Dear A-Letter Reader:
If you're a U.S. citizen living offshore, you can save big on income taxes on your earned income-up to US$82,400/year if you're single and US$164,800 if you're married and your spouse accompanies you abroad.
You can obtain additional tax credits for your housing expenses.
Living offshore makes it much easier to operate an offshore business and legally defer taxes on the profits.
To qualify for this "foreign earned income exclusion," or FEIE, you must pass one of two tests established in the U.S. Tax Code:
Bona fide residence test. If you have established legal residency in another country for an uninterrupted period of at least one year, you qualify under this test.
Physical presence test. You qualify under this test if you are physically present in a foreign country or countries for at least 330 full days during any period of 12 consecutive months.
You must also be able to prove that you have a new "tax home" outside the United States, although there is no requirement that you live in a country that imposes an income tax.
For instance, you can live in a country without an income tax, such as The Bahamas, and not be subject to any tax on the first US$80,000 of your earned income. Or, in a country like Panama, that taxes only domestic income, and all your earned income derives from non-Panamanian sources, not subject to any Panamanian tax.
To qualify for this tax savings, you must continue to file U.S. tax returns, and attach IRS Form 2555 each year with your return. And if you live in a country that imposes income taxes, you must pay them-although you may credit any foreign income taxes paid against income tax you owe in the United States.
You're also required to still pay U.S. tax on unearned income-interest, dividends, royalties, etc. You must also continue to pay Social Security taxes if you're working for a U.S. employer or if the country you're living in has a "totalization agreement" in force with the United States (fortunately, most countries don't).
Why is Uncle Sam so strangely benevolent? There's a sound reason that Congress has extended these benefits to U.S. citizens living abroad.
Unlike most nations that impose income, Social Security and similar taxes on the basis of residence, the U.S. taxes not only on the basis of residence, but also of citizenship.
Someone living in Mexico, the United Kingdom, Japan or almost any other country in the world can live free of tax obligations to his or her home country after a prolonged (one-to-five year) period of non-residence.
Without the FEIE, U.S. citizens living abroad would be subject in many cases to double taxation-both by the United States and their new country of residence. That would make companies that employ U.S. citizens abroad uncompetitive in the global marketplace. While double taxation can often be avoided through tax treaties, these agreements don't cover all types of taxes Americans working abroad may face. The bottom line is the FEIE is a sound investment for Uncle Sam to make on behalf of its citizens living abroad.
Unfortunately, Congress is having second thoughts about providing this benefit. The $70 billion tax cut recently passed by Congress including several "revenue enhancing" measures-including some important new restrictions to the FEIE. Among the most severe was limiting the ability of employers to offer tax-free housing to U.S. employees working abroad.
In addition, the amount of foreign earned income that surpasses the level of exemptions will be taxed as though the income was earned in the U.S., at a much higher rate. Further, income from foreign retirement accounts can in certain cases now be taxed.
Still, even with these new limitations, short of giving up their U.S. citizenship, the FEIE is the best deal that Americans living offshore have to reduce their U.S. tax liability.
MARK NESTMANN, Wealth Preservation and
Tax Consultant on behalf of The Sovereign Society
www.nestmann.com
assetpro@nestmann.com