U.S. Taxation of American Citizens/Permanent Residents Living Abroad

TAXES.  Everyone wants to avoid them and only a few people really know how.  This goes double for US citizens who earn income in China.  This is because the US taxes foreign income as well as income earned within the States.  Even worse, the IRS requires any US person with a financial account overseas to register it with the treasury department, as long as such account has held over $10,000USD at some point during the year. This provision was meant to discourage the use of overseas tax shelters, but they equally apply to US people teaching English in China that have managed to save $10,000USD in their Bank of China account. And speaking from personal experience, the process is complicated because it involves both the IRS and the Treasury department.  Luckily, the filing can be done online, even if it is not particularly simple.

For those earning a salary in a foreign country, the most important exclusions to know about are foreign earned income and foreign housing exclusions.  For 2012, the foreign earned income exclusion is up to $95,100 and the foreign housing exclusion/deduction is 30% of the foreign earned income exclusion (but varies by location).  The housing exclusion applies to income received from an employer, and the deduction applies to self-employment income. The details for calculating the foreign housing exclusion/deduction are maddeningly complicated and beyond the scope of this article.  The foreign earned income exclusion is more straightforward as it directly excludes the income from taxes.   Most important to these exclusions is how to qualify for them.

First, you must be a resident alien or citizen of the United States.  Resident aliens are those who have Green Cards or who have been in the United States for a total of 183 days over the past 3 years, only counting 1/3 of days in the 2nd year and 1/6 of the days in the least recent year. (That is the easy math. Imagine what the housing exclusion entails.)

Second, you must have a foreign country as your tax home.  This means you have employment in that country and it is where you permanently or temporarily work.  Business trips don’t count, but moving there to fulfill employment or contract work likely would. As a general rule, if you expect to be working in the country for over a year, it is your tax home.

Third, you must be in a foreign country for a significant time, determined by the bona fide resident test or the physical presence test.  Bona fide residence means you are living in a foreign country as a resident would for a full tax year. Each case is evaluated individually, but those who rent an apartment in a foreign country, live there 7 days a week, and only leave the foreign country for business and vacation with a clear intention to return to the foreign country, are almost certainly residents. The physical presence test is for those who live a long time in a foreign country but not the January-December tax year.  If you spend 330 days in a foreign country over a consecutive 12 month period, you meet the physical presence test.  Unlike the bona fide resident test, you could live out of your suitcase, travel through Europe to multiple countries for any reason, and as long as you spent 330 days outside the US you can meet the test.

Finally, you must have foreign earned income. Usually, foreign earned income is any income earned when you have met the tax home and bona fide residence/physical presence test. Foreign income also includes housing and meals provided by the employer, allowances such as cost of living or education reimbursement, and commissions earned. Money from the US government or a pension does not count as foreign earned income.
If all four factors are met, then you can use the exclusions and can avoid some or all US taxes on your foreign income.  Of course, if you have set up a company in a foreign country, the process is very different.

Posted by Frank Caruso.  Chair, China Practice Team for IPG.
Sean Hayes, IPG’s Co-Chair of the Korea Practice Team, may be contacted at: SeanHayes@ipglegal.com

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