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Special Tax Rules for Income that Comes from Abroad

Foreign Interests

From work or investments - through family members - after retiring outside the US - many Americans have income earned abroad.

If you have this kind of income, special tax rules apply - and there are surprising traps to avoid.

The basic rule is that US citizens and permanent residents (green card holders) are subject to income tax on all their worldwide income, and to estate and gift tax on transfers of all worldwide assets. This is true no matter where such people live or travel, or how long they've been outside the US. So, merely earning income from outside the US, or being outside the US, will not reduce your federal tax bill. To minimize tax, you must utilize specific Tax Code provisions.

Working abroad

If you take a job in a foreign country, there is a US tax exclusion available for the first $80,000 of foreign earned income annually plus certain unreimbursed housing expenses. To use it, one must have a tax home (a "principal place of business") in a foreign country and also - Be a bona fide resident of a foreign country for a 12-month "rolling period" - if the 12 months stretch across two calendar years, the exclusion is prorated between the years.

The two tests can be used together for consecutive calendar years.

Example: John works in Britain for 18 months from July 1 through December 31 of the following year. He passes the physical presence test for 330 days in the period from July 1 to the following June 30, and so gets a $40,000 exclusion for the last half of the first calendar year. He is a resident for the entire following calendar year, so he gets an $80,000 exclusion for that year. He may also be able to deduct certain housing expenses.

One need not be in the country of foreign residence for all 330 days, but just be outside the US. For example, John could have worked in Britain for 11 months and vacationed in Italy for one and still passed the test.

Trap: One must have a set foreign residence that is a "principal place of business" to obtain the exclusion. Thus, a consultant or salesperson who travels the world for a year, outside the US the entire time, but who has no fixed foreign residence, does not get any exclusion.

If one works abroad for less than a year, or earns more than $80,000 abroad, income will be received that is not protected by the exclusion. To learn the rules for such income, look for a US tax treaty with the foreign nation in which the income was earned. The US has tax treaties with more than 50 countries to coordinate tax laws and avoid problems such as double taxation. Find the text of these tax treaties on the IRS Web site, www.irs.gov, by clicking "Businesses," then "International Businesses," and "Tax Treaties."

Important: The tax treaties are complex, so have an expert review any relevant tax treaty for you. Ask your employer or accountant to recommend a specialist on international taxes who can advise you.

Generally, tax treaties are more favorable than the foreign tax credit. However, if no favorable tax treaty applies, one can claim a credit on IRS Form 1116, Foreign Tax Credit, which provides an offset for specified foreign taxes against the US tax bill.

Also review the Social Security "Totalization agreement" that may exist with the foreign nation. These agreements integrate the Social Security benefit and tax rules of the US and foreign country - determining tax rates and benefit accruals. Find them on the Social Security Administration's Web site at www.ssa.gov/international.

Investment income

There is no US tax exclusion for investment income earned abroad - it is all taxable. Again, the foreign tax credit or a tax treaty with a foreign nation may act to prevent double taxation.

Of course, many people invest in foreign jurisdictions with no or low taxes of their own. Doing so is perfectly legal - but as of this year, not reporting these investments to the IRS can result in big new penalties.

Anybody who is a US citizen or permanent resident and who owns or has signatory power over foreign financial accounts with a total value exceeding $10,000 must report them by filing Form TD F 90-22.1, Report of Foreign Bank and Financial Accounts (available on the IRS Web site), with the Treasury.

Trap: This form's due date is June 30 with no extensions - extending your tax return due date does not give you extra time to file it.

New danger: Legislation enacted last year creates penalties as large as $10,000 for nonfiling, even when failure to file is not willful. If nonfiling is willful, the penalty is the greater of 50% of the account balance or $100,000.

How the foreign tax credit works: Specific rules are complex, but generally you pay the higher of the tax rates of the two countries. You get a credit on your US taxes for the amount that you paid to the foreign country - but not exceeding what your US tax would be if the income had been earned in the US.

Foreign relatives and spouses

Families with members in different countries may make gifts and bequests among them. These are not subject to income tax in the US.

But, when gifts and/or bequests from abroad totaling more than $110,000 in a calendar year (or distributions from a foreign trust) are received by a US citizen or resident, they must be reported to the IRS on Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts. Plus, a US citizen or domiciliary who establishes a foreign trust must file Form 3520A.

Trap: Failure to file the form results in a 35% penalty, unless good cause for the failure is shown.

All gifts and bequests made by US citizens and people with a US domicile to persons abroad, and gifts and bequests of US property made by nondomiciliaries of the US are generally subject to US gift and estate tax rules.

But when a US citizen marries a noncitizen, the normal unlimited gift and estate tax marital exclusion does not exist. Instead, tax-free gifts to the noncitizen spouse of up to $117,000 per year (in 2005, indexed for inflation) are permitted. On the death of the US citizen, a marital exclusion is available only for assets left to the spouse through a qualified domestic trust (QDOT) - even if the surviving non-citizen spouse is a US resident who hasn't been out of the US for decades.

Why: To prevent the spouse from taking the assets tax free and leaving the US with them so they will never be taxed in the US again. A QDOT can provide income to the surviving spouse for life, with the remaining balance in it subject to estate tax when the spouse dies.

Trap for nondomiciliaries: No lifetime exclusion for gifts and only $6,000 of assets at death are excluded.

Retirement

Retiring abroad does not free a US citizen from US tax rules - even if the person is outside the US for years at a time. For instance, contributions to foreign retirement plans made when working abroad are generally nondeductible. You may also owe foreign estate and gift taxes if you acquire assets in the foreign country.

Before retiring abroad, look to tax treaties and discuss them with your tax adviser to see how they will affect the treatment of retirement and other income. And before considering marrying a foreigner, buying foreign property, or making other foreign commitments, consider the tax consequences with such an expert.