US Income Tax Pitfalls for Americans Living Abroad

While the U.S. has traditionally been seen as a low-tax jurisdiction for individuals, with its many exemptions and generous deductions, its rules can bite hard for U.S. expatriates.

In the past, “long distance Americans” generally responded by ignoring their U.S. tax obligations, and expat filing rates were notoriously low. Now, a combination of tougher anti-abuse legislation such as the Foreign Account Tax Compliance Act (FATCA) and more aggressive enforcement by the IRS has convinced more Americans living overseas that they must comply with U.S. rules. 

So a crash course in U.S. Tax 101 is advised. 

In a recent article for BNA Tax Planning International Review, Chris McLemore and Erin Fraser of Butler Snow LLP highlight the following pitfalls for Americans abroad – including dual citizens who may not have a U.S. passport, or persons who acquired U.S. citizenship at birth, but never lived in the U.S. for any period of time.  

  • U.S. citizens are taxed on their worldwide income.  There is a foreign earned income exclusion (US$100,800 for 2015) but to be eligible for the full exemption, the taxpayer must be a bona fide tax resident of another country for the entire tax year, or have spent at least 330 days outside the U.S. Furthermore, the exemption does not apply to unearned income such as pension income or dividends from a corporation, including a corporation that is the taxpayer’s employer.
  • Even a taxpayer with a nil tax liability must file a return on an annual basis.
  • Unlike countries such as the U.K., the U.S. does not exempt the sale of a principal residence from capital gains tax. Instead, the U.S. assesses capital gains tax, generally at the long-term capital gains rate, which is currently 20 percent, if the U.S. taxpayer’s share of the gain exceeds US$250,000 or US$500,000 for married U.S. taxpayers. Note that U.K. stamp duty at the time of purchase cannot be credited against U.S. tax upon a subsequent sale.
  • Employer contributions to certain pension plans, such as a Singapore Central Provident Fund, can be subject to U.S. tax (while exempt in Singapore) and are also not eligible for the foreign earned income exemption discussed above. The U.S. tax treatment of a U.K. Self-Invested Personal Pension is unclear, and is likely to trigger special reporting requirements. Additional tax charges may apply under the “Passive Foreign Investment Company” rules, which were intended to deter Americans from sheltering income in foreign investment vehicles, but have a surprisingly broad reach.
  • The 3.8 percent net investment income tax (NIIT), applicable to taxpayers with modified adjusted gross income (modified AGI) of more than US$200,000 or married taxpayers filing jointly with modified AGI of greater than US$250,000 may apply to various types of income, including dividends, interest, and even gain on the sale of a residence. This NIIT is imposed on top of income tax, and cannot be offset by foreign tax credits.

In sum, McLemore and Fraser advise that as a general matter, U.S. taxpayers should assume that all income from any source is potentially taxable in the U.S. unless a specific exemption applies. Careful advance planning is required to ensure that a taxpayer will be eligible for these exemptions at the time the income crystallises.

Uncle Sam Wants You (To Pay Tax): Income Tax Pitfalls for Americans Living Abroad , by Chris McLemore and Erin Fraser, is published in the March, 2015 issue of BBNA Tax Planning International Review. This is the first article in a series addressing U.S. tax considerations for U.S. expatriates.  Their forthcoming articles will address inheritance tax considerations, planning techniques for U.S. expatriates to reduce their U.S. tax exposure, and the expatriation procedure for Americans wishing to renounce their U.S. citizenship.

By Joanna Norland
Technical Tax Editor

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