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| The Basics | Even overseas, you can't escape the IRS
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Leaving the country to work doesn't mean leaving your tax obligation. But knowing the rules can cut what you pay.
By Jeff Schnepper
So, you want to work overseas. You just got a great offer to move to and work in exotic Singapore. Youre facing exciting travel, adventure -- and a whole new set of tax traps and opportunities.
These are not trifling issues. Let's set the stage so you don't find yourself in big trouble later on.
First, the general rule: U.S. citizens are taxed on their worldwide income and must file and pay U.S. income taxes regardless of where the income is earned. In 2001, some 4.2 million Americans living outside the country filed income tax returns, double the number who filed in 1996. The foreign countries with the most U.S. taxpayers are the United Kingdom, Canada, the Netherlands and Germany.
With the general rule come some exceptions and special rules to watch for.
Temporary or indefinite?
The first tax issue is whether your job qualifies as temporary. Thats a job thats expected to last for less than one year. If so, you are considered to be away from your tax home (where you normally work), and all of your travel expenses to and from Singapore or wherever would be deductible. These expenses would include not only the airfare, but lodging, meals, dry cleaning, phone, baggage, automobile and other costs.
If the foreign job is expected to last one year or more, then the job becomes indefinite, and the new job location becomes your new tax home. Since you then arent away from home, you cant deduct the travel expenses. And you'll be subject to local taxes in both countries.
You will love the earned-income exclusion
The idea of double taxation doesn't wash in this country. So, states with income taxes let you may give you a credit on taxes you paid to another state. Congress has a similar attitude toward taxes you pay abroad. You shouldn't pay taxes twice. So, theres a special rule for earned income, if you qualify. For 2005, qualified taxpayers can exclude from gross income as much as $80,000 in income earned while living abroad.
Foreign earned income includes foreign-source wages, salaries, bonuses, commissions, cost-of-living differential, home leave, tips, professional fees and any other form of compensation for personal services rendered. It even includes non-cash income, such as the use of a car.
This exclusion applies regardless of the amount of tax paid to the foreign country.
Heres how to qualify:- You must have your tax home in a foreign country. Foreign countries dont include American Samoa, the Commonwealth of the Northern Mariana Islands, Puerto Rico, the U.S. Virgin Islands or the Antarctic region.
- You must have a bona fide foreign residence. To meet this requirement, you have to be a bona fide resident of a foreign country or countries for an uninterrupted period that includes a full tax year. For a calendar-year taxpayer, youd need to include a January-to-December period. Brief or temporary trips for business or vacation wont disqualify you.
- If you dont qualify under the above bona fide residence test, you may be eligible under the physical presence test. With this test, you can qualify if you spend 330 full days out of any 12 consecutive months in a foreign country or countries. Here, physical presence in 2004 can count in determining if you qualify for the exclusion for 2005.
See if you qualify for the foreign tax credit
Any foreign taxes you pay can either be deducted as an itemized deduction on your U.S. federal return as you would treat state income taxes, or potentially taken as a credit against your U.S. tax bill.
If you deduct the taxes, you can't take the credit. Similarly, if you take the credit, it will reduce your deductions. And here's a rule of thumb for dealing with the question: If the tax bracket you are subject to in the host country is higher than your U.S. tax bracket, you may be able to wipe out any U.S. tax liability. If its lower than your U.S. tax rate, you may be paying tax to both locations.
Do yourself a favor and do both calculations before you file. The odds are the credit will help your U.S. tax bill more.
Let's say you live overseas and have taxable income of $100,000 a year. The first $80,000 will be excluded from U.S. taxes. The last $20,000 (or 20% of the total) will be subject to U.S. tax.
If the host country taxes you at, say, 25% on your entire taxable income, you will pay $25,000. But you can claim a credit of 20% of that amount -- or $5,000 -- against your U.S. tax bill. If you're in the 25% bracket for U.S. tax purposes, the credit will wipe out any U.S. tax liability. Remember: You get no credit for income excluded from U.S. taxes.
See Form 1116 to compute your foreign tax credit. Remember, this credit is potentially a dollar-for-dollar reduction in your U.S. tax bill. But the credit cant exceed the U.S. taxes paid on the foreign income.
Foreign housing costs exclusion
In addition to the election to exclude foreign earned income, you may also elect to exclude from your gross income a certain amount of employer-provided foreign housing expenses.
The amount of the exclusion is the excess of:- Your foreign housing expenses for the year, over
- A base amount equal to 16% of the salary of a federal employee at grade level GS-14 (Step 1) as of Jan. 1 multiplied by the percentage of qualifying days in the year. (Whew!)
For 2005, the GS-14 amount is $76,193, 16% of which is $12,191. So, if you had $25,000 in housing costs and were out of the country for a full year, you could exclude $12,809 from your income. (That's the result of $25,000 less $12,191.)
These exclusions are NOT automatic. You must elect them on Form 2555, which is attached to your Form 1040. Use Form 673 to keep your employer from withholding on these excluded amounts.
Check out IRS Publication 54 for more details.
These rules are the general rules for working abroad. But, many countries have special direct treaties with the U.S. government that may affect your potential financial obligations. If youre planning to work abroad, find out if theres a special treaty with the nation youre planning to work in.
A bit of advice
It can be tricky in some countries to get paychecks cashed. An easy way around this problem is to open an account in the United States at a bank with offices in the country where you'll work. Have your salary deposited directly into that account, but in the local currency. That will reduce the chances of getting hit with foreign withholding.
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