Our practice deals with many expatriate US citizens of varying income levels working abroad as well as supporting CPAs and attorneys with their expatriate clients. We find that many clients are directed by their advisers to take advantage of the US Foreign Earned Income Exclusion (“FEIE”) rather than the US Foreign Tax Credit (“FTC”). The problem that we see is that those taking, or many giving, this advice do not understand how these different rules apply or even how they may interact to benefit the taxpayer.
Our advice to any expatriate taxpayer is that there is no one size fits all answer to which method works best. A US citizen working and/or living abroad must pay US tax on their worldwide income so the question of what works best is very important. Each methodology has some rather basic pros and cons that can help the taxpayer or their adviser pick what works best for that taxpayer. Let’s take a basic overview of these rules to outline the issues and recommended approach. This is not meant to be a technical dissertation of these rules but rather a practical approach.
The Foreign Earned Income Exclusion
The most popular method to address US expatriate taxation is the FEIE. It’s relatively easy to apply and understand and most US tax preparation software can do the heavy lifting. Those are all positives for the tax preparer or adviser but not always for the taxpayer.
The FEIE only applies to foreign earned income which is generally defined as salary and wages and related income. The FIEI for 2018 is $104,100. This means that this amount of foreign earned income may be excluded from US taxable income provided it otherwise qualifies. It may not be excluded from local country taxation but the US will allow it to escape US taxation.
The FEIE does not apply to foreign source passive income like, for example, any interest, dividend, or investment income earned outside the US. It also does not shelter foreign self-employment income from US self-employment taxes. Thus, you can have income from self-employment earned outside the US that is excluded from US income tax that is still subject to US self-employment taxes. Determining whether the self-employment tax applies is a separate analysis that depends upon whether the US has what is known as a Totalization Agreement with the country where the self-employment income is earned.
One final point to note regarding the foreign earned income exclusion is that once a taxpayer decides to take the exclusion, and then does not take it in a subsequent year, they are barred from taking it for the following 5 years. The only way to reverse is IRS permission via a US tax ruling which can be complicated and costly to obtain.
The Foreign Tax Credit
The US FTC is a tax credit that reduces or offsets a US taxpayer’s US income tax liability based on the foreign income taxes that have been paid during the relevant tax period. It sounds simple enough but it can be complex in practice and, sometimes more importantly, most US tax software packages cannot handle the FTC or are unable to properly take into account the many variables impacting a properly prepared FTC calculation. This leads many US tax preparers and advisers to avoid it even when it would provide a better result.
The purpose of the US FTC is to avoid double taxation on US taxpayers. In general, if the taxpayer lives and pays taxes in a country where the income taxes are higher than the US the expected result of utilizing the FTC will usually be that the taxpayer owes zero income tax to the IRS. If the foreign taxes paid are lower than the US tax rate, then there will likely be incremental US taxes due to meet the US tax expense.
If a US taxpayer has unused FTCs from prior years, they are automatically carried forward and can be utilized in future years where the taxpayer may not have paid sufficient foreign income tax credit to offset their US income tax owing. This is a valuable tool for US expatriates moving between high tax and low tax jurisdictions.
It must be noted that foreign social security taxes cannot be used for the US FTC since only income taxes are creditable. This is a common error that is made and it must be noted that if the IRS audits the related personal tax return, they will disallow from the FTC any foreign social security taxes or any other taxes for that matter that are not income taxes including sales taxes, VAT, etc.
Taking Both the FEIE and the FTC?
Most practitioners understand that a US taxpayer can either take the FEIE or the FTC on the same income but not both. This rule is simple enough but it leads to much confusion.
For example, does this mean if the US taxpayer earns over $104,100 in foreign earned income in 2018 that they have to pick one regime over the other? The answer is no. The US taxpayer can actually use the FEIE for the foreign earned income up to the annual limitation and then use the FTC mechanism for the remainder. This blended approach is often the approach for high income taxpayers.
The rules tell us these two regimes can be used in the same tax year but the same foreign income taxes excluded by the FEIE cannot be credited under the FTC. In other words, if a certain amount of foreign earned income was excluded, and there is additional income to be taxed exceeding the FEIE, then the foreign taxes paid on the income that was already excluded cannot be used to offset US income taxes on the remaining income.
Why is this so complicated and misunderstood? As noted above, the US FTC can be very complex. Also, most US tax software packages are not able to handle this blended approach to foreign income taxation and the FTC calculation must be performed offline and typed into the return.
The Bottom Line
The proper taxation of a US taxpayer’s foreign earned income can be very complex especially when that income exceeds the FEIE. However, as this article points out, there are still ways to reduce or entirely avoid US income taxes for these taxpayers. The problem is that many practitioners are not familiar with these methods and most US tax preparation software packages do not help with a blended approach of the FEIE and FTC. As such, practitioners and taxpayers must remain aware that this approach exists and it could save them a considerable amount of current and future US taxes.
Frank J. Vari, JD, MTax, CPA is the practice leader of FJV Tax which is a CPA firm specializing in complex international and U.S. tax planning. FJV Tax has offices in Wellesley and Boston. The author can be reached via email at firstname.lastname@example.org or telephone at 617-770-7286/800-685-2324. You can learn more about FJV Tax at fjvtax.com.