1. I was told that if my income was less than the foreign earned income exclusion, I did not have to file a U.S. return - is that correct?
That is absolutely incorrect. The bottom line is that you are required to file a U.S. tax return regardless of whether or not you owe U.S. tax. Also, please be aware that the foreign earned income and housing exclusions allowed to expatriate taxpayers are considered elections that must be claimed on timely filed tax returns. If your returns are not timely filed, you could potentially lose the ability to claim the exclusions.
2. How do I qualify for the foreign earned income exclusion?
Bona Fide Residence (BFR)
- You must first establish foreign tax home (tax home being where you earn your primary subsistence or primary living).
- The maximum exclusion for income earned in foreign country for 2006 is US$82,400.
- You must qualify under one of the following two tests: Bona Fide Residence (BFR) or Physical Presence Test (PPT).
- Even if you go on assignment mid-year, you can still qualify for a prorated exclusion if qualifying days are less than 365 (qualifying days being days in the foreign country)
Physical Presence Test (PPT)
- Based on calendar year, January 1 through December 31.
- Can use subsequent year to qualify, but return is not filed until qualifying period ends. Example: For 2006 returns, this is within 30 days after end of 2007, or between 1/1/2008 and 1/30/2008. You are using the subsequent year, 2005, to qualify you for the foreign earned income exclusion for 2006.
- Must spend 330 days in a foreign country during any 12 month period.
- Therefore, maximum days in U.S. is 35, for any purpose (36 days in leap years).
3. My spouse and I are both on assignment. How are the exclusions calculated for each of us?
The foreign earned income exclusion is calculated for each taxpayer separately, even if you are filing a joint return. Thus each of you must qualify individually for one of the tests discussed earlier. If you are filing a joint return, the return will be filed after both of you have qualified. For example, if one of you goes on foreign assignment in June and qualifies under the physical presence test in May of the following year, but the other goes on assignment in October, and must wait to qualify under the bona residence test until January of the second subsequent year, then the joint return will be filed in January of the second subsequent year.
Note that the housing exclusion is generally calculated per household, not per taxpayer. Exceptions apply in the case of a second qualified household maintained elsewhere for your family due to adverse living conditions, or in the event that you and your spouse maintain separate households because you each have tax homes that are not within a reasonable commute of the other.
4. I haven't filed U.S. returns since I started my assignment. What can I do to get in compliance with U.S. tax return filing requirements?
As mentioned earlier, expatriates do not automatically get the exclusions if their income amount is less than the exclusion amount. It is easier to claim the foreign earned income and housing exclusions if you file prior to being contacted by the IRS. As such, we suggest that you file your late U.S. tax returns as soon as possible. If the IRS has already contacted you, and you owe tax after electing the exclusion, then the IRS may disallow the exclusion if you are filing outside of two years of the original due date. If you are filing within two years of the original due date of the return (not including extensions), certain procedures can be followed to elect the exclusions on late returns.
5. I am self-employed and on a foreign assignment. Am I still responsible for U.S. self-employment taxes?
The first item that you need to determine is if the United States has a totalization agreement (also referred to as a reciprocal agreement) with your new host country. The U.S. Social Security Administration (SSA) enters into a totalization agreement with the tax authorities of the other country to address issues involving social taxes and social tax contributions of each country and individuals working in either of the countries.
Totalization agreements have two principal purposes:
- Relief from double taxation - The agreements provide that a taxpayer is subject to social security tax in one of the two countries that are party to the agreement.
- Coordination of benefits - The agreements provide that if you pay social security tax in one country but you claim benefits in the other country, then you can count coverage periods in the other country when determining your benefits.
Each agreement is a little different. Some of the agreements may state that if you normally work in the U.S., but are self-employed in the foreign country for five years or less, you may continue to pay into the U.S. system and be exempt from the social tax requirements of the foreign country. In this case, you would need to request a "certificate of coverage" from the U.S. Social Security Administration. Other agreements state that if you are self-employed, you pay your social tax contributions to the country in which you are residing, in which case you would request your "certificate of coverage" from the foreign tax authority.
At present, the U.S. has totalization agreements with Austria, Belgium, Canada, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, and the United Kingdom.You can review the agreements through the SSA's website at www.ssa.gov/international.
there is no reciprocal agreement in place, you will still be responsible for U.S. self-employment taxes.
6. I am a U.S. citizen on a foreign assignment and I am married to a foreign citizen. Can I file jointly with my foreign spouse?
You may elect to treat your nonresident alien spouse as a full-year U.S. resident taxpayer, and thus file a joint return. This election is done when filing your first joint return together. The primary benefits of making an election would be the ability to use the more beneficial filing status of married filing joint and getting a personal exemption for your spouse. However, because the election requires that your nonresident alien spouse also report worldwide income, you may not want to make the election if your nonresident alien spouse has significant non-U.S. source income, and such income is not subject to significant foreign income taxes that could be used to offset any U.S. tax liability on such income. Also, your nonresident alien spouse must apply for and obtain an individual taxpayer identification number ("ITIN", obtained by filing the application on Form W-7 with the Internal Revenue Service).
The election is revocable in certain situations; however, after revocation, generally neither spouse can make the election again in a future year, even in the event of a divorce.
7. I am a U.S. citizen on a foreign assignment and I am married to a foreign citizen with children by a previous marriage. May I claim my spouse's non-resident children as dependents on my U.S. tax return?
Unless the children are legally adopted and the adoption is final, generally, the children cannot be claimed as dependents unless they are residents of the U.S, even if they meet all the other dependency tests (i.e. you provided over 50% of their total support, the children have little or no gross income, they have not filed a joint U.S. return with someone else and they are a member of your household). However, residents of Mexico and Canada may be claimed as dependents assuming they meet the other requirements to be claimed as a dependent.
8. In the year I return to the U.S., if I don't spend at least 330 days in the foreign country, do I lose my foreign earned income exclusion?
Once you have passed one of the tests your first year on assignment, you remain qualified up to the time your foreign assignment ends. As with the transfer year moving to the foreign country, in the year you return to the U.S. you can still qualify for a prorated exclusion if qualifying days are less than 365 (qualifying days being days in the foreign country).
9. Is it better for me to remain on my employer's U.S. payroll, or switch to the company's foreign entity payroll?
On which scenario is better for you depends on your personal circumstances. You should always discuss matters such as this with your personal tax advisor. However, if you remain on your employer's U.S. payroll, you can continue to participate in the company's 401(k) plan, if applicable, you can continue participating in company provided medical and other benefits, and you will remain on the U.S. social system. Social security taxes will continue to be withheld from compensation, including the expatriate allowances and reimbursements that are included in taxable wages.
Depending on your host country, if you switch to the host country's payroll, you will generally be subject to the host country's social tax laws, but your social tax contributions may be lower (however, it is questionable on whether or not you will see a benefit for your contributions upon retirement). If your host country is not a country with which the United States maintains a reciprocal agreement on social taxes, then social taxes potentially can be used for foreign tax credit purposes.
Again, your personal circumstances will dictate which is better for you.
10. I've heard other expatriates talking about tax equalization. What is that?
Tax equalization is a concept designed to protect an expatriate employee from any adverse tax consequences resulting from foreign assignment. Under a typical tax equalization policy, the employer guarantees to the expatriate employee that he or she will pay the same amount of tax while on foreign assignment as the employee would have paid had he or she remained in the U.S. The underlying theory of tax equalization is that the expatriate assignment should be tax neutral (no tax benefit or detriment) to the employee, no matter what country to which they may be assigned. Many companies establish tax equalization policies so that all employees are treated fairly and consistently.