Tom LR Griffiths is a US expatriate tax expert and consultant. Here he busts some common expat tax myths for US citizens living abroad.
It’s not uncommon to see some extremely creative tax advice circling online forums for Americans living abroad.
Incorrect advice from these online expat communities can be very damaging to expats just trying to understand their filing obligations.
Filing a US tax return and getting expat taxes right is complex
Americans living abroad deal with arguably the most complex and demanding tax rules in the world.
This is because the US tax system requires every citizen to file taxes and pay income tax regardless of where they live.
Tax misinformation, therefore, can lead to misunderstandings regarding their tax liability and lead to either double taxation or U.S expats suffering punitive penalties from the IRS.
US taxes are complicated and apply to the worldwide income earned by every citizen
The US is the only major nation that organizes regulations to tax residents on their worldwide income in this way.
So, for U.S expats that want to avoid negative tax consequences, it’s essential to understand their obligations and need to file a federal tax return every year.
Given the complexity of US expat tax, the confusion over what that means with a foreign employer or demands from foreign governments, here’s a quick rundown of some of the most common U.S tax myths.
Seven of the most common U.S tax myths
Myth 1: I never end up owing U.S tax so it doesn’t matter if I file late or break tax rules
It’s true that the majority of penalties issued by the IRS regarding late tax returns are calculated as part of the income taxes owed.
However, even when no tax is due to be paid, filing obligations still stand.
For example, there can be significant penalties for filing forms late. These penalties on late income tax return and corresponding form filing start at a whopping $10,000 per month they’re late – per form.
Late, incomplete, or incorrect filing of forms like Form FinCEN can also lead to penalties.
The onus is on the US expat to ensure tax compliance on worldwide income
FinCEN Form 114 is the form that documents income from foreign financial account holders. It needs to be filed when the aggregate foreign income held in a bank account exceeds $10,000.
Any US citizen that realizes that they’ve either made mistakes filing their U.S tax return, or that something has been missed do have options.
However, it is incumbent on the person who is obliged to pay tax to assess their options and find a way to get back on track with their U.S tax obligations.
For example, the Streamlined Offshore Procedures could help them to understand that their worldwide income is subject to US income tax.
Myth 2: I work in a foreign country, so I don’t need to pay social security
Usually, US citizens working in a foreign country will participate in that country’s social security system.
However, if American citizens or green card holders are self-employed, they may also have to comply with paying taxes for social security as part of the US system.
This isn’t the case if they are eligible and able to secure a Certificate of Coverage as a self-employed expat taxpayer.
A certification is available if there is an agreement between foreign countries and the US regarding social security.
Where this kind of tax treaty does not exist, then it’s possible the US citizen will have to pay into both systems and risk double taxation.
Myth 3: My company is in my spouse’s name, so I don’t need to report foreign income from that business to the IRS
This is the kind of idea regarding foreign taxes, foreign earnings, and U.S tax filings that you will see in expat forums online.
However, this hack is potentially problematic for several reasons.
One of the most common ways that people are caught out regarding their foreign financial assets is that any shares of a foreign business owned by a spouse from the country of residence is considered under the ownership of the US citizen.
This means that they are still obliged to fulfil the reporting obligations of the foreign business on the U.S tax return.
This obligation includes filing Form 5471, which is one of the information returns that can result in fines of tens of thousands of dollars if it’s not filed on time.
Myth 4: State taxes don’t apply to me as my country of residence is not the US
A number of US states can continue to facilitate asset reporting penalties for citizens who are living abroad but have not severed ties with their former state.
States including Pennsylvania, New Jersey, California, and New York can feasibly do this, among others.
If a US citizen is ostensibly no longer a resident of a state, but they still spend physical time there, still have a driving licence for that state, vote for state offices and continue to have special connections then they could still be subject to state taxes.
Myth 5: This doesn’t count as income because there is no requirement for a foreign tax return
A surprising number of US expats may assume that because their income isn’t taxed by the country of residence, then they don’t need to file it as income to the IRS.
However, the IRS does not concern itself with the tax treatment of the same income by the foreign system.
If said income is part of the US citizen’s gross income and is not excluded via the Internal Revenue Code tit is subject to US tax returns.
There is zero exception for any income that is not covered by foreign tax systems. Every separate item must be evaluated under expat tax rules and reported to the IRS accordingly.
Myth 6: I’m owed this deduction as it’s a foreign tax credit on my foreign tax return
Deductions and any tax credits, such as the foreign earned income exclusion or foreign tax credit are assessed, decided, and granted by the US tax system only.
US expat taxes are on worldwide income, and totally uninterested in whether there is a tax deduction from the foreign country.
Myth 7: Foreign investments are no different to US investments
Yet another reason why US expats must work with tax preparation services and dynamic wealth advisors or an investment advisor representative to ensure that all these confusing areas are covered.
Usually, exchange traded funds (ETFs), foreign mutual fund accounts and any other pooled investment comes under Passive Foreign Investment Companies (PFICs) for IRS reporting purposes.
PFICs are taxed at ordinary rates and do not benefit from tax breaks in the way that US funds do.
Financial institutions won’t necessarily make this clear and the punitive nature of taxation can catch expats out.
Instead, PFICs are taxed at normal rates – and possibly at the very highest rate – and they will be subject to interest.
As they also need a lot of extra paperwork and compliance for tax purposes, it’s often easier for US expats to invest in US funds.
The above information does not constitute any form of advice or recommendation by London Loves Business and is not intended to be relied upon by users in making (or refraining from making) any finance decisions. Appropriate independent advice should be obtained before making any such decision. London Loves Business bears no responsibility for any gains or losses.