10 Real-Life Examples Why American Expatriates Should File a U.S. Tax Return
Believe it or not, American citizens and residents are obliged to file a U.S. income tax return even if residing outside the United States. Despite the media coverage of the IRS efforts to enforce offshore compliance, many taxpayers are still unaware of the tax implications that follow a decision to relocate abroad. On the other side are the taxpayers who knowingly object filing a return for a number of reasons ranging from a frustrated "It's not fair!" or "Why to pay taxes if I live abroad?" to the stranded "I'd never go back!" To all of you, regardless of your reasons, these real-life examples will make you think twice when the tax season comes!
#1. Foreign Earned Income & Housing Exclusions
The Tax Code contains provisions aiming to alleviate the burden on taxpayers who reside overseas. The Foreign Earned Income Exclusion (FEIE) and the Foreign Housing Exclusion (FHE) are the most prevalent one. The FEIE exclude from U.S. tax compensation attributable to services performed in a foreign country. The maximum amount of the foreign earned income exclusion is set to $100,800 for 2015 and $101,300 for 2016 tax year. The exclusion is also increased annually for inflation.
The FHE is applied on top of the FEIE granting an additional exclusion to taxpayers who paid housing expenses abroad. The foreign housing exclusion is generally limited to 16% of the FEIE, but might be higher depending on the location where the housing costs were incurred. Of course, one must file a tax return to avail of the foreign earned income and housing exclusions.
According to the IRS statistics over 26% of the taxpayers who claimed the foreign earned income and housing exclusions had not encountered any U.S. income tax liability. How about the remaining 74% who had passive income or earned more than the exclusions? Well, the foreign tax credit moves in.
#2. The Foreign Tax Credit
If you paid income taxes to a foreign country and are subject to U.S. tax on the same income, you may be able to take either a credit or an itemized deduction for those taxes. Often, the credit is more advantageous as it gives you a dollar-for-dollar reduction of your prospective U.S. income tax liability.
Income from all categories qualifies for the foreign tax credit, including compensation for services and passive income. Moreover, the credit could be taken together with the foreign earned income and housing exclusions. Further, the unused foreign taxes could be carried back or forward to another tax year.
When the foreign tax credit is accounted for, 40% of all income tax returns result in no U.S. income tax liability. Still, the foreign tax credit might be insufficient to secure a U.S. tax exemption. Should you pay U.S. income taxes then?
#3. Tax Planning
In an event the foreign income exclusions and tax credit provisions do not work for you, I stress the importance of being proactive in tax matters. Do not wait till April 15th to pay a visit to your accountant. By the return due date, even the best accountant has limited options to reduce your tax liability.
To be proactive means to plan ahead of time and consider the long-term effect of current transactions and events. A competent tax practitioner will not only prepare your tax return but also advise you on structuring your personal and business affairs in a way that minimizes income tax exposure.
The tax planning makes the difference when you run the numbers at the year end. Still, many of our clients consider it safe to keep a low profile. The IRS is not concerned with them, so why filing a return at all?
#4. Tax-Related Identity Theft
Well, have you thought the IRS might be precluded from contacting you because of an issue with your tax records? When no tax return is filed, a gap appears in the IRS records and criminals may take advantage of it. Tax-related identity theft occurs when a perpetrator uses your name and Social Security Number to file a fraudulent tax return to obtain a tax refund.
The IRS estimates that each year more than 1.1 million identity theft tax returns remain undetected, which results in over $3.6 billion of bogus tax refunds. In April 2015, The Treasury Inspector General for Tax Administration released an audit report criticizing the IRS' efforts to identify fraudulent tax returns. The report has also revealed that over 70% the individuals victimized are typically those who have not filed or were not required to file a tax return!
Consequently, many expatriates who were victims of tax-related identity theft might be unaware that their personal information had been compromised. It is not until the legitimate taxpayer files a return, and the resulting duplicate filing alerts the IRS that an identity theft has occurred. An effective way to protect yourself from a tax-related identity theft is keeping your address current with the IRS and filing your income tax returns as early as possible!
#5. Passport Denial
The enactment of a controversial statute also deserves your attention. The Fixing America's Surface Transportation Act of 2015, included provisions that allow passports to be denied to any person the IRS certifies as having a seriously delinquent tax debt. A seriously delinquent debt is defined as any outstanding tax debt subject to a lien or levy in excess of $50,000.00. To avoid passport denial, a taxpayer is required to enter into an installment agreement with the IRS or take steps to pay the debt in full.
The rationale behind the new statute is to prevent the taxpayers from fleeing the United States in an attempt to avoid paying their tax liability. However, the law has unintended negative implications for Americans who are residing abroad. If a passport is denied or revoked, an expatriate might end up like Tom Hanks in The Terminal. A taxpayer with an invalid passport will be denied reentry into the United States and will be precluded from taking trips to other countries too.
As of today, the IRS has not released any regulations or technical guidance to clarify the application of the law. As a consequence, the effect on expatriates and Americans residing overseas is hard to justify. On top, a taxpayer argued with me that it is not possible to have a tax debt of $50,000.00 if no tax return is filed. After all, the IRS employees cannot assess the amount of the liability if there are no records on file. Or perhaps they could?
#6. Statutory Assessment of Tax Liability
Section 6020(b)(1) of the Internal Revenue Code, authorizes the IRS to prepare a tax return on behalf of any person who failed to file a return or made a false statement on any return filed with the IRS. And the IRS exercises its powers to prepare such substitutes for return on a regular basis!
In doing so, the IRS relies on information available to them from various third-parties, such as employers and financial institutions, including information obtained through testimony and assessment of the taxpayer's assets, spending patterns and lifestyle. Moreover, all US tax treaties contain an exchange of information clause which empowers the IRS to request taxpayer information directly from a foreign government or agency.
In result, each year we have clients who come to us with a computer-generated substitute for a return. As the IRS is often forced to "guestimate" a significant portion of the return the substitutes usually report inflated income and deflated deductions. Expectedly, the taxpayer ends up with a much higher tax liability compared to a self-prepared and timely filed return.
Furthermore, one piece of legislation transformed the exchange of financial information between the IRS and foreign governments from sporadic need-to-know requests to a mandatory reporting on a yearly basis. Have you heard about the FATCA?
#7. Financial Information Exchange
The Foreign Accounts Tax Compliance (FATCA) Act of 2010, introduced a mandatory bank and financial accounts information exchange between foreign financial institutions and the IRS. The Act mandates foreign banks and other financial institutions to report the accounts owned or controlled by U.S. persons to the IRS. The exchange is sufficed through comprehensive intragovernmental agreements that have the status of law in the country that signed them. As of 2016, the U.S. Government signed intergovernmental agreements with more than 115 countries, and the number continues to grow!
The FATCA exchange applies to all new and grandfathered bank and financial accounts if the funds held in the account exceed a statutory threshold. The information IRS receives from the banks is used to crosscheck the taxpayer's self-reported data. If there is a mismatch, the IRS may initiate a review of the return. If there is no return on file, the IRS may use the information to prepare a substitute for return.
Depending on the amount of the misstatement or omission, civil and criminal penalties exceeding thousands of dollars may also apply. So, next time when you open a bank account in a foreign country, pay attention to the section asking you to certify your citizenship and tax residency.
#8. Denial of Foreign Earned Income Exclusion
At least several taxpayers inquired why to bother filing a tax return before the IRS "asks" them to do so. All in all, the income they earned was less than the foreign earned income exclusion, and the taxpayers did not worry much. Ms. McDonald was probably driven by similar reasoning regarding her 2009 tax return obligations.
Ms. McDonald worked overseas in 2009 but did not file an income tax return for that year. In 2010 the IRS prepared a substitute for return, and in April 2012 a notice of deficiency was mailed out. The taxpayer did not challenge the notice of deficiency but decided it is about time to file a correct return. She did so in May 2012. Ms. McDonald has claimed the foreign earned income exclusion on the self-prepared tax return.
The IRS audited the taxpayer's return and issued a second notice of deficiency denying the requested foreign earned income exclusion because the taxpayer did not make a timely election to exclude income. The taxpayer challenged the IRS in the Tax Court. In McDonald v. Commissioner, TC Memo 2015-169, the court ruled for the IRS concluding that the agency has statutory authority to prescribe regulations under Section 911.
And Treasury Regulation 1.911-7(a)(2) gives the definition of a timely filed return that qualifies for the foreign earned income exclusion. The moral is to file the tax return on time or at least before the IRS steps in. Otherwise, the option to exclude foreign earned income will be permanently lost!
#9. The Traps of the Statute of Limitations
Many expatriates believe that if they fail to file a return the IRS will give it a pass and they will get away with it. After all, the Statute of Limitations was enacted to protect taxpayers from unreasonable-in-time IRS examinations. Under the statute, the IRS has 3 years to audit a return and assess any tax liability. Right?
Wrong! Section 6501(c)(3) states that "in the case of failure to file a return, the tax may be assessed, or a proceeding in court for the collection of such tax may be begun without assessment, at any time."In short, if you file a return, you get the three years safe harbor, but if no tax return is filed, the IRS may come after you at any time, indefinitely!
A recent Tax Court case typifies the IRS authority to assess a tax liability when no return has been filed. In the Estate of Edward S. Redstone v. Commissioner, 145 T.C. No. 11 (2015), the taxpayer was hit with a notice of deficiency for $737,625 in federal gift tax liability. Thousands of notices of deficiency are served each year, so why are we so picky about this case? Well, the notice of deficiency was issued in 2013 for a purported violation that occurred in 1972. The taxpayer failed to file a return some 41 years ago!
Luckily, the taxpayer's attorney proved that no taxable gift occurred, and the court ruled against the IRS. What if you encounter identical situation? Would you be in a position to hand over supporting evidence for income earned outside the United States some 40 years ago?
#10. The Streamlined Foreign Offshore Procedure
At last but not least, many taxpayers are afraid to file a return because of a significant record of noncompliance with the internal revenue laws. Consider a taxpayer who has not filed tax returns for more than 5 years due to a prolonged stay abroad. Is the expatriate required to file all delinquent returns to regain compliance? How about the penalties and interest due on any potential tax liability?
In such an event the Streamline Foreign Offshore Procedure (SFOP) might be the answer to your needs. The IRS introduced the SFOP as a mean to ease taxpayers willing to regain compliance with the tax laws. Under the SFOP, the taxpayer is required to only file the 3 most recent delinquent returns and up to 6 Foreign Bank Account Reports (FBAR).
Moreover, a taxpayer who is eligible to use the SFOP will not be subject to the failure-to-file and failure-to-pay penalties, accuracy-related penalties, information return penalties, FBAR penalties, and the like. The taxpayer must pay only the net tax liability if any at all!
The Streamlined Foreign Offshore Procedure is a temporary initiative implemented and conducted by the IRS. The IRS has absolute discretion to extend or wind the program up at any time, so make up your mind before it is not too late!
File Your Tax Return Now
I must admit I do agree with you. The current state of our tax system is far from being perfect, reasonable or just. Take the social security benefits, healthcare, public safety, roads and infrastructure, public education and all other welfare benefits funded out of our paycheck. The taxpayer who lives outside the States has limited access to tax-backed benefits. Thus, isn't it fair and just to lay the tax burden on those who benefit most? True. But recall that filing a return and paying taxes are two separate things. So, why not turn your tax return filing requirement into an advantage at no additional tax costs for you?