Learn the Best Way for US Expats to Reduce their US Tax Bill
American citizens and green card holders living abroad have to keep filing US taxes every year, however, there are strategies available that they can use to reduce their US income tax bill, often to nothing.
In theory, American expats have to report and pay US tax on their worldwide income, even if they have to pay foreign taxes too.
Furthermore, expats often have to report their foreign-registered bank and investment accounts, financial assets, and business interests.
The best way for expats to reduce their US tax bill depends on their circumstances, including which country they live in (and the income tax rules there), and details of their income, including income levels, types, and where it is sourced.
The US has signed international tax treaties with over 60 other countries, however, none of them prevents expats from having to file US taxes.
Instead, tax treaties define where different types of personal and corporate income are taxable first, and define measures to reduce the risk of double taxation. Americans always have to file to claim these measures though, or otherwise, they are assumed to owe tax on their worldwide income.
While each tax treaty is slightly different, expats who benefit from tax treaty provisions are most often teachers, students, researchers, and sometimes retired expats.
The US Foreign Tax Credit
The Foreign Tax Credit allows expats to claim US tax credits to the same value as the foreign taxes that they’ve paid.
The Foreign Tax Credit can be claimed on IRS Form 1116.
Because many other countries have higher income tax rates than the US, this normally means that expats claim more US tax credits than they need, reducing their US tax bill to zero and leaving them excess US tax credits that they can cary forward for up to 10 years.
Expat parents who reduce their US tax bill to zero this way can also claim the US Child Tax Credit, which as they have already eradicated their US tax bill will give them a refundable US tax credit (i.e. a payment) of $1,400 per child per year).
The Foreign Earned Income Exclusion
The Foreign Earned Income Exclusion is an alternative way for expats to reduce their US tax bill.
It lets expats exclude the first $105,900 (in 2019) of their earned (as opposed to passive, such as from retirement income or from investments) income from US taxation.
Expats can claim the Foreign Earned Income Exclusion on IRS Form 2555. Form 2555 asks them to prove that they live abroad, in one of two ways.
The first involved demonstrating that they spent over 330 days outside the US in a 365 day period that was, or coincided with, the tax year. So if they moved abroad (or moved back to the US) mid-year, they can only exclude their earned income for the 365 day period after they lived abroad (or before they moved back to the US, respectively).
Alternatively, expats can demonstrate that they are a permanent resident in another country, for example through having a permanent residency visa or other evidence of living there full time.
Expats can’t claim and apply both the Foreign Earned Income Exclusion and the Foreign Tax Credit on the same income, so they need to determine which is more appropriate and advantageous to them.
Which is preferable depends on how much an expat earns, and how much their foreign income tax bill is.
Expats who pay foreign income taxes at a higher rate than the US rate are normally better off claiming the Foreign Tax Credit, however much they earn.
Expats who don’t pay foreign income taxes, perhaps because they don’t spend enough time in a single foreign country to qualify as a tax resident, and whose income is earned, are often better off claiming the Foreign Earned Income Exclusion. This is also true for expats who live in a country with lower income tax rates than the US.
Expats who earned over $105,900 in 2019 and who don’t pay foreign income taxes may still have to pay some US income tax on their global income above this amount. If they rent their home abroad though, they may be able to further exclude the value of many of their rental expenses from US tax by claiming the Foreign Housing Exclusion, also on Form 2555.
Another factor is whether they have children, as expats who claim the Foreign Earned Income Exclusion can’t also claim the Child Tax Credit.
It’s always worth consulting a US expat specialist though to ensure that you file to your maximum, long-term benefit.
Social security taxes
Expats who are self-employed or who work for a US firm are also required to pay US social security taxes.
Social security taxes aren’t covered by the Foreign Tax Credit or the Foreign Earned Income Exclusion, however, expats who live in on of the 26 countries the US has a Totalization Agreement with won’t have to pay both US social security taxes and those in the country where they live.
Self-employed expats may also be able to reduce their US social security tax bill by incorporating their business abroad, so that they’re then employed by it rather than self-employed, although having a foreign-registered business involves additional reporting and may have tax implications abroad, too, depending on where it’s registered.
Reducing US Tax Bill
It’s always worth consulting a US expat tax specialist firm, who will be able to advise on the best way to stay compliant, avoid US penalties, and minimize their US tax bill given their particular circumstances. Expats who are behind with their US filing may be able to catch up under an IRS amnesty program called the Streamlined Procedure.
Bright!Tax is the global leader providing US expat tax services for the 9 million Americans living abroad. Expat tax is all we do, and we are very good at it. If you have any questions about your US tax situation, don’t hesitate to get in touch for some advice.