Foreign Tax Credits American Expats Should Know About

American expats have a couple of considerations about expat taxes and retirement plans. The only method to avoid paying any U.S. taxes is to renounce your citizenship, which is not an option every expat wants to consider.

We’ll discuss all options in brief.

Who Is Due to Pay State Taxes?

Americans living abroad must file U.S. federal tax returns and pay taxes on their income regardless of where it was earned as long as they are U.S. citizens. To top it off, Americans who are residents and have income in the state are also due to pay taxes.

An American expat is considered a resident if:

• They lived in the state for any duration during the tax year

• They have a permanent place of residence in the state

• They have immediate family that lives in the state while they’re abroad

• They keep their voting rights, ID card, or driver’s license in the state (any of these)

American Expats are considered to have income in the state if:

They earn income in the state regardless of where they live

They get pensions, retirement income and or any other government benefit in the state

The USA is only one of two countries deploying citizenship-based taxation. Still, some U.S. states are an exception.

The states that don’t apply state income taxes to expats are Alaska, Florida, Nevada, South Dakota, Texas, Washington State and Wyoming. New Hampshire and Tennessee apply only a tax on dividends and interest income.

California, South Carolina, New Mexico and Virginia apply state income taxes to American expats who:

• Own a property in the state

• Own a bank- or investments account in the state

• Hold an ID card, a driving license, or a voter registration in the state

• Have a mailing address in the state or if their relatives do

• Have dependents in the state

Preventing Double Taxation

There are alternatives to avoid double taxation. Depending on your status in the foreign country, you may be eligible to some of the available programs.

The alternatives to prevent double taxation include tax treaties, the Foreign Earned Income Exclusion (FEIE), and the Foreign Tax Credit (FTC).

Tax Treaties

The U.S. has tax treaties with ca. 70 countries. You are eligible for this program if your business is established in a country with which the United States has a tax treaty.

The Foreign Earned Income Exclusion (FEIE)

You can apply for the FEIE if you can pass either the Bona Fide Residency test or the Physical Presence Test. With this program, you can exclude up to $107,620 of your foreign-earned income from your taxable income each year.

The Foreign Tax Credit (FTC)

The FTC allows American expats to claim a dollar-for-dollar credit on foreign income taxes. To qualify, you should obtain a foreign tax liability.

In addition, there is a housing exclusion and a foreign tax credit.

By filling out the appropriate sections of Form 2555, you may opt for the overseas earned income exclusion and/or the foreign housing exclusion. Generally, you must choose the exclusion(s) on Form 2555, Foreign Earned Income, first using:

• A return that is timely filed (including any extensions)

• A return that amends a timely filed return

• A late return that is filed within a year of the return’s original due date (determined without regard to any extensions)

If you don’t owe any federal income tax after accounting for the exclusion, simply select the exclusion on a return.

You can pick the exclusion on a return if you owe federal income tax after accounting for the exclusion as long as you do so before the IRS learns that you neglected to do so. On the top of page one of Form 1040, you must enter or legibly print the words “FILED PURSUANT TO SECTION 1.911-7(a)(2)(i)(D).”

If the IRS determines that you did not select the exclusion and you still owe federal income tax after accounting for it, you need to submit a private letter ruling request in accordance with Income Tax Regulation 301.9100-3 and the guidelines laid out in the IRS’s first Revenue Procedure of the year.

Domestic Pension Plan Transfers

If you’re seeking alternatives, you don’t have to rely solely on foreign finances. Another alternative is to transfer a local pension plan abroad. The rules governing pension funds and taxes in the country where you reside likely differ.  

If you are making contributions to a retirement plan through a foreign company, the IRS does not recognize those plans the same way it does domestic ones.

The following actions are required:

• File Form 1040 (reports wages from the foreign company)

• File Form 1040 Schedule B (Interest and Ordinary dividends) to disclose the location of the foreign savings account

• File Form 2555 to claim the foreign earned income exclusion

• Report the interest income from the foreign savings account

• File an annual FinCEN form 114 (electronically) to notify the IRS about the foreign savings account

Consider Foreign Trusts

Foreign trusts are not for everyone but they may be a good option for some expats. Namely, foreign trusts are not free from US taxation; they are taxed according to their status (grantor or non-grantor).

A non-grantor trust is a trust in which the grantor has relinquished all ownership and control. A grantor trust is a trust over which the grantor still has ownership and control.

IRS taxation of foreign grantor trusts involves taxing the grantor (not the trust or its beneficiaries). Simply put, an American expat who uses this kind of foreign trust will be taxed as though they had personally earned the income.

Except for the cases where the funds were earned in the U.S. or have some other connection to the States, the IRS taxes distributions made to foreign non-grantor trusts.

It is advisable to consider important foreign tax credits before deciding which of the options is most suitable for your circumstances.

Streamlined Tax Filing Procedures

Lastly, there are there are Streamlined Filing Procedures (SFP), which are suitable for Americans living abroad looking for an alternative to IRS procedures. Basically, they offer a variety of tax returns and assist expats in keeping up with any unpaid taxes.

To qualify, an expat should:

• Demonstrate that the reason for not filing taxes in the past was because you didn’t know you were required to

• Have lived outside the U.S. for at least 330 full days during one or more of the three most recent tax years

• Not have had an abode in the U.S. for one or more of the three most recent tax years

• Produce a signed statement (Form 14653) certifying all of the above

Overall, there are numerous options available to American expats. Look up each of the advantages listed above before deciding on the best course of action. Asking the expat community for advice is recommended.