Is Foreign Income for Expats Taxed in US: Missed Filings & Penalty

Is Foreign Income for Expats Taxed in US: Missed Filings & Penalty

Foreign Income for Expats 

When a U.S. Person resides outside of the United States full-time, they are considered to be ‘expats.’ US person expats who live abroad will oftentimes have income and earnings from overseas and foreign sources, such as earned income (wages/salary), interest income, dividends, capital gains, rental income, and more. The main problem arises because many expats believe that because they are not living in the United States, they are not subject to US tax on their foreign income – and therefore do not file Form 1040 with the IRS or FBAR, etc. This can lead to serious tax implications and international reporting penalties – as well as possible passport revocation and denial of renewal. With that said, the IRS has developed a specific streamlined procedure that many expats will qualify for. Let’s review the rules for foreign income for expats —

U.S. Worldwide Income (aka Citizenship-Based Taxation)

The idea behind the Citizenship-Based Taxation model is the concept that a person is subject to tax on the income of the country they are a citizen of, whether or not they reside in the country — and whether or not the income they generate is sourced in that country. In other words, a taxpayer is forced to pay tax simply for the benefit of being a citizen of that country. The United States is one of only two countries that practices this type of tax system. Take for example a US Taxpayer who lives abroad. If the US Citizen abroad resides in a foreign country and earns all of their money from foreign sources, is it really fair for the United States to have the power to tax that individual — upwards of 37% — simply because they have US Citizen status? Making matters worse, is that even though it is referred to as Citizenship-based taxation, in fact, it refers to US persons and not just US citizens – which is why foreign nationals who are considered US residents can get swept up into the definition of CBT.  But, if a taxpayer has paid taxes overseas on foreign income then they can usually claim a foreign tax credit. Likewise, if the taxpayer resides overseas sufficient to meet either the bonafide residence test or physical presence test, then they should qualify for the foreign earned income exclusion –– which allows them to exclude upwards of 108,000 of annual income from US tax liability — along with a housing exclusion –– and married couples can each claim FEIE.

Citizenship-Based Foreign Asset Reporting

In addition to having to report worldwide income, taxpayers who fall under Citizenship-Based Taxation are oftentimes required to disclose their global assets such as foreign accounts, assets, and investments to the US government on a host of different reporting forms. Some of the most common international information reporting forms include FBAR and FATCA.  While the failure to timely report these forms may result in significant fines and penalties, the US government has also created various offshore tax amnesty programs to assist taxpayers we get into compliance with offshore and overseas money.

Reporting Foreign Income

When it comes to reporting foreign income in the US, there are various limitations, exceptions, and exclusions.

Here are a few tips to keep in mind:

Tax Treaties

The United States has entered into tax treaties with many countries. Common types of tax and reporting treaties include:

      • Income Tax Treaties

      • Estate Tax Treaties

      • FATCA Agreements

      • Totalization Agreements

For example, you may have a retirement plan in a country where there is no tax treaty, and therefore, the accrued but non-distributed income might be presently taxable, even if it is non-taxable (aka growing tax-free) in the country of origin (example CPFs in Singapore).

Conversely, if there is a tax treaty in place as with the UK, then typically the non-distributed retirement funds will be tax-deferred until they are distributed and even the contributions may be tax deductible.

Foreign Earned Income Exclusion (Form 2555)

If you work overseas and meet the Tax Home test as well as either the Physical Presence Test or Bona-Fide Resident test, you may qualify to have upwards of $105,900 excluded from your income, along with a portion of your housing deduction. This will jump to nearly $108,000 for 2020.

 If you are Married Filing Jointly, you can each take the exclusion (although you cannot double-dip the housing exclusion).

Foreign Tax Credit (Form 1116)

If you already pay taxes in a foreign country on the income you earned abroad, you may be able to apply those taxes you paid toward your US tax liability. This is referred to as the “Foreign Tax Credit.”

Typically Individuals will use Form 1116 to claim credit for different categories.

While exceptions apply, usually you cannot mix earned income credits against investment income credits, although there are some highly technical rules that sometimes allow you to use a hybrid method.

Offshore Reporting Requirements

In addition to tax liability, you may also have offshore/foreign/international reporting issues for overseas accounts, assets, income, and investments. 

FBAR (FinCEN 114)

The FBAR is used to report “Foreign Financial Accounts.” This includes investment funds and certain foreign life insurance policies.

If on any day of the year, a person’s aggregated (not each account but the total) maximum balances of all of their foreign accounts exceeds $10,000, they will likely have to file the form.

The most important thing to remember is that a person does not need to have more than $10,000 in each account; rather, it is an annual aggregate total of the maximum balances of all the accounts.

Form 8938

This form is used to report “Specified Foreign Financial Assets.”

There are four main thresholds for individuals as follows:

      • Single or Filing Separate (in the US): >$50,000 at the end of the year/>$75,000 at any other day of the year

      • Married with a Joint Return (In the US): $100,000/$150,000

      • Single or Filing Separate (Outside the US): $200,000/$300,000

      • Married with a Joint Return (Outside the US): $400,000/$600,000

Form 3520

Form 3520 is filed when a person receives a Gift, Inheritance, or Trust Distribution from a foreign person, business, or trust. There are three (3) main different thresholds:

      • Gift from a Foreign Person: More than $100,000

      • Gift from a Foreign Business: More than $17,339

      • Foreign Trust: Various threshold requirements involving foreign trusts

Form 5471

Form 5471 is filed in any year that you have an ownership interest in a foreign corporation and meet one of the threshold requirements for filling (Categories 1-5). These are general thresholds:

      • Category 1: US shareholders of specified foreign corporations (SFCs) subject to the provisions of Section 965.

      • Category 2: Officer or Director of a foreign corporation, with a U.S. Shareholder of at least 10% ownership.

      • Category 3: A person acquires stock (or additional stock) that bumps them up to 10% Shareholder.

      • Category 4: Control of a foreign corporation for at least 30 days during the accounting period.

      • Category 5: 10% ownership of a Controlled Foreign Corporation (CFC).

Form 8621

Form 8621 requires a complex analysis, beyond the scope of this article. It is required by any person with a PFIC (Passive Foreign Investment Company).

The analysis gets infinitely more complicated if a person has excess distributions. The failure to file the return may result in the statute of limitations remaining open indefinitely.

*There are some exceptions, exclusions, and limitations to filing.

Current Year vs Prior Year Non-Compliance

Once a taxpayer missed the tax and reporting (such as FBAR and FATCA) requirements for prior years, they will want to be careful before submitting their information to the IRS in the current year. That is because they may risk making a quiet disclosure if they just begin filing forward in the current year and/or mass filing previous year forms without doing so under one of the approved IRS offshore submission procedures. Before filing prior untimely foreign reporting forms, taxpayers should consider speaking with a Board-Certified Tax Law Specialist that specializes exclusively in these types of offshore disclosure matters.

Avoid False Offshore Disclosure Submissions (Willful vs Non-Willful)

In recent years, the IRS has increased the level of scrutiny for certain streamlined procedure submissions. When a person is non-willful, they have an excellent chance of making a successful submission to Streamlined Procedures. If they are willful, they would submit to the IRS Voluntary Disclosure Program instead. But, if a willful Taxpayer submits an intentionally false narrative under the Streamlined Procedures (and gets caught), they may become subject to significant fines and penalties

Golding & Golding: About Our International Tax Law Firm

Golding & Golding specializes exclusively in international tax, specifically IRS offshore disclosure

Contact our firm today for assistance.