Relatives who can be included on the return
- Any child of a US citizen who is born abroad can be included as a dependent on the return, provided he/she has a valid US Social Security Number which was assigned before the due date of the return on which they are being included. So if a child is born before June 15th 2020 but is assigned a Social Security number after that date, the child cannot be included on the 2020 tax return.
To apply for a social security number, the child needs to have a consular report of birth abroad or a certificate of citizenship.
- One can choose to treat a non-resident alien spouse as a US resident, as per IRS Code 6013(g)
Many taxpayers chose to do this in order to enjoy the additional benefits of the ‘married filing joint’ status. These include lower tax rates and greater deductions. Additionally, including the spouse’s income and foreign taxes paid can increase the foreign income credit and child tax credit that can be claimed and as such reduce the taxes owed. Every case is different and needs to be analyzed to determine the best way to file.
Double Taxation
Many expats worry that they will be doubly taxed and will need to pay taxes to both the US and their country of residence. Luckily there are a number of exemptions in place to avoid double taxation.
- THE FOREIGN EARNED INCOME EXCLUSION (Form 2555) allows you to exclude a portion of your foreign earned income from US taxation, under IRS Code Section 911. The exclusion amount increases every year, in 2019 it was $105,900. To be eligible for the exclusion you must meet the tax home test and satisfy either the bona fide residence test or the physical presence test as explained below.
Tax home test – the taxpayer’s regular or principal place of business or employment must be in a foreign country throughout the period of the bona fide residence or physical presence (regardless of where he maintains his family residence).
Bona fide resident – to qualify as a bona fide resident you must reside in the foreign country for an uninterrupted period that includes an entire tax year and prove your intent was to establish a permanent, indefinite residence in the foreign country.
Physical presence test – you need to be physically present in a foreign country for at least 330 full days during any successive twelve-month period. For this test, travel days over international lands or waters must be taken into account.
There is an additional exclusion of foreign housing expenses available for expats who are self-employed or salaried employees and who meet the bona fide residence or physical presence test. The exclusion amount varies and takes into account the cost of living in different cities, and is subject to limitation.
If you file a Form 2555, you are in effect electing to exclude the income for that tax year and all subsequent tax years filed. To end this election an official revocation can be filed, or a return can be filed in a manner where the exclusion is clearly not taken. For example, claiming the foreign tax credit (explained below) on income amounts that would have been eligible for the foreign earned income exclusion can revoke the 911(a) election.
Revoking the exclusion bars you from making use of it again for the five tax years subsequent to the year of revocation. One of the main motives for revoking the exclusion is in order to be able to claim the child tax credit, which cannot be claimed on a tax return where the foreign earned income exclusion is claimed.
- THE FOREIGN TAX CREDIT (Form 1116) AND THE FOREIGN TAX DEDUCTION (Schedule A) may both be used as credits to offset the taxes owed to the US. This means that for every dollar of tax that is paid to your country of residence, one dollar is taken off your US income tax due. However, the credit is not available for taxes paid on earnings excluded by the foreign earned income or housing exclusions.
Foreign tax that was paid on US based earnings will not be eligible for this credit, although there are some exceptions as determined by different tax treaties.
Another bonus is that unused credit can be carried forward and used for up to ten future tax years.
Foreign taxes can be used as both a credit or a deduction. If used as a deduction on a Schedule A, the foreign taxes can reduce the taxable income rather than the actual taxes.
- TAX TREATIES between the US and foreign countries are enacted to determine which of the two countries has the first right to the taxation of income earned. They also provide tax exemptions and lower the tax rates of both countries. Such treaties usually include a ‘savings clause’, the purpose of which is to ensure taxpayers do not use the treaty‘s lowered tax rates to completely avoid US taxation. There are exceptions to this clause which allow a US expat reduced tax rates or exemption.
- SOCIAL SECURITY AND PENSION BENEFITS are taxable depending on the tax treaty between the US and the country of residence. A careful analysis of the tax treaty is needed to determine whether the social security income, or foreign pension benefits are taxable to the country of residence.
- TOTALIZATION AGREEMENTS alleviate double taxation of self-employed individuals. This is because self-employment income is subject to self-employment social security tax in the US and this can mean double taxation. Therefore, the US has ‘totalization agreements’ with many countries which usually allow expats to avoid double taxation. However, since these agreements vary and are not the same for every country, care must be taken to correctly evaluate when a US Expat is subject to US social security/Medicare tax or to the social security taxes of his/her foreign country.
As of January 2020, the following countries had all entered into totalization agreements with the US.
Australia, Austria, Belgium, Canada, Chile, Czech Republic, Denmark, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Japan, Luxembourg, Netherlands, Norway, Poland, Portugal, Slovak Republic, South Korea, Spain, Sweden, Switzerland and the United Kingdom
Other Tax Considerations
A number of credits can be used when filing your tax returns, as explained below.
- Child tax credit is claimed on a form 8812 which is submitted with the tax return. This credit can be claimed for children who are under 17 at the end of the tax year in question. The tax credit is worth $2000 per child, with a refundable portion which is calculated based on the parent’s earned income, up to a maximum of $1400 per child. Foreign wages and/or self-employment income can be used to calculate the credit. However, as mentioned, the child tax credit and the foreign earned income exclusion cannot be claimed on the same tax return.
In order to understand the relation between the child tax credit, foreign tax credit and earned income exclusion, let us consider the following scenario.
Laura and Jack, both US citizens from birth relocate to Britain from the US. They both find employment as salaried employees and pay taxes to the British tax authority. Since their US tax obligation is higher than its British counterpart, using the foreign tax credit will not eliminate their taxes due to the US. As such, they chose to use the foreign earned income exclusion which fully excludes their income and reduces their US taxes to $0.
A number of years later, baby Jeremy is born and receives a social security number due to his automatic US citizenship through his parents. Now, Laura and Jack chose to revoke their foreign earned income exclusion which means they now cannot use it for the following 5 tax years. They can now use their foreign tax credit to reduce their taxes, dollar for dollar. The remaining portion of taxes is eliminated using the child tax credit, and the remaining child tax credit can be claimed as a tax refund, up to the sum of $1400.
- Education credits assist with the cost of higher education. This can be education for the taxpayer, spouse or dependents claimed on the return. There are two types of education credits, the American opportunity tax credit (AOTC) and the lifetime learning credit (LLC).
AOTC can give as much as $2,500 of the cost of tuition and other qualifying expenses to eligible students. To be eligible the following criteria must to be met.
- The US student or resident alien student is within their first four years of post-secondary education.
- They must be pursuing a degree or other recognized education credential.
If the AOTC reduces a person’s tax liability to less than zero, 40% (up to $1000) is refundable.
LLC is not limited to a number of years, but is available for all years of post-secondary education, and for all courses taken for skill improvement or acquisition of new skills.
It is a credit of up to $2000 and reduces tax owing but is not refundable.
Both these credits are limited and not available above a certain income threshold.
Some international schools are recognized as institutions of higher learning and its students are eligible for education credits. Follow this link to find out which international schools are recognized for purposes of claiming the US education tax credits.
State Taxes
If you are a US citizen who is residing abroad on April 15th, you have an automatic two-month extension to file your return. Note, this is an automatic extension and you do not have to do anything in order for it to be granted. In cases where tax is due, it is recommended to add a note at the top of the return that this extension is being used.
Late Filing
If you file late, you will be hit with penalties if either or both of the following apply.
- You owe taxes
- You are filing informational returns with your tax returns
Refund Deadline
The last date to claim a refund is three years after the original due date of your return. So a 2020 refund can be claimed until April 15th 2023. If you had an automatic two-month extension until June 15th as a non-resident, then technically you have three years from July 15th to claim your refund. However, the IRS often challenge this and it is best to avoid using this extra extension and always advisable to file before April 15.
Penalties
The late filing penalty is 5% of taxes owing, per month, up to a maximum of 25% of the taxes owing. If you owe tax and have not filed by the due date, it is advisable to file as soon as possible to avoid penalties and interest accruing further.
If you are filing other informational returns with your tax return, then there are separate late-filing penalties that may apply to those forms. Penalties for missing or late-filed 5471 forms are $10,000 per year, with potential to increase to $60,000. Penalties for missing or late-filed 8938 Forms are $10,000 per year. For 3520 Forms, we are looking at a minimum $10,000 penalty as well.
Compliance Procedure
If you did not file taxes for many years then you can become compliant by using the Streamlined Foreign Compliance Procedure. This is a special opportunity given by the IRS to allow taxpayers to begin filing tax returns again without facing penalties for all the years missed.
It has been available to more people since June 18th 2014, when the IRS removed the criteria that one needs to owe $1500 or less in taxes in any of the three delinquent tax years being filed.
This procedure includes filing three years of delinquent tax returns, six years of Fbars and submitting a signed certification of non-willful conduct. This is a real boon if you owed taxes and failed to file for a number of years. The IRS have not disclosed how long this program will run.