5 Common Tax Pitfalls for Americans Living Abroad (Featured on Expatica.com)
December 21, 2015
With the upcoming tax season lurking around the next corner, we wanted to
make American expats aware of some common misunderstandings that can get
them on the bad side of the IRS. As overwhelming and challenging as taxes may
be, learning some of the basics can help taxpayers avoid making costly mistakes.
Failing to file a tax return
When Americans move overseas they logically expect to file a tax return in their new country of residency. What they find counter-intuitive is to continue filing a return in the United States where they no longer live and work. Unfortunately, the American tax law requires just that; U.S. citizens and permanent residents are obligated to file a tax return irrespective of where they reside. Filing you return on time will help you avoid interest and penalties and will keep you on good terms with the IRS.
The standard April 15th deadline applies but in a rare act of kindness, knowing that it can sometimes be hard for expats to gather the necessary information and find a tax advisor, the IRS has granted Americans living abroad an automatic 2-month extension until June 15th.
Not claiming available exclusions and credits
Many first time expats are not aware that the U.S. has adopted specific deductions and credits to alleviate Americans working abroad from double taxation. The foreign earned income exclusion, for instance, allows eligible expats to exclude up to $100,800 of income earned abroad from being taxed in the U.S. The foreign tax credit on the other hand gives expats the opportunity to use the taxes they paid in a foreign country to offset their U.S. taxes.
Even the expats who are aware of these favorable provisions sometimes mistakenly believe that they don’t need to file a tax return as long as their income is below the exclusion limit or their U.S. taxes are eliminated by the amount of foreign tax credits they have. This, however, is an erroneous and potentially costly assumption because neither the exclusion nor the credit are automatic, and the only way they can be claimed is by filing a tax return.
Disregarding the FBAR and FATCA filings
Aside from the above mentioned tax return filings, expats also “enjoy” additional compliance requirements related to their foreign financial assets that can sometimes easily be neglected. Americans with foreign bank and financial accounts with combined value of over $10,000 during the year are obligated to file Form FINCen114, commonly known as FBAR. In addition to that, some expats owning foreign stocks and offshore financial assets may be required to file Form 8938 related to the recently talked about in the news Foreign Account Tax Compliant Act (FATCA). The filing threshold for FATCA is higher and thus, it affects a smaller number of expats.
Even though both forms are simply informational and do not result in any tax, the filing obligations should not be taken lightly as the penalties for not complying are severe. For instance, the IRS can impose a $10,000 penalty for non-willful failure to file an FBAR, while a willful violation can reach the greater of $100,000 or 50% of the account value.
Not considering your state return filing requirements
State return filing requirements can often be overlooked because of the complexity and the uniqueness of the residency rules that some states employ. States which determine residency based on physical presence are expat-friendly and don’t require taxpayers who have lived out of the state for over a certain period of time, typically six months, to file a tax return.
Other states, however, follow complex domicile rules that can make it challenging for someone to break residency when moving abroad. Under this type of law, the presence of ties such as family members, real estate property, driver’s license, voting registration, etc. may continue to connect a taxpayer to a certain state and require him to file a state return even years after the person has moved away. California, Virginia, South Carolina and New Mexico are some of the states that make it very difficult for taxpayers to terminate tax residency when moving abroad.
Misunderstanding the self-employment tax intricacies
Self-employed individuals generally continue to be liable for U.S. Social Security and Medicare taxes while working overseas. The caveat of calculating the self-employment liability is that the foreign earned income exclusion is not taken into account. Therefore, even if a taxpayer’s foreign self-employment income is excluded for income tax purposes, they may still owe self-employment tax. Fortunately, there are a number of strategies available, which can help self-employed individuals decrease their tax liability. Talk to your tax advisor to determine the best approach for your specific situation.