Today's comment is by Mark Nestmann, The Sovereign Society's Wealth Preservation and Tax Consultant and President of The Nestmann Group.

Dear A-Letter Reader,

When was the last time the IRS actually did something nice for U.S. taxpayers?

About three weeks ago, actually.

The IRS issued an obscure notice on Feb. 23, 2007. This notice might not have received much publicity, but it promises to make life a little easier, tax-wise, for many of the more than three million U.S. citizens working outside the United States.

I'll try to summarize the IRS notice in plain English in a moment. But first, you might be scratching your head and thinking...

"You mean, Mark, that even if a U.S. citizen leaves the United States to live somewhere else, that person still has to pay U.S. income tax?"

The sad answer to that question is "yes." The United States is the only major country that taxes citizens on their worldwide income, wherever they live.

This creates considerable difficulties for U.S. citizens working abroad, not to mention the employers who might want to hire them.

Would You Hire an American Abroad?

Put yourself in the shoes of a company in a country like, say, Dubai. You live and work in a booming economy, where you have a huge demand for foreign workers, and zero taxes. You have a position opening up in the data processing department that will pay the equivalent of US$100,000.

You're looking at three top candidates. The first, from Sweden and Japan, won't pay any taxes at all in Dubai because they're considered non-residents in their respective countries. But the U.S. candidate will likely demand more compensation, because he'll be taxed by the United States on his income (although not all of it, as you'll learn momentarily).

From the above example, you can see how taxing foreign earned income makes U.S. citizens less competitive in the global marketplace. Thanks, Congress. And thanks Supreme Court, too, since more than 80 years ago it upheld global taxation.

Fortunately, there's a silver lining... U.S. citizens who live abroad may exclude up to US$82,400 of annual compensation from their income and can also exclude or deduct certain housing expenses. If you're a U.S. citizen living abroad with your spouse, both of you can exclude up to US$82,400 each year, for a total "foreign earned income exclusion" of US$168,400 annually.

Fringe benefits that are non-taxable to a U.S.-based employee are also non-taxable overseas. For instance, your employer can pay for your health insurance, or contribute to a retirement plan, with no additional tax liability.

How You Qualify for the US$82,400 Tax Exclusion

You must qualify under one of two tests to be eligible for this foreign earned income exclusion (FEIE): the bona fide residence test or the physical presence test:

Bona fide residence test : If you have established legal residence 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're physically present in a foreign country or countries for at least 330 full days during any period of 12 consecutive months.

Under either test, you must prove that you have a new tax home outside the United States. For example, you live in a jurisdiction that can tax your income on the basis of residence or other ties. However, there is no requirement that you live in a country that imposes an income tax.

Meddling Congress Tries to Squash FEIE - and Fails!

It only seems fair that since the United States forces its non-resident citizens to pay income tax, it would provide some measure of relief via a mechanism like the FEIE. But that hasn't stopped congressional demagogues from regularly demanding that it be scrapped.

Indeed, in virtually every congressional session over the least five years, they introduce a bill requiring Americans who work and live in other nations to pay tax on their worldwide income.

It's true there's another provision of the U.S. Tax Code that says if, while abroad, you earn income that's subject to foreign taxes, then you may apply those taxes as a credit towards your U.S. tax bill.

But there are problems with foreign tax credits. One problem is that they don't apply to all types of taxes. Another hitch is the competitiveness issue-eliminating the FEIE would make U.S. citizens even less competitive in the global marketplace than they already are.

Nonetheless, in 2006, our enlightened Congress, spearheaded by Sen. Charles Grassley (R-Iowa), made significant changes to the FEIE to make it less attractive. In some cases, U.S. citizens working abroad will see their taxes go up US$30,000 or more!

IRS Swoops in to Help Expats

But the IRS stepped in to rescue U.S. expatriates on February 23. The agency gave a huge break to expats living in areas with high housing costs. Specifically, they increased housing exclusion allowances in dozens of locations.

U.S. citizens working in China and India will see the biggest increases, along with those working in several suburbs of London. In some cases, expats working in these locations could see their tax bill fall by several thousand dollars.

Of course, there's no assurance that Charles Grassley and his congressional killjoys won't do their best to eliminate or further restrict the FEIE exclusion again this year. Nor is there any guarantee that the IRS will be willing to come to the rescue again if they do.

However, in this era of big government, Big Brother and increasingly onerous taxation, I'll take what I can get. And I'll say something I thought I'd never say:

"Thanks, IRS."

MARK NESTMANN, Wealth Preservation & Tax Consultant, and
President of The Nestmann Group
www.nestmann.com

P.S. True expatriation, or giving up your U.S. citizenship, is the last legal way to get out of paying U.S. taxes. It's a big step, but if it seems like the right one for you, click here to learn more.