If you’re an American citizen or green card holder living abroad, you must file your US tax return just like those living in the United States. In this article, I’ll review your tax filing obligations and consider the many expat tax traps that can trip up Americans abroad.
According to the U.S. State Department, over 9 million U.S. citizens live outside of the country full time. Both expats and residents have until April 18 to file their personal income tax returns this year because April 15th falls on a Saturday. If you have a foreign trust or domestic corporation, you must file by March 15.
You can get an automatic extension until October 15, but any taxes owed still have to be paid by the April 18 deadline. If you don’t make an estimated payment with your extension, interest and penalties will accrue from April 15 to October 15.
If you’re using the physical presence test to qualify for the Foreign Earned Income Exclusion, you can use IRS Form 2350 to extend your filing deadline past October 15 for the sole purpose of qualifying for the FEIE. For more, see: Extension of Time to File in Order to Qualify for the Foreign Earned Income Exclusion.
Expat entrepreneurs with foreign corporations file IRS Form 5471, which is usually attached to their personal return. Thus, it’s due on April 18 or June 15 with an extension when you file your Form 1040.
Remember that you must keep business records and prepare your foreign corporate return with the same care you would a US Form 1120. That is to say, a US expat has the same obligation to prove business income and expenses as does someone living in the United States.
What if I get Audited
If you’re audited, all deposits will be counted as income and you must prove all expenses with receipts and other supporting documents. The IRS can audit an offshore corporation just like a domestic business. In fact, the government is more aggressive with offshore companies who get it wrong because the penalties are much larger and their return per audit hour is higher.
For this reason, most of the expat tax traps lie in the reporting forms and compliance. Your audit and accounting responsibilities are the same as a US business, but your cost of getting out of compliance is much higher. I will review all of these filing obligations below.
Here’s How to Report Foreign Income
The Foreign Earned Income Exclusion allows you to exclude the first $101,300 of salary from your US return. If a husband and wife are both working abroad, they can earn over $200,000 free of US income tax.
What trips up many expats is assuming they don’t need to file if they earn less than $100,000. This is VERY wrong. In fact, if you’re audited and haven’t filed, you can lose the FEIE entirely. Failure to file can cost you tax, interest, and penalties on your entire salary. This “use it or lose it” clause in the FEIE has crushed many an expat over the years.
If you’re self-employed or operating a business outside of the United States, watch out for self-employment tax. This is not reduced by the FEIE and is 15% of your net profits. The FEIE applies to income tax but not SE tax.
So, someone earning $100,000 in self-employment income might pay zero income tax using the FEIE. But they will pay about $15,000 in SE tax as a penalty for failing to plan.
And SE tax is a penalty, pure and simple. If you operate your business through an offshore corporation formed in a tax-free country and report your income on Form 2555 as a salary from that offshore corporation, you can eliminate self-employment tax entirely.
Credit or Exclusion
Another trap many expats fall into is taking both the FEIE and the foreign tax credit. This is especially common with those earning more than $100,000 a year.
You can take the Exclusion or the credit, but not both. You can take the Exclusion on your first $100,000 of income and the credit on your second $100,000 of income (and more), but you can’t double dip the credit.
Likewise, you can’t take the FEIE and the child tax credit. This credit is only $1,000 and phases out after $110,000 of income, so it doesn’t make a difference to most expats. However, taking the child credit with the FEIE is a sure way to get audited, so avoiding this trip is a big deal.
If one expat is living abroad and one in the States, you should be filing separately. Likewise, if one is operating a business that might incur a tax debt, you should be filing separately to protect your “innocent” spouse.
If you met and married your spouse outside of the United States, you should be filing as single or separately. That is if your spouse is a nonresident alien to the United States, that gives you a lot of tax and business planning options. Don’t give that up forever to get a small tax break today!
For more on this topic, see: Expat Entrepreneurs Should File Taxes Separately
The same goes for anyone using the physical presence test to qualify for the Foreign Earned Income Exclusion. If you spend time in the US and miss your 36-day window by even one day, you lose the Exclusion in its entirety. This can result in a massive tax debt that you don’t want to reach your spouse.
Remember it’s always better to use the residency test over the physical presence test when available. You can get residency in a country like Panama or Nicaragua with a small investment. This will allow you to spend 3 or 4 months a year in the US and stop stressing over your travel days.
If You Owe the IRS, Watch Out for Trump’s 2017 Travel Ban
Beginning in early 2017, the IRS will begin revoking or refusing to renew US passports of those who owe $50,000 or more… a low threshold for an expat entrepreneur. If you’re at risk of losing your passport, consider getting permanent residency or a second passport as soon as possible.
Be aware that you must complete the residency or second passport program before you lose your US passport. You must have a valid passport throughout the application process.
For more on this topic, see: Trump’s next travel ban will affect up to 16 million American citizens
International Bank and Brokerage Accounts
Now let’s get to the crux of the expat tax traps… those compliance forms.
One of the most critical filing requirements is the Report of Foreign Bank and Financial Accounts. Anyone who is a signor or beneficial owner of a foreign bank or brokerage account(s) with more than $10,000 must disclose these accounts to the U.S. Treasury.
The law imposes a civil penalty for not disclosing an offshore bank account or the offshore credit card of $10,000 or 50% of the balance in the account. Criminal penalties for willful failure to file an FBAR can also apply in certain situations.
In addition to filing the Foreign Bank Account Report, the offshore account must be disclosed on your personal income tax return, Form 1040, Schedule B.
Corporate and Trust Filing Requirements
There are a number of offshore filing requirements for IBCs and International Trusts. Failure to file the required returns may result in civil and criminal penalties and may extend the statute of limitations for assessment and collection of the related taxes.
- Form 5471 – Information Return of U.S. Persons With Respect to Certain Foreign Corporations must be filed by U.S. persons (which includes individuals, partnerships, corporations, estates, and trusts) that own a certain proportion of the stock of a foreign corporation or are officers, directors or shareholders in Controlled Foreign Corporation (CFC). If you prefer not to be treated as a foreign corporation for U.S. tax reporting, you may be eligible to use Forms 8832 and 8858 below.
- A foreign corporation or limited liability company should review the default classifications in Form 8832, Entity Classification Election and decide whether or not to make an election to be treated as a corporation, partnership, or disregarded entity. Making an election is optional and must be done on or before March 15 (i.e. 75 days after the end of the first taxable year).
- Form 8858 – Information Return of U.S. Persons with Respect to Foreign Disregarded Entities was introduced in 2004 and is to be filed with your personal income tax return if making the election on Form 8832. A $10,000 penalty is imposed for each year this form is not filed.
- Form 3520 – Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts is required when a U.S. person
- Form 3520-A – Annual Information Return of Foreign Trust is required of any foreign trust with a U.S. Owner (Grantor). Failure to file this form can result in a penalty of 5% of the gross value of the U.S. person’s portion of the trust.
- Creates or transfers money or property to a foreign trust,
- Receives (directly or indirectly) any distributions from a foreign trust, or
- Receives certain gifts or bequests from foreign entities.
- Form 5472 – Information Return of a 25% Foreign-Owned U.S. Corporation is required to be filed by a “reporting corporation” that has “reportable transactions” with foreign or domestic related parties. A reporting corporation is either a U.S. corporation that is a 25% foreign-owned or a foreign corporation engaged in a trade or business within the United States. A corporation is 25% foreign-owned if it has at least one direct or indirect 25% foreign shareholder at any time during the tax year.
- Form 926 – Return by a U.S. Transferor of Property to a Foreign Corporation is required to be filed by each U.S. person who transfers property to a foreign corporation if, immediately after the transfer, the U.S. person holds directly or indirectly 10% of the voting power or value of the foreign corporation. Generally, this form is required for transfers of property in exchange for stock in the foreign corporation, but there is an assortment of tax code sections that may require the filing of this form. The penalty for failing to file is 10% of the fair market value of the property at the time to transfer.
- Form 8938 – Statement of Foreign Financial Assets was created in the tax year 2011 and must be filed by anyone with significant assets outside of the United States. Who must file is complex, but, if you live in the U.S. and have an interest in assets worth more than $50,000, or you live abroad and have assets in excess of $400,000, you probably need to file. If you are a U.S. citizen or resident with assets abroad, you must consult the instructions to Form 8938 for more information. Determining who must file is a complex matter.