The foreign earned income exclusion is only available from income that is earned, such as income from salary and employment. It is not eligible for passive type investment income. The tax law in this area, like most areas of U.S. tax law is excessively complex in the restrictions and requirements that exist in the law.
The foreign earned income exclusion (“FEIE”) is a completely different concept from the foreign tax credit (“FTC”).
The foreign tax credit requires the USC or LPR to reflect the non-U.S. source income on their tax return along with the non-U.S. income tax paid. The FTC then allows a credit to be calculated to reduce the amount of U.S. tax, which may reduce it to zero. In addition, any excess FTC amounts (i.e., where greater taxes were paid outside the U.S. as compared to the U.S. tax) can be carried forward or carried back under a set of specified rules.
In contrast, the FEIE, simply excludes the entire amount of the “earned” income from taxation in the U.S.
There is also a very different tax form used for the FTC as compared to the FEIE. See USCs and LPRs Living Outside the U.S. – Key Tax and BSA Forms
One basic requirement for the FEIE is that a U.S. income tax return must be filed, in order to elect and obtain the tax treatment to exclude the income from taxation. In addition to filing a U.S. tax return, the taxpayer must meet the residency tests and file IRS Form 2555, Foreign Earned Income
One common misunderstanding, is that a FEIE is always better than a FTC. This is not always true. The following spreadsheet reflects “earned” income in the form of salary. The taxpayer also has three other different types of income; dividend income, interest income and long-term capital gain from the sale of real estate.
As the example demonstrates, the USC or LPR living outside the U.S. has a higher tax burden in their country of residence on long-term capital gain, as compared to the tax on the earned income. Hence, in this particular case, the taxpayer will probably be better off by not electing to exclude the salary income from taxation under the FEIE. Instead taking a foreign tax credit for all income specifically including the salary income, i.e., “earned income” should produce a lower over-all U.S. income tax burden.
I will demonstrate in a later post the actual difference between how the FEIE and FTC produces a different result in the above example.
Many USCs or LPRs who live outside the U.S. often make the erroneous assumptions that – (1) “I must have no U.S. federal tax owing, since I pay more taxes in my country of residence than the U.S. tax applicable; and (2) If I owe no U.S. federal taxes, I do not need to file a U.S. federal income tax return.”
Unfortunately, the federal tax law does not work in such a common sense manner. Any USC individual (and any LPR who does not live in a country with a U.S. income tax treaty) is obligated under the U.S. federal tax law to file a federal income tax return IRS Form Form 1040 if they meet minimum thresholds of income. The thresholds are low, and are reached once the gross income is at least the sum of (i) the “exemption” amount (currently US$3,900 per exemption) and (ii) the “standard deduction” amount.
Accordingly, even if a USC or LPR has even a modest sum of “gross income”, which equates to at least US$10,000 (in whatever currency earned), the USC or LPR will probably have a U.S. tax return filing requirement.
This is true, even if all of the income is earned income and eligible for the foreign earned income exclusion, which is US$97,600 for the year 2013. See, USCs and LPRs Living Outside the U.S. – Key Tax and BSA Forms
Will the Justice Department and Criminal Investigation Division of the IRS Turn Their Sights on USCs or LPRs living Overseas?
To date, there have been numerous indictments of non-U.S. resident persons in the “offshore financial account world” which has been a great focus of the U.S. federal government starting in 2008. An updated list of indictments of these persons can be found at Jack Townsend’s federal tax crimes blog here where he keeps a spreadsheet of cases.
To date, the author is not aware of any tax indictments (solely based upon a tax crime) of any United States Citizens or LPRs who have lived most all of their lives overseas. Is this an anomaly? Will the government be interested in bringing criminal charges against non-resident USCs or LPRs in the future?
Those persons living outside the U.S. who have been indicted (typically for conspiracy/aiding and abetting charges) have been so-called enablers; non-U.S. bankers, lawyers and accountants. Some of these cases can also be reviewed at at the federal tax crimes blog of Jack Townsend, which is the most comprehensive source of this information.
U.S. citizens and Lawful permanent residents living outside the U.S. generally have additional tax and financial account (from the Bank Secrecy Act – “BSA”) reporting requirements. These filings are unique for persons who reside in their home country compared to those who reside in the U.S.
The forms and basic concepts that may be applicable are as follows:
A common misconception that contributes to the international tax gap is that this potentially excludable foreign earned income is exempt income not reportable on a US tax return. In fact, only a qualifying individual with qualifying income may elect to exclude foreign earned income and this exclusion applies only if a tax return is filed and the income is reported.
In addition to filing a U.S. tax return, the taxpayer must meet the residency tests and file IRS Form 2555, Foreign Earned Income
Importantly, as the government explains, ” . . . Once you choose to exclude either foreign earned income or foreign housing costs, you cannot take a foreign tax credit for taxes on income you can exclude. If you do take the credit, one or both of the choices may be considered revoked. . . ”
In addition to filing a U.S. tax return, the taxpayer must meet various conditions for eligibility for the foreign tax credit. The calculation is complex and is ultimately reported on IRS Form 1116 and must be attached to the income tax return, which will always be IRS Form Form 1040 for U.S. citizens and LPRs who reside in a country with no U.S. income tax treaty; and could be IRS Form 1040NR for certain LPRs residing in a country with a U.S. income tax treaty.
C) Information Reporting Requirements
There can be multiple reporting requirements, depending upon the type of transaction, foreign asset, etc.
A summary of these reporting requirements is set forth towards the end of the article “Accidental Americans” – Rush to Renounce U.S. Citizenship to Avoid the Ugly U.S. Tax Web” International Tax Journal,CCH Wolters Kluwer, Nov./Dec. 2012, Vol. 38 Issue 6, p45.
In addition to the forms reflected in the article, IRS Form 8938 Statement of Specified Foreign Financial Assets became part of the law for 2011 tax year filings in 2012. There is often overlap of reporting on this form and the FBAR referred to below.
This form 8938, along with most other forms must be attached to your income tax return (e.g., IRS form 1040) when filed with the IRS. It is common for most types of tax preparation software NOT to have support for this and other particular forms that must be filed regarding non-U.S. assets. Accordingly, the forms often times need to be completed manually by using an Adobe Acrobat version.
The definition of “ownership interest in” or “signature authority over” is very broad under the FBAR regulations. See, FOREIGN BANK ACCOUNT REPORTS – 2011 REGULATIONS EXTEND RULES TO MANY UNAWARE PERSONS
The filing of the FBAR form is not with the IRS, but rather with FinCEN. It must now be filed electronically on Form 114, Report of Foreign Bank and Financial Accounts through the BSA E-Filing System website. The electronic form supersedes TD F 90-22.1 (the FBAR form that was used in prior years).
The penalties for not filing or even filing late are by statute $10,000 for each failure to file (or up to 50% of the account balances when intentionally not filed by the person with the requirement to file).
* Simply More Compliance Obligations for Persons Residing Outside the U.S.
At the end of the day, a USC or LPR residing outside the U.S. necessarily has a much greater burden of tax compliance and filings of these forms, compared to someone living in the U.S. without foreign bank accounts, foreign assets, foreign income, etc.
U.S. taxation of citizens has a long history going back to 1861 and the Civil War.4 The concept of citizenship based taxation was upheld by the U.S. Supreme Court in the 1920s.5 See Cook v. Tait,6 where a U.S. citizen resided permanently and was domiciled in Mexico City with his Mexican citizen wife and the Court found that U.S. taxation of his Mexican source income was indeed constitutional. Notwithstanding the long history of U.S. citizenship based taxation, the authors view it as an anachronism in the 21st century since it is particularly difficult to administer and cannot be enforced effectively overseas.7
The complete proposal can be read at “Tax Simplification: The Need for Consistent Tax Treatment of All Individuals (Citizens, Lawful Permanent Residents and Non-Citizens Regardless of Immigration Status) Residing Overseas, Including the Repeal of U.S. Citizenship Based Taxation,” by Patrick W. Martin and Professor Reuven Avi-Yonah, 2013.
The Big Gap ? – How U.S. Citizens and LPRs Residing in the U.S. versus those Living Outside the U.S. File U.S. Tax Returns.
The U.S. worldwide taxation system of U.S. citizens and LPRs causes much confusion. It is unique in the world as most all other countries only impose worldwide taxation on their residents. See, . “Tax Simplification: The Need for Consistent Tax Treatment of All Individuals (Citizens, Lawful Permanent Residents and Non-Citizens Regardless of Immigration Status) Residing Overseas, Including the Repeal of U.S. Citizenship Based Taxation,” by Patrick W. Martin and Professor Reuven Avi-Yonah, 2013.
These U.S. citizens and LPRs living outside the U.S. have (at least prior to FATCA) little third party reporting of income directly to the IRS. There are numerous government reports that demonstrate that when third parties (e.g., banks, tenants, securities brokers, credit card companies, real estate sales transactions, etc.) report the income of a particular transaction to the government, the voluntary compliance of taxpayers increases significantly. See, OECD FORUM ON TAX ADMINISTRATION: COMPLIANCE SUB GROUP
and the U.S. GAO-12-342SP: General government: 44. Internal Revenue Service Enforcement Efforts which highlights that the ” . . . where IRS can improve its programs which can help it collect billions in tax revenue, facilitate voluntary compliance, or reduce IRS’s costs. These include pursuing stronger enforcement through increasing third-party information reporting . . . Expanding third-party information reporting improves taxpayer compliance and enhances IRS’s enforcement capabilities. The tax gap is due predominantly to taxpayer underreporting and underpayment of taxes owed. At the same time, taxpayers are much more likely to report their income accurately when the income is also reported to IRS by a third party. By matching information received from third-party payers with what payees report on their tax returns, IRS can detect income underreporting, including the failure to file a tax return.”
The current trend of worldwide reporting of assets and income via FATCA and the OECD programs is designed to accomplish just this; increase information reporting by third party payers (e.g., principally from foreign financial institutions) directly to the IRS and tax revenue authorities around the world to deter U.S. citizens and LPRs living outside the U.S. from under-reporting or not reporting at all their income on their U.S. income tax returns.
Traditionally, there were limits on the law and the jurisdictional authority the U.S. government had to require non-U.S. institutions to report non-U.S. source income directly to the IRS. This has changed significantly now with FATCA, which started in earnest this year, in 1 January 2014. See,
GAO Yr2014 Report on Offshore Voluntary Disclosure Program Indicates Less Than 4% of Taxpayers Lived Outside the U.S.
The GAO has now issued two reports on taxpayers who participated in the Offshore Voluntary Disclosure Programs. See, The 2013 GAO Report of the IRS Offshore Voluntary Disclosure Program, International Tax Journal, CCH Wolters Kluwer, January-February 2014.
The extensive March 2013 GAO Report was followed by this year’s January 2014 GAO Report of 10,533 taxpayers analyzed; all of which participated in the 2009 OVD program. Interestingly, the report identifies the countries where the accounts were located; with Switzerland being the predominant country. See Table II below from the report –
In addition, the report identified the location of the taxpayers. Not surprisingly, the states with the greatest populations, such as California, New York and Florida had the states with the greatest number of taxpayers participating in the OVD program. There is, however, no direct correlation to the population in those states and the number of OVD filers.
Most interesting for U.S. citizens and LPRs living outside the U.S., are the 457 addresses identified as “other addresses”. These “other addresses” include P.O. addresses, such as from Army Post Offices, residents of Puerto Rico, income earned by U.S. government employees and “other U.S. citizens abroad.”
A more comprehensive list of the countries where the accounts were located is listed in Table 2 from this report.
Switzerland dominates the list with 42% of the accounts. See, Is the new government focus on U.S. citizens living outside the U.S. misguided or a glimpse at the new future? – with the Permanent Subcommittee on Investigations focusing primarily on Swiss Banks and Swiss accounts.
The UK is number two on the list with 1,058 accounts. Interestingly, Canada is number three on the list with 4%, presumably due to many dual nationals living in Canada.
India has only 2% of the accounts reported from this 2009 program, but has become a clear focus of the U.S. federal government. See, U.S. Justice Department Seeks Information on HSBC Customers with Offshore Accounts regarding the John Doe summonses filed with a San Francisco federal judge regarding HSBC accounts in India.
In addition, the Criminal Investigation office of the IRS in Northern California reported at the Annual California Tax Bars meeting in October 2013 in San Jose, California, that their office had just received a number of cases from India regarding unreported foreign accounts (part of a nationwide distribution of cases centered in India).
IRS Releases New IRS Form W8-BEN. * U.S. citizens and LPRs beware of completing such form at the request of a third party.
Hot off the press!
The long awaited revised IRS Form W8-BEN has been released (March 2014). The major changes to IRS Forms W8, particularly W-8BEN-E (which is still in draft form), have been driven by the changes in the law under FATCA.
Importantly, no U.S. citizen can legally sign and certify they are NOT a “U.S. person” under U.S. federal tax law. Hence, they cannot sign and complete IRS Form W-8BEN.
The form, as is true with all IRS forms, is signed under penalty of perjury. For a discussion of tax crimes of filing false documents see What could be the focal point of IRS Criminal Investigations of Former U.S. Citizens and Lawful Permanent Residents?.
Some key highlights of information on new IRS Form W-8BEN is set out below:
Importantly, lawful permanent residents (“LPRs”) have a much more complicated analysis to undertake to determine whether they ARE or are NOT a “U.S. person.”
One of the key considerations of this determination is whether the individual lives in the U.S. or is living outside the U.S. in a country which has a U.S. income tax treaty with the U.S. See Oops…Did I “Expatriate” and Never Know It: Lawful Permanent Residents Beware! International Tax Journal, CCH Wolters Kluwer, Jan.-Feb. 2014, Vol. 40 Issue 1, p9.
What could be the focal point of IRS Criminal Investigations of Former U.S. Citizens and Lawful Permanent Residents?
Below is a fairly detailed summary of the type of tax crimes that are commonly investigated by IRS Criminal Investigation (“CI”) agents.
As has already been noted, TaxAnalysts reporter Jaime Arora reported in the 3 March 2014, Worldwide Tax Daily certain comments made by Mr. Jeffrey Cooper, who is the deputy director of the IRS Criminal Investigation division’s international operations. It was reported that IRS CI is looking into why people are making the choice to shed their U.S. citizenship; whether it is related to any particular laws. Cooper was quoted at the Federal Bar Association’s Section on Taxation’s 38th Annual Tax Law Conference held on February 28, 2014.
TaxAnalysts journalist Arora quoted Cooper as identifying why people are making the choice and “If we find something, we do; if not, we just move on,” he said.
It is common policy for the IRS CI not to provide information on how they commence taxpayer investigations, including how they obtain U.S. citizenship renunciation referrals or documents. There could be a number of ways these investigations are commenced. It may be as simple as taking the list from the Quarterly Publication of Individuals, Who Have Chosen to Expatriate – Quarterly Publication of Individuals, Who Have Chosen To Expatriate, as Required by Section 6039G and start reviewing their tax return files (IRS Forms 1040, 8854, etc.) along with FBAR filings.
IRS CI tax investigations generally focus on false documents or false statements, evasion of taxation, aiding and abetting of the above along with other related tax and Bank secrecy (Title 31) crimes.
There are a host of reporting requirements and factual information that must be provided under Sections 877 and 877A, for all persons (including those with little to no assets), specifically including filing IRS Form 8854 which asks for a “boat load” of asset, income, liability and tax information. A former U.S. citizen or LPR always needs to be careful that the information provided is true, accurate and complete. See Part V of the form.
A summary of these crimes is set out below:
a. Tax Evasion (IRC Section 7201)
b. Filing a False Return or Other Document – Perjury (IRC Section 7206(1) )
(i) Aiding or assisting in the perpetration of a false or fraudulent document (26 U.S.C. § 7206(2))
(ii) Removal or concealment with intent to defraud, commonly related to untaxed liquor (26 U.S.C. § 7206(4))
(iii) Compromises and closing agreements involving fraud or concealment (26 U.S.C. § 7206(5))
c. Failure to File Return, Supply Information, or Pay Tax – (IRC § 7203 – Misdemeanor – up to 12 months imprisonment)
d. Fraudulent Returns, Statements, or Other Documents (IRC § 7207)
e. “Structuring” Transactions to Evade Cash Reporting (IRC § 6050I)
2. Tax Related Criminal Offenses under Titles 18 and 31 (Not Tax Law Specific)
a. Conspiracy (Section 371 of Title 18)
(i) Elements of the Offense
(ii) Penalties and Statute of Limitations
b. False Statements (Title 18 U.S.C. § 1001)
(i) Penalties and Statute of Limitations
d. Mail fraud
e. Principals and those Who Aid and Abet (Title 18)
f. Accessory After the Fact
Finally, it is worth noting that the government regularly collects information from internet resources, such as blogs and e-mails as they build a case for criminal prosecution. A former head of the Tax Division at the U.S. Department of Justice once told me that “e-mails and internet communications was God’s gift to prosecutors”.
What are the consequences of becoming a “covered expatriate” for failing to comply with Section 877(a)(2)(C)?
Many lay persons are stumped as they try to understand the tax consequences of Sections 877 and 877A. The language in the drafting of the statutes is not so clear. Be careful to understate the meaning and how the IRS interprets the law.
One of the greatest risks for anyone who wants to self-diagnose their path towards becoming a former U.S. citizen, is Section 877(a)(2)(C). To be blunt, anyone who renounces their citizenship at the Embassy or Consulate will find that process relatively easy. However, no one at the U.S. Department of State will provide tax advice or try to interpret the meaning of Section 877(a)(2)(C). Indeed, the Foreign Affairs Manual used to read to the person taking the oath, simply provides the standard overview language of “special tax consequences” arising form the renunciation.
Even the most economically modest individual, with little assets or income, can fall into this trap for the unwary – Section 877(a)(2)(C). The statute is spelled out below –
- This section shall apply to any individual if—
- (A) the average annual net income tax . . . is greater than $124,000,
- (B) the net worth of the individual as of such date is $2,000,000 or more, or
- (C) such individual fails to certify under penalty of perjury that he has met the requirements of this title for the 5 preceding taxable years or fails to submit such evidence of such compliance as the Secretary may require.