Many Americans are surprised to learn that they will face U.S. taxation even when they are living for extended periods in another country. The United States taxes "U.S. persons" on their worldwide income, regardless of where they live.

The term "U.S. person" encompasses:

  • American citizens
  • Resident aliens with permanent status (green card holders)
  • U.S. residents by voluntary election
  • Citizens of another country who spend a certain number of days per year in the U.S.

A U.S. person can also treat a non-resident alien (NRA) spouse as a U.S. resident for income tax purposes so the couple can file a joint income tax return. To do so, the NRA spouse needs to obtain a Social Security number or Taxpayer Identification number (TIN). Filing jointly may be useful and may save taxes, depending on the relative income and deductions of the partners. However, it is important to have an experienced tax professional calculate the various options, as it could also be more tax efficient for the U.S. person to file separately, or as head of household if there are dependent children.

Tax Filing Requirements: Getting Ready for the U.S. Deadline

U.S. persons, regardless of where they work or live, must follow the basic rules for reporting their worldwide income. These include, among other things:

  • Observing the U.S. tax year
  • Meeting U.S. tax-filing deadlines
  • Making estimated tax payments
  • Observing the de minimus income threshold for filing

They are also subject to the same tax brackets and the same penalties for late filing as someone living in the U.S.

Personal exemptions and deductions are generally the same as they would be if living in the U.S. However, there are a few issues particularly relevant to those living abroad. For instance, the general rule is that children must be U.S. citizens to be claimed as exemptions. It is also important to remember the prohibition against deductions for contributions directly to foreign churches and charities.

U.S. income tax returns must be computed in U.S. dollars. Taxpayers are required to convert income and expenses to U.S. dollars as of the date they are received or incurred. The IRS website provides links to two commonly used conversion sites: www.oanda.com and www.xe.com.

U.S. employers generally must withhold U.S. income tax from the pay of U.S. persons working abroad, unless the foreign government requires its own withholding. To mitigate the level of withholding, an employee can attest to his or her employer that he or she intends to claim the Foreign Earned Income Exclusion, so the employer doesn't withhold on these wages. The IRS has sanctioned Form 673 as an acceptable statement for attestation. It is also important to remember to file a change of home address with the IRS on Form 8822.

Strategies to Avoid Double Taxation

In addition to a tax liability to the IRS, U.S. persons may face a variety of filing requirements and taxes in the foreign country in which they are working. Countries have different criteria for determining tax liability. Unlike the U.S., most base this primarily on residence rather than citizenship.

To further complicate matters, other countries may follow a different tax calendar than the January–December tax calendar used by the U.S. For instance, in the United Kingdom, the tax year runs from April 6 through April 5; in Hong Kong it runs from April 1 through March 31.

U.S. persons working outside the U.S. continue to face the possibility of at least some measure of double taxation. There are, however, a number of strategies to mitigate the impact. Navigating the myriad rules requires the assistance of a tax advisor with strong knowledge of both U.S. and local tax requirements. Below is a brief overview of some of the most commonly used avenues, though each option has specific criteria that limit who may qualify.

Tax Treaties

Tax treaties are agreements between two countries to reduce or eliminate double taxation for non-native workers. Treaties are typically most helpful for U.S. persons on short-term assignments in another country. Some also address U.S. taxation of non-U.S. retirement accounts. In general, however, they do not reduce the total U.S. tax liability for a U.S. person.

The U.S. has tax treaties with over 60 countries, and these agreements have continued to evolve over the years. However, it is dangerous to make assumptions about the existence of a treaty with a given country, or the content of the treaty. For instance, although the U.S. has a tax treaty with the People's Republic of China, this treaty does not cover Hong Kong, and there is currently no treaty between the U.S. and Hong Kong.

Furthermore, while treaties between the U.S. and other countries often include similar provisions, each has been negotiated separately and customized. The devil is in the details. Navigating the protocols requires counsel from a tax advisor with experience in the tax laws of the host country as well as the U.S.

Foreign Tax Credits

U.S. taxpayers may be able to claim a credit or a deduction for taxes paid to a foreign country. The choice between a credit or a deduction is largely up to the taxpayer. Tax advisors can run scenarios showing both options. Depending on the situation, one may be more beneficial than the other.

The tax credits and deductions do not always provide a complete offset to the foreign taxes paid. Mismatches can occur due to differing tax years, different classifications of taxable investments (e.g., outside of the U.S., municipal bonds may not be tax exempt), and the complex interaction of deductions, personal exemptions and other features of the U.S. tax system.

Exclusions on U.S. Tax Returns

The Foreign Earned Income Exclusion is the most useful offset for many U.S. persons working abroad. This exclusion is voluntary and is elected on Form 2555 or 2555-EZ, which may be filed by the tax-return due date (including extensions) or within one year after the original due date. This election stays in effect until revoked. Under this exclusion, a U.S. person may treat up to $101,300 (in 2016) of income earned abroad as not taxable by the U.S. If the spouse is also a U.S. person, and he or she works abroad, he or she can also exclude an equal amount.

The Foreign Housing Exclusion can also be very helpful, allowing U.S. persons living and working abroad to deduct some of their housing costs. The calculation of this "housing amount" can be somewhat complex. Generally, it consists of:

  • Total housing expenses
  • Minus a "base housing amount" (16% of the Foreign Earned Income Exclusion, computed on a daily basis)
  • Multiplied by the number of days ($44.41 a day, or $16,208 in 2016)

There is also an upper limit to the housing exclusion — generally 30% of the Foreign Earned Income Exclusion. However, the limit may vary depending on location. If married, spouses may each be able to claim the housing exclusion if they maintain separate households.

The Foreign Housing Deduction may be a useful alternative for those with self-employment earnings. It applies only to amounts paid for with self-employment earnings. This cannot exceed earned income less the total of the Foreign Earned Income Exclusion and the Foreign Housing Exclusion.

There is also an Employer Provided Meals Exclusion. The exclusion only applies to meals which are provided by an employer on the business premises for the employer's convenience.

The deduction for moving expenses, which is also available to U.S. persons who move more than a minimum distance within the U.S., can require some special calculations for a U.S. person living abroad. The amount of the deduction must be reduced proportionally for the portion of income that was excluded from taxes under the Foreign Earned Income Exclusion. In addition, it is important to note that an employer's reimbursement for moving expenses is generally considered earned income, and therefore subject to U.S. income tax. However, the upside is that it could be offset by the Foreign Earned Income Exclusion.

U.S. persons wishing to take advantage of the above exclusions must satisfy several key criteria:

  • The U.S. taxpayer must have "foreign earned income," defined as income from personal services including salaries, wages, bonuses, professional fees and commissions for work in a foreign country. The income can be considered "foreign" regardless of where the actual compensation is paid (i.e., an employer could make deposits directly into the employee's U.S. bank account, as long as the compensation is for the employee's work outside the U.S.). However, this does not include "unearned income" such as interest, dividends, capital gains, Social Security, pensions or alimony.
  • The U.S. person's current "tax home" must be in a foreign country. The IRS defines "tax home" as "the general area of your main place of business, employment or post of duty, regardless of where you maintain your family home" or "the place where you are permanently or indefinitely engaged to work as an employee or self-employed individual."1
  • The U.S. person must be either "physically present in a foreign country" for at least 330 full days during any period in 12 consecutive months, or be a "bona fide resident of a foreign country" for an uninterrupted period that includes a complete tax year. Determining "bona fide residency" can be very complex. The decision is based on specific circumstances of the individual, with key factors being length of stay, intent, purpose and nature of their stay abroad.

Taxpayers cannot claim a credit or deduction to offset income that is shielded from U.S. taxes by the Foreign Earned Income Exclusion. Instead, they must start off at the (usually higher) marginal rate that they would have been subject to if they had not excluded any income. According to the IRS, "you must compute the non-excluded income using the tax rates that would have applied had you not claimed the exclusions."

Next: Retirement Plans Abroad

In the next part of our Wealth Planning for Americans Abroad series, we'll discuss the complexities surrounding retirement plans, in particular how to handle contributions, earnings, and taxation in foreign pension plans.

1 Source: IRS Publication 54: Tax Guide for US Citizens and Resident Aliens Abroad.

  • This material is provided for illustrative/educational purposes only. This material is not intended to constitute legal, tax, investment or financial advice. Effort has been made to ensure that the material presented herein is accurate at the time of publication. However, this material is not intended to be a full and exhaustive explanation of the law in any area or of all of the tax, investment or financial options available. The information discussed herein may not be applicable to or appropriate for every investor and should be used only after consultation with professionals who have reviewed your specific situation. BNY Mellon Wealth Management conducts business through various operating subsidiaries of The Bank of New York Mellon Corporation. ©2016 The Bank of New York Mellon Corporation. All rights reserved.