U.S. Persons are taxed on their worldwide income. When it comes to foreign income, accounts, and assets, it brings additional attention to both the IRS and the taxpayers. Failure to meet specific regulations may impose severe penalties on taxpayers. In this blog, I will give some practice tips on reporting foreign income matters and ways to avoid or mitigate double tax issues.
Who is subject to U.S. income tax?
In general, U.S. Citizens are subject to federal income tax on their worldwide income, no matter where the taxpayer resides. Not so surprisingly, foreign citizens with U.S. green cards and foreign citizens with substantial presence in the U.S. maybe consider U.S. Resident Aliens. U.S. Resident Aliens' worldwide income is subject to federal income tax as well. Exceptions apply, but they're beyond the scope of this post.
Foreign Earned Income
A U.S. taxpayer may occur foreign earned income when he or she performs personal services in a foreign country. It's a similar concept of being an employee and get paid by wages, salaries, or professional fees. Of course, self-employment or business produce ordinary income is earned income as well.
Foreign Income Exclusion
If you have earned income in a foreign country, it normal to pay the local taxes on such income. Don't panic about double tax matters because the U.S. taxpayer can utilize the foreign income exclusion to avoid or mitigate the tax burden. The exclusion amount is adjusted by inflation. The 2020 amount is $107,600, and for the 2021 tax year, it will rise to $108,700.
The taxpayer has to meet certain requirements to use the foreign income exclusion.
Firstly, the taxpayer must establish a tax home in a foreign country. It means if you're working abroad for 3 months and get paid locally but return to U.S. after, it doesn't make you qualify for the exclusion.
Secondly, of course, you have to receive foreign earned income.
Finally, the taxpayer must have been a bona fide resident of a foreign country for the entire taxable year of the present in a foreign country for at least 330 full days during any period of 12 consecutive months.
Qualified taxpayers can file Form 2555 with their tax return to take advantage of the foreign earned income exclusion.
FBAR - Fincen Form 114
FBAR stands for foreign bank account reporting requirements("FBAR"). As you can tell from the name, it's about your financial account in a foreign country or institution.
If you have a financial interest in or signature authority over at least one financial account located outside of the U.S. and the aggregate value is exceeding $10,000 at any time during the calendar year, you must file IRS FinCEN Form 114, Report of Foreign Bank and Financial Accounts.
Penalties are significant for not filing the report. Civil penalty for willful violation may impose thousands of dollars burden on taxpayers. The criminal penalty for a willful failure is up to $250,000 or 5 years in prison or both.
Practice tip is to examine potential foreign bank accounts and communicate with experienced CPA or professional. The actual FABR filing is not as hard as people think.
Foreign Financial Assets - Form 8938
In addition to foreign bank account, it's common for taxpayer to process other foreign financial assets. A U.S. taxpayer must file Form 8938 to report all financial accounts maintained by a foreign financial institution. Typical examples include but not limited to:
Checking or saving account, brokerage account, foreign corporation issued stock or securities, foreign-issued note or bond. The name goes on and on, but you get the idea.
By practice, you don't need to report every single minor foreign financial ownership to the IRS. The filing thresholds vary by the tax filing status. For example, a single taxpayer needs to file Form 8938 only if the total value of the specified foreign financial assets is more than $50,000 on the last day of the tax year or more than $75,000 at any time during the tax year. Married file jointly status has even higher filing thresholds.
The requirements are new and foreign countries, or institutions may have different reporting or record-keeping requirements. Taxpayers need to collect appropriate records and discuss thoroughly with experienced CPA or tax professionals.
Good News is you may not need to pay extra tax.
Either the FBAR or Form 8938 imposes an additional burden on taxpayers. The penalty is quite large if taxpayers don't meet the requirement. The bad news is that taxpayers may face risk and spend more time and money on tax professionals. In most cases, the good news is that taxpayers don't need to pay additional tax on owning foreign assets. Even the foreign earned income can utilize credit or deduction to mitigate or even avoid double tax issues.