United States: Uncle Sam Wants You (To Pay Tax): Income Tax Pitfalls For Americans Living Abroad

I. Introduction

In an effort to crack down on individuals obtaining U.S. citizenship illegally, the U.S. Department of Justice recently raided several “maternity tourism” operations in Southern California.1 These companies cater to wealthy foreigners seeking to give the gift of U.S. citizenship to their children. Since at least 1868, the most effective way of guaranteeing U.S. citizenship has been birth on U.S. soil.2

If the rumors and anecdotes are believed, these maternity tourists return to their home country, tuck the baby’s American passport away for a rainy day, and everyone forgets the whole thing happened. Yet for these young Americans living abroad—like those of us born in the U.S. and drawn overseas by a career, a loved one, or chance—American citizenship comes with substantial tax and compliance burdens.

II. U.S. Income Tax: A Brief Primer

The U.S. is notable for its citizenship based system of taxation. As a general rule, U.S. citizens, lawful permanent residents (i.e. green card holders), and U.S. residents are subject to U.S. federal income taxation on their worldwide income.3 A combination of the “earned income exclusion”, foreign tax credits and various income tax treaties are available to minimize or eliminate double taxation.

The first port of call for U.S. taxpayers abroad is the foreign earned income exclusion found in Section 911. A taxpayer may exclude up to $100,800 of foreign earned income each year from his or her gross income if the taxpayer is a qualified individual.4 While the exclusion can be very beneficial to those living and working abroad, it is often misunderstood.

One of the most common misconceptions is that Section 911 applies automatically to every U.S. taxpayer. Income may be excluded only “[a]t the election of a qualified individual.”5 A taxpayer must elect (on his or her tax return) to exclude the income. Further, the election is only available for “qualified individuals.” An individual is only qualified if she is a U.S. citizen who was a bona fide tax resident of another country (not the U.S.) for the entirety of the taxable year, or if she is a U.S. resident or citizen that spent at least 330 days outside the U.S.6

If a taxpayer is a “qualified individual,” she may exclude foreign earned income, including wages, salaries, or professional fees, and other amounts received as compensation for personal services actually rendered in a foreign country.7 Pension income, dividends from a corporation (even if the corporation is the taxpayer’s employer), and other unearned income cannot be excluded.8

It is important to note that even is a taxpayer is able to exclude all of her income, she is not relieved of her filing obligation. Even if a return with income properly excluded under Section 911 would yield taxable income of $0 (and $0 tax due), the return must be filed in most cases.9

Not surprisingly, most Americans will have more complex facts (and income) which will result in additional filings and potential tax exposure. Earned income in excess of the applicable exclusion amount ($108,000), and unearned or passive income (which is not excluded under Section 911) is taxable. U.S. taxpayers abroad will owe tax to the U.S. unless a foreign tax credit applies or there is a relevant provision under a tax treaty.

Footnotes

1. CNN, Mar. 3, 2015, http://www.cnn.com/2015/03/03/us/maternity-tourism-raids-california/index.html.

2. Section 1 of the Fourteenth Amendment to the Constitution provides, “All persons born or naturalized in the United States, and subject to the jurisdiction thereof, are citizens of the United States and of the State wherein they reside.” See also 8 U.S.C . §1401 (2011) (clarifying the definition of terms in the Fourteenth Amendment).

3. Technically, the U.S. taxes “U.S. Persons” on a worldwide basis. The term “U.S. Person” refers to an individual who is either a U.S. Citizen or a U.S. federal income tax resident for U.S. federal income tax purposes. An individual who is not a U.S. citizen will be treated as a U.S. federal income tax resident (and thus a U.S. Person) with respect to any calendar year if (and only if), she meets one or more of the following requirements:

She is a “lawful permanent resident” of the U.S. (i.e. she holds a U.S. “green card”);
She meets what is known as the “substantial presence test”; or
She makes a special election to be treated as a U.S. federal income tax resident.
An individual can also be considered a US Federal income tax resident if he meets the “substantial presence test.” See Treas. Reg. 301.7701(b)-1.

4. See IRC §911(b)(2)(D)(i) (setting the exclusion at $80,000 per year). See also §911(b) (2)(D)(ii) (providing that the limitation on the exclusion be indexed for inflation); Rev. Proc. 2014-61, 2014-47 I.R.B. 860, at §3.32 (setting the 2015 exclusion amount to $100,800).

5. IRC §911(a).

6. IRC §911(d)(1); Treas. Reg. 1.911-2(a).

7. IRC §911(d)(2). See also Treas. Reg. 1.911-3.

8. Treas. Reg. 1.911-3(a), (c).

9. The filing requirement depends on a taxpayer’s filing status and her income. See IRS Publication 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad, Dec. 4, 2014, available at http://www.irs.gov/pub/irs-pdf/p54.pdf.