Taxing Matters: The Long Reach of Uncle Sam

by Conrad de Aenlle

Americans who have settled abroad may feel far from home, but to the Internal Revenue Service, it is almost as though they never left.

The United States is one of a very few countries that continue to tax citizens and even U.S. permanent residents, or green-card holders, who live overseas. But tax experts point out that most American expatriates will have little or nothing to pay – as long as they follow the rules carefully and take advantage of deductions they are entitled to, including key ones that are unique to nonresident citizens.

The most basic rule is to file a return. Many Americans assume that once they move abroad, they no longer are obligated to file, or that there is no point in filing because they know they will owe no tax. Not so, said Jim Stidham, a partner in the international tax practice at Price Waterhouse Cooper.

“The Number One issue that there is oftentimes confusion over is whether you have to file,” he said. “Regardless of what you hear at parties, all Americans and green-card holders have to file every year, except those whose incomes fall below the level of personal exemptions. Still, I run into people who haven’t filed for 10 or 15 years because they think they don’t need to.”

Even American expats who are aware of the filing requirement may skip it because they know the foreign-earned-income exclusion will leave them with no tax to pay. This provision allows Americans living overseas to exclude from taxation up to $76,000 of income earned abroad.

The exclusion, plus one for foreign housing and the usual personal exemptions and deductions, means that an American foreign resident will have to earn close to $100,000 before being subject to tax. Even then, credit for taxes paid to foreign governments may reduce the bill close to zero.

The problem, Stidham said, is that expats have to use the exclusions or lose them. If returns are not filed, then the IRS can revoke eligibility to write off foreign wages. That is not as scary as it sounds. Stidham pointed out that income generally cannot be taxed twice and so the credit for foreign taxes paid still applies, although foreign tax credits can be “tricky procedural things,” compared with the straightforward exclusions. In any case, the IRS is more forgiving than people realize, so taxpayers who come forward and admit that filing a 1040 form has slipped their minds for the last several years will be welcomed back into the system with no penalty applied.

“Like anything else, once you haven’t done it for five or six years, you don’t want to open a can of worms,” Stidham said, “but if people want to come clean, the IRS is trying to be kinder and gentler on these things.”

The agency also allows considerable leeway on when returns must be filed. There is an automatic two-month extension for taxpayers who are out of the country on April 15, and then a Form 4868 will provide another two months of grace.

Should you owe any tax, the IRS is not as gracious. Interest will accrue from April 15 on the balance due.

Michael Kaltz, a partner at Ernst Young who specializes in expatriate tax issues, noted that April 15 is still a red-letter day for Americans who make estimated tax payments, perhaps because they are self-employed.

“Around this time of year, many Americans overseas comfort themselves with the thought that, compared with the folks back home, they have an extra two months to file their U.S. tax returns, but it can be dangerous to relax too much,” he advised. “Taxpayers who need to make estimated tax payments for the current year have to make the first of these on April 15, and they will need to figure out the previous year’s liability if they want to use the safe method of basing the current year estimate on last year’s tax.”

That means they must know how much they made and how much they owe by April
15, even if they have no obligation yet to file a return.

American expats who do not have all of their tax liability wiped away by the
various exclusions and credits will be glad to know that most of the same write-offs that worked back home are still valid abroad.

“In general there is the philosophy that if you are a U.S. citizen who is taxable on worldwide income, then you should get worldwide deductions as well,” explained Diane Schofield, a senior manager in the PWC tax practice and Stidham’s colleague.

But there are some exceptions to note. One is charitable contributions. The IRS will only allow write-offs of donations to American charities.

“Because of Sept. 11, we might find that more people are making donations to charities,” Schofield said. “One of the big misconceptions is that if you give money to a church, it is deductible because it is a worldwide organization, but it is only going to be deductible if you give to a church in the United States. If you stick £5 in the box when you go to church in London, it doesn’t count as when you go back on holiday and make a donation to your church back home.”

She added, though, that there are organizations in countries with large American expat populations that have been set up as IRS-qualified charities, even though they benefit foreign causes. They will often have names in the form: American Friends of….

Mortgage interest remains deductible, even on foreign property, but only on one or two main residences and only when the total indebtedness is $1 million or less. A well-off expat who has two homes in the United States and decides to buy a third one overseas may not be able to write off all mortgage interest.

Care should also be taken when figuring investment income and capital gains, Schofield said, especially when it is not even obvious that they have been earned. Many countries have tax-advantaged pension and savings programs, but those cut little ice with the IRS.

Some investment funds are structured so that gains are accumulated rather than being paid out to shareholders, a sensible thing based on local tax regulations. Under U.S. law, however, those gains have been earned, even if they have not been paid, and they must be accounted for. This can be difficult, Schofield said, because it is hard to know how much of a fund’s increase in value is actually income, dividends and realized capital gains accrued in a given year.

She also mentioned that if Americans were lucky enough to hit the jackpot in a foreign lottery, the windfall may not be taxed there, but it was still taxable back home.

However, she pointed out that the United States was still one of the lowest-tax countries in the developed world.

This piece was originally published in the International Herald Tribune and is reprinted here with permission.