A Guide to Taxation on Foreign Income for U.S. Taxpayers

It is common knowledge that U.S. citizens living domestically or abroad are subject to the 3.8% Net Investment Income Tax (NIIT). However, did you know that in the landmark case of Christensen v. United States, two U.S. citizens residing in France obtained a favorable court ruling that allowed them to offset the NIIT by utilizing foreign tax credits under the U.S.-France tax treaty?

Related article: What Is the U.S. Tax Treaty with Portugal? 

The “Convention between the Government of the United States of America and the Government of the French Republic for the avoidance of double taxation and the prevention of fiscal evasion concerning taxes on income and capital” (it’s a mouthful) allowed the French couple to claim tax credits on their income earned in France.

This case clearly illustrates that knowing the finer details and nuances of tax laws can significantly reduce one’s tax burden and maximize one’s income.

Taxation in the U.S. is complex as is, and it becomes even more intricate when dealing with diverse income sources, including foreign income. Understanding how to navigate these complexities is essential for minimizing tax liabilities and ensuring compliance with all relevant regulations. 

A critical aspect of U.S. income tax is Effectively Connected Income (ECI). ECI refers to income earned by non-U.S. residents that is effectively connected with the conduct of a trade or business in the United States.

As the world becomes increasingly multilateral, cross-border income streams will continue to grow. Foreign income can quickly become a significant portion of your earnings.

The good part is that the Internal Revenue Service (IRS) provides credits and offsets, which we will discuss in this article to help you understand the nuances of taxation on foreign income for U.S. nationals. 

At doola, in our endeavor to give you the best tools, services, and guidance on your taxation requirements, we aim to provide comprehensive insights and support to help you manage your international finances effectively.

Understanding Foreign Income Types

Understanding foreign income and its typesย 

The IRS website states that “You [U.S. citizens and resident aliens] are subject to tax on worldwide income from all sources and must report all taxable income and pay taxes according to the Internal Revenue Code.”

You may wonder what a resident alien is. A resident alien is a non-U.S. citizen who meets either the Green Card Test, meaning they have been granted lawful permanent resident status by the United States Citizenship and Immigration Services (USCIS).

Or the Substantial Presence Test, which requires being physically present in the U.S. for at least 31 days in the current year and 183 days over three years. Exceptions apply for certain visa holders and specific circumstances, such as medical conditions.

Further, taxable income includes various streams of revenue, which are listed below.  

  • Earnings from international employment, such as salaries and wages.

  • Additional compensation like bonuses, allowances, and benefits provided by employers overseas.

  • Income from self-employment activities conducted with foreign businesses.

  • Interest accrued from bank accounts or bonds held in foreign financial institutions.

  • Dividends distributed by corporations based outside of your home country.

  • Profits from selling foreign assets, including real estate or stocks.

  • Revenue from renting out properties located in other countries.

  • Other forms of foreign income include royalties, alimony, and gambling winnings.

U.S. Tax Obligations on Foreign Income

As a U.S. citizen or resident alien, you must report your worldwide income, including foreign income, to the IRS. Several essential IRS forms are used for this purpose:

Key IRS Forms for Reporting Foreign Income

๐Ÿ“œ Form 1040: This is the primary tax form U.S. taxpayers use to report their annual income. All worldwide income, including income from foreign sources, must be reported on this form.

๐Ÿ“œ Schedule B (Form 1040): This schedule reports interest and ordinary dividends, including those from foreign accounts. Part III of Schedule B asks about foreign accounts and whether you must file FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR).

๐Ÿ“œ Form 1116: This form is used to claim the Foreign Tax Credit. The credit helps avoid double taxation by allowing taxpayers to claim a credit for taxes paid to a foreign country on income also subject to U.S. tax.

๐Ÿ“œ Form 2555: This form is used to claim the Foreign Earned Income Exclusion and the Foreign Housing Exclusion or Deduction. These exclusions allow taxpayers to exclude a certain amount of foreign-earned income from U.S. taxation and to exclude or deduct certain housing expenses.

๐Ÿ“œ Form 8938 (FATCA): Under the Foreign Account Tax Compliance Act (FATCA), U.S. taxpayers holding specified foreign financial assets with values exceeding certain thresholds must report them on Form 8938, Statement of Specified Foreign Financial Assets. This is required to ensure proper reporting and taxation of foreign assets.

If you are an international founder looking for detailed information on your tax requirements, you can refer to a more detailed article or book a consultation with our tax experts. (Because non-compliance is a big no-no for the tax popo.) 

Penalties for Non-Compliance

Failing to report foreign income or to file the required forms can result in substantial penalties. Some of those are discussed below. 

๐Ÿšซ Failure to File Form 8938: Up to $10,000 for each tax year, with additional penalties if the failure continues after IRS notification.

๐Ÿšซ FBAR Penalties: Up to $10,000 per violation for non-willful violations and more than $100,000 or 50% of the account balance for willful violations.

๐Ÿšซ Accuracy-Related Penalties: Up to 20% of the underpaid amount due to negligence or disregard of rules.

Understanding these forms and ensuring compliance is crucial for avoiding penalties and managing your foreign income effectively. 

Tax Relief Options Available For U.S. Citizens Earning Foreign Income

Tax Relief Options Available For U.S. Citizens Earning Foreign Income

U.S. citizens earning foreign income have several options to mitigate their tax liabilities and avoid double taxation. The primary mechanisms available are the Foreign Earned Income Exclusion (FEIE) and the Foreign Tax Credit (FTC).

Foreign Earned Income Exclusion (FEIE)

The Foreign Earned Income Exclusion (FEIE) allows U.S. taxpayers to exclude a significant portion of their foreign-earned income from U.S. taxation, provided they meet specific criteria. FEIE can significantly reduce taxable income and overall tax liability. 

The maximum exclusion amount for 2023 is $120,000 (Source). The exclusion must be prorated if the eligibility criteria are not met for a full tax year. The Foreign Earned Income Exclusion (FEIE) has a cap and does not apply to passive income like interest or dividends. 

However, it significantly reduces taxable income and can be combined with the Foreign Tax Credit for better tax planning. Understanding these exclusions is vital for managing your tax obligations if you’re a digital nomad. Learn more about navigating the world of taxes as a digital nomad in the linked article.

Eligibility Criteria for FEIE:

โœ… Foreign Earned Income: Income must be earned from working in a foreign country.

โœ… Tax Home Test: Your tax home must be in a foreign country.

โœ… Bona Fide Residence Test: You must be a bona fide resident of a foreign country for an uninterrupted period that includes an entire tax year.

โœ… Physical Presence Test: You must be physically present in a foreign country for at least 330 full days during any 12 months.

Foreign Tax Credit (FTC)

The Foreign Tax Credit (FTC) lets you reduce your U.S. tax bill by the taxes you’ve already paid to another country on the same income. This helps prevent you from being taxed twice on the same earnings. The credit is calculated using Form 1116, which considers the foreign income, the foreign taxes paid, and any applicable limitations.

The Foreign Tax Credit (FTC) helps avoid double taxation by providing relief from paying taxes twice on the same income. Unlike the Foreign Earned Income Exclusion (FEIE), the FTC has no cap on the amount of foreign taxes that can be claimed. However, it does not apply to passive income, such as interest or dividends.

Eligibility Criteria for FTC:

โœ… Foreign Taxes Paid: You must have paid or accrued foreign taxes.

โœ… Source of Income: The income on which the foreign taxes were paid must be included in your U.S. taxable income.

Foreign Tax Credit Limit

The credit is limited to the lesser of the foreign taxes paid or the U.S. tax liability on the same income.

By utilizing the FEIE and FTC, U.S. taxpayers can effectively manage their foreign income tax obligations, reduce their overall tax liabilities, and ensure compliance with U.S. tax laws. At Doola, we provide comprehensive tools and guidance to help you navigate these tax relief options and optimize your international tax strategy.

Tax Treaties and Their Impact

The United States has established income tax treaties with numerous foreign countries to help mitigate the burden of double taxation on individuals and entities that may be subject to taxes in both the U.S. and another country.

These treaties are designed to allocate taxing rights between the countries involved, reduce or eliminate double taxation on various forms of income, and prevent tax evasion. 

Each treaty is negotiated individually and includes specific provisions that vary from country to country. These provisions address issues such as residency, permanent establishment, and types of income that may be exempt or taxed at reduced rates.

For instance, under many U.S. tax treaties, residents of the treaty country may be taxed at a lower rate or exempt from U.S. taxes on certain types of income, such as pensions, dividends, interest, and royalties. 

These treaties also often contain “saving clauses,” which preserve each country’s right to tax its residents as if the treaty did not exist, albeit with specific exceptions. For instance, if you are considering relocating or setting up a business entity in a country like Portugal, understanding programs such as the Non-Habitual Residency (NHR) can be beneficial. 

Common Treaty Benefits That Reduce Double Taxation

Tax treaties generally provide several key benefits to reduce the potential for double taxation. Let’s take a look below.

Exemption or Reduced Tax Rates

Treaties may exempt certain types of income from U.S. tax or allow them to be taxed at a reduced rate. For example, dividends and interest earned by a treaty country resident might be subject to a lower withholding tax rate than those without a treaty.

Foreign Tax Credits

While the FTC is a general provision, treaties often clarify and enhance the ability to claim these credits, ensuring that taxes paid in the foreign country can be credited against U.S. tax liability on the same income.

Permanent Establishment Rules

These rules help determine when a business’s activities in a foreign country create a taxable presence. Thus, taxation is avoided unless a significant presence or activity level is met.

Mutual Agreement Procedures

Treaties include provisions for resolving disputes over double taxation or treaty interpretation. The MAP allows tax authorities from both countries to negotiate and resolve issues, ensuring the taxpayer is not unfairly taxed by both jurisdictions.

How to Claim Treaty Benefits on a U.S. Tax Return

U.S. taxpayers must typically disclose their treaty-based position on their tax return to claim benefits under a tax treaty. This is done using IRS Form 8833, “Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b).” This form must be attached to the taxpayer’s annual tax return and details the treaty position being claimed and the relevant treaty provisions.

Additionally, taxpayers must ensure they meet all the requirements of the applicable treaty. This might include demonstrating residency in the treaty country and providing evidence of income subject to reduced or exempt tax rates under the treaty.

Tax treaties can be complex, and their benefits and requirements vary significantly. It is often advisable to consult with a tax professional who has experience in international taxation and is familiar with the specific treaties relevant to your situation.

Tax Planning and Strategies for Maximum Benefit

Tax Planning and Strategies for Maximum Benefit

Navigating the complexities of U.S. tax obligations while earning income abroad requires careful planning and a strategic approach to minimize tax liability legally. One effective strategy is to make full use of the FEIE.

By meeting the above-mentioned criteria, you can exclude up to $120,000 of your foreign-earned income from U.S. taxation. This exclusion can significantly reduce your taxable income, lowering your overall tax burden.

Proper timing of income and deductions can also be crucial in tax planning. For instance, if you anticipate changes in tax laws or your circumstances, such as moving to a country with different tax treaties, it might be beneficial to accelerate or defer income and deductions accordingly.

This strategic timing can help maximize available exclusions and credits, minimizing tax liability.

Timely and accurate reporting of foreign income is essential. The IRS requires U.S. taxpayers to report all worldwide income, including income from foreign sources, on Form 1040.

Additionally, if you have foreign financial accounts with an aggregate value exceeding $10,000 at any time during the calendar year, you must file FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR).

Accurate and timely filing of these forms helps avoid substantial penalties and ensures compliance with U.S. tax laws.

Given the intricacies of international tax laws and the potential for significant financial implications, seeking professional tax advice is highly recommended. Professional tax advisors (like us) can provide expert guidance tailored to your specific circumstances, ensuring you navigate the complexities effectively and remain compliant with all relevant regulations.

Our expertise can help you identify the best strategies for minimizing your tax liability while maximizing the benefits of available exclusions and credits.

Special Considerations

The U.S. tax treatment of foreign pensions and retirement accounts varies significantly depending on the type of account and the country where it is held. Generally, contributions to foreign retirement accounts may not be deductible on your U.S. tax return, and the earnings within these accounts may be taxable.

Distributions from foreign pensions and retirement accounts are typically subject to U.S. tax. However, the specific tax treatment can depend on tax treaties between the U.S. and the respective foreign country. 

These treaties can provide favorable treatment, such as reduced withholding rates or tax deferral opportunities, so it’s crucial to understand the provisions of applicable treaties. Another way to reduce the tax liability is to set up your LLC in a state where offsets and rebates are generally available, such as Wyoming.

Changes in residency status can also impact your foreign income taxation. For example, if you become a non-resident alien for U.S. tax purposes, you are only taxed on your U.S.-source income rather than your worldwide income. 

This shift can alter your tax obligations and planning strategies considerably. Similarly, suppose you are an expatriate who relinquishes U.S. citizenship or a long-term resident who terminates residency. In that case, you may be subject to the expatriation tax, also known as the exit tax.

This tax can apply to the net gain on your worldwide assets as if they were sold on the day before your expatriation.

Expatriates and “accidental Americans” โ€“ individuals who are U.S. citizens by birth but have lived their entire lives outside the U.S. โ€“ face unique challenges.

These individuals may be unaware of their U.S. tax obligations, including filing annual tax returns and reporting foreign accounts and assets.

Failure to comply can result in significant penalties, so expatriates and accidental Americans must understand their tax responsibilities (updated 2024 guide here for expats). Special voluntary disclosure programs may be available to help them come into compliance without incurring severe penalties.

How Can doola Help You in Your Tax Journey?

The importance of professional tax advice cannot be overstated in all these scenarios.

If you are living overseas but have a US-registered business, then sign up today on our platform and let us handle your taxes while you handle your income. 

FAQs

FAQ

What is the Net Investment Income Tax (NIIT) for U.S. taxpayers?

The NIIT is a 3.8% tax on investment income for U.S. taxpayers, including those living abroad.

How can U.S. citizens reduce their tax burden on foreign income?

U.S. citizens can utilize foreign tax credits and exclusions, such as the Foreign Earned Income Exclusion (FEIE) and the Foreign Tax Credit (FTC), to reduce their tax burden.

What are the key IRS forms for reporting foreign income?

Important forms include Form 1040, Schedule B, Form 1116, Form 2555, and Form 8938 (FATCA).

What is Effectively Connected Income (ECI)?

ECI refers to income earned by non-U.S. residents that is effectively connected with conducting trade or business in the U.S.

What penalties can result from failing to report foreign income?

Penalties can include fines for failing to file Form 8938, FBAR penalties, and accuracy-related penalties of up to 20% of the underpaid.

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