costs for foreign housing.
3. US citizens can elect to deduct foreign income tax as an itemized deduction or claim foreign tax credits against their total US tax. The purpose of either election is to mitigate double taxation that would otherwise occur if both the IRS and a foreign country tax authority taxed the same income. In general, a credit is almost always better than a deduction because a credit reduces the taxpayer’s tax liability on a dollar-for-dollar basis. On the other hand, the value of a deduction is tied to the taxpayer’s marginal tax bracket, making tax savings only equivalent to the marginal tax rate.
4. Taxpayers need to make estimated tax payments. Per IRS guidance, taxpayers must generally pay at least 90% of their taxes throughout the year through withholding, estimated tax payments, or a combination of the two. If they don’t, they may owe an estimated tax penalty. To avoid penalties, individuals must pay estimated tax if they expect to owe tax of $1,000 or more when their return is filed.
5. Taxpayers must file informational forms for foreign accounts. If a taxpayer has a financial interest in (or a signature authority over) foreign or non-US banks, securities or other financial accounts, either business or personal, he or she must file FinCEN Form 114 or Report of Foreign Bank and Financial Accounts (FBAR). This form should disclose foreign accounts that hold an aggregate of more than $10,000 at any time during the calendar year.
6. State tax filing must be checked. Federal tax filing does not cover state tax obligations. Considering that tax laws vary greatly from state to state, it is mandatory that taxpayers check if they are required to file state income tax returns to the revenue department of the state(s) of either their residence or the place where income their was earned.
To err on the side of caution, it is advisable for US citizens who live and work abroad to seek assistance from tax advisors before proceeding with tax filing. From a long-term perspective, legislators may need to revisit the citizenship- based taxation system and consider a simpler and fairer alternative that would encourage Americans to work abroad and help them save more. In the meantime, US expats will have to contend with the current tax system to avoid incurring penalties, with the hope that the Federal tax code may someday be amended to their benefit.
The views or opinions expressed in this article are solely those of the author and do not necessarily represent those of Isla Lipana & Co. The content is for general information purposes only, and should not be used as a substitute for specific advice.
Aniway L. Asi is a senior manager at the Tax Services Department of Isla Lipana & Co., the Philippine member firm of the PwC network.
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