According to the IRS, living or working outside the US doesn’t mean you no longer have to pay US taxes – even if you’re already paying taxes to another country. International taxpayers who are US citizens are subject to taxation on any income from any source. Failure to file and pay your taxes can result in penalties and fines, no matter your location.
Even though there are some tax benefits available to expats, these can only be claimed if you file a US tax return.
This also extends to back taxes. Not only can back taxes impact your credit score, but you’ll also face penalties charged at steep interest rates.
Below, we’ll help you navigate the complexities of expat back taxes, and how to reduce the risks.
Understanding Your Tax Obligations
The first step in ensuring tax compliance is knowing the tax laws that affect you.
Most countries use tax systems based either on your territory, or your residence. Territorial-based systems tax individuals on income earned from outside the country’s borders. Residence-based systems, on the other hand, tax income earned from local and foreign sources. However, in the case of non-residents, this is usually limited to local income, similar to the territorial system.
But not in the US. Here, taxation is based on citizenship, and all income is taxed, no matter where it was earned, or where you live. In fact, if you’re a US citizen, you need to pay taxes to the IRS if your income exceeds any of the minimum thresholds. This includes international taxpayers in a country that doesn’t collect any income tax, like Bahrain, Monaco or the Bahamas.
Foreign income is taxed at the same marginal rate as income earned within the US. However, the filing process for international taxpayers is more complex.
Filing requirements
The IRS considers wages, dividends, interest and rental income earned abroad to be taxable.
But unlike when you live in the States, international taxpayers won’t just complete Form 1040. You also need to fill in Form 2555 (for foreign-earned income), and potentially Form 4868 (if you need an extension to file your taxes). If you make use of tax credits, you’ll complete Form 1116 (Foreign Tax Credit), Form 8812 (Additional Child Tax Credit), and Form 8833 (for any tax treaty benefits). Finally, if you have foreign bank accounts, you must also complete Form 8938.
Then, if you’re self-employed, you’ll also pay a separate 15.3% self-employment tax, just as you would in the US.
And you may also still be subject to state taxes. Expats with a permanent home or who have lived in a US state for part of a tax year, or earned money there are subject to state taxes.
However, different states also have different filing requirements. For example, Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming don’t collect income tax for expats. Others, like Tennessee and New Hampshire, only tax US expats on interest and dividends.
One of the benefits of being an expat is that you have slightly longer to file your taxes. By completing Form 4868, you get a two-month extension to do so.
Tax credits that help to reduce the burden
There are currently several tax benefits and exclusions to lower the tax liability for international taxpayers.
The Foreign Earned Income Exclusion (FEIE)
This allows you to exclude part of your foreign-earned income when filing your US taxes. This amount is adjusted annually for inflation, but for the 2023 tax year, it covers up to $120,000.
This exclusion only applies to earned income. Passive income like interest, dividends, and your pension are not eligible for FEIE. Moreover, you can’t exclude your self-employment taxes.
The Foreign Housing Exclusion
The IRS allows international taxpayers to deduct certain housing expenses from US tax payments, of up to 14% (or roughly $16800 for the 2023 tax year).
But there are limitations. Firstly, the amount you can exclude depends on where you now live, as the IRS considers some cities to be more expensive than others. Secondly, this exclusion mainly covers expenses like rent, occupancy taxes, and some utilities.
Eligibility also depends on two tests:
- The physical presence test requires that you spend more than 330 full days in one or more foreign countries during a 12-month period. Note that the IRS tracks this very carefully, so if you are in the US at all during this time – even for a few hours – you will not qualify.
- The bona fide residence test means you need to live in a foreign country for an entire calendar year, with no plans of returning for the foreseeable future.
The Foreign Tax Credit (FTC)
This can help international taxpayers reduce US tax obligations. It allows you to take a dollar-for-dollar credit or reduction on the taxes you pay in another country, and use that on your US income tax.
Consequences of Late Returns or Not Filing Your Taxes
The IRS imposes penalties for both late filing and late payment. Not filing will cost you 5% of your unpaid taxes for each month, up to a maximum of 25%. Late payments incur an additional penalty of 0.5% a month, also up to 25%. You’ll also be charged interest on these penalties.
Failing to file or pay can also give the IRS reason to investigate or audit you. This can have severe consequences, including criminal charges for tax evasion.
It doesn’t end there; there are several other potential ramifications. These include:
- The State Department denies you a passport, or refuses to renew it.
- Forfeiting any refunds due to you.
- Losing eligibility for tax credits and benefits.
- Receiving a federal tax lien (or claim to your property).
With these penalties, it’s clear that failing to file your taxes, or delaying payments, just isn’t an option.
Common Challenges for International Taxpayers
One of the primary concerns for many international taxpayers is the issue of double taxation. Paying US taxes as well as taxes to your current country of residence means your income is effectively taxed twice.
The credits mentioned above go a long way in avoiding this, but there’s also the option of tax treaties. The US has tax treaties with most countries across the globe to help prevent double taxation. They determine which countries have the right to tax certain types of US citizen income, and the amount that can be taxed.
Another area of concern is fluctuations in exchange rates. The IRS stipulates that your returns must be reported and paid in US dollars. Depending on where you live, and the current exchange rate, this can have significant implications for your tax liability.
It’s also worth noting that some countries do not have the same fiscal years as the US tax year, meaning that you may be required to pay taxes at different times. For this reason, it’s essential to keep up to date with all US tax filing deadlines.
If you’re a US expat, it’s also vital to ensure that you always have the most recent information on tax laws, as they change constantly. A CPA or tax professional can help you with this.
Steps to Resolving Back Taxes from Abroad
Below are several important ways to file your taxes and resolve back taxes while abroad:
- Confirm your obligations. First identify your status, including which income is taxable, and whether you need to pay state taxes. Make sure you have the correct forms for your returns, and that they are current for the tax years you are filing.
- Prepare your documentation. Collect all relevant financial documents to complete your reports, including your foreign income statements, proof of tax residency, and records of taxes paid to foreign governments.
- File your returns. Complete all your forms correctly and accurately. The IRS requires that you file only the last three years of delinquent returns, unless you have Foreign Bank and Financial Accounts Reports (FBARs), in which case you’ll need to file for up to six years previously to be compliant.
- Disclose any FBARs. If you have accounts in other countries with a total value exceeding $10,000, you must complete Form 114.
- Research payment and settlement options. The IRS offers payment plans for expats struggling to make payments. Also note that if you are due a refund, you will not have to pay penalties on late returns.
A CPA or tax professional can advise you on all the above steps, and ensure that you take the right measures to ensure tax compliance.
Tax relief options for expats who file late
If you have unintentionally not filed your US taxes while abroad, and can provide reasonable cause for this, you may be eligible for the Streamlined Foreign Offshore Program. This is an IRS program to ensure that you become compliant without facing penalties for failure to file.
To be eligible for the Procedure, you cannot have lived in the US for the last three years, and may not have any amended or delinquent tax returns. You also need to confirm that not filing your taxes was an honest mistake.
You’ll still need to pay the taxes due on past returns, but the IRS will waive all penalties. Also, your returns must have a valid Taxpayer Identification Number (TIN).
Avoiding Future Back Taxes
To ensure you don’t fall behind on taxes in the future, keep updated on tax laws and obligations. Also ensure that you fully understand the penalties associated with late payments, as these change regularly.
Proactive financial planning is also essential. This includes strategies to manage your income, and using any available deductions and credits to lower your tax liability. Moreover, ensure that you keep the necessary documents for filing, organized chronologically. This means all previous US tax returns, income taxes paid overseas, foreign housing costs, and proof of time spent in the country.
For assistance with US taxes from abroad, or help settling your back taxes, schedule a Discovery Call with one of our CPAs.
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