Filing income tax returns is an arduous and stressful task for a person living in the United States. But the process is simple compared with that of U.S. citizens living abroad.
According to the State Department, some 5.2 million Americans live outside U.S. borders. And just like other American citizens, these people must file an annual income tax return.
For Americans abroad, this is no easy task. Complicated foreign tax laws, treaties, and a host of other challenges make the process difficult. According to tax experts, there are steps to make the filing process easier. But even with a simplified process, there are few advantages for Americans living overseas.
Income overseas, taxes at home. According to Robert Goulder, editor-in-chief of international tax publications for Tax Analysts, a nonprofit publisher, all income earned overseas must be reported at home.
"The U.S. individual income tax operates on a ´worldwide´ basis, meaning taxable income must be reported on your Form 1040 regardless of geographic source," Goulder says. "Both foreign-source and domestic-source income falls within the U.S. tax net. Absent some form of specific relief, your foreign income will be subject to double taxation–once in the source country [where the money was earned], and again in the U.S."
This means people living overseas are hit twice by taxes. For instance, someone living in the United Kingdom has to pay U.K. taxes as well as U.S. taxes.
However, Goulder says that people living abroad can claim a credit for taxes they paid overseas, eliminating double taxation. But this is easier said than done, he says.
“The IRS may reject a taxpayer’s claim for this credit unless they can provide official documentation establishing that the foreign tax was, in fact, paid. This often creates timing problems where the taxpayer has yet to receive the necessary documentation by the time the U.S. filing deadline rolls around,” Goulder says.
[See How to Avoid an IRS Audit.]
Small upside, big downside. Michelle Koroghlanian, technical manager of taxation at the American Institute of CPAs, says one of the potential upsides to living abroad is that certain countries have more favorable deduction laws than the United States.
But these deductions hardly offset the downsides to filing taxes from abroad. According to Koroghlanian, one of the most challenging aspects is the informal filing process.
"The biggest disadvantage is how confusing the rules are. When you are living overseas, you have to figure out what you owe on the U.S. side,” Koroghlanian says. “Then you get into what you owe the foreign side. You’re used to a system when you get W2s and 1099s and prepare a return with a due date. Not every country has a system like that."
Goulder adds that the sale of assets in the United States by people living overseas is also taxed differently. He recounted a situation in which friends living in Europe attempted to sell a house they owned in Maryland. If they sold the house, they’d be responsible for a large tax on the money they made from the sale, or a capital gains tax. If these friends were citizens living inside the United States, these gains would not be taxed.
"Our tax code is essentially preventing them from disposing of an asset," Goulder says. A large slice of their personal wealth is tied up in the house, which they desperately want to sell, but can´t without suffering a tax hit."
Goulder also dismisses any ideas about stashing assets in an offshore account. "Stashing your assets in an offshore account or holding company leaves you no better off than if it were invested ´onshore.´ … All income is subject to U.S. tax regardless of its geographic source," he says. "It all goes on your tax return just the same. The only benefit of having an offshore account is if you don’t report the income–and that’s illegal, regardless of the misleading gimmicks you occasionally see on some unsavory website."
A drastic option. There is one way to avoid paying U.S. income tax: Give up U.S. citizenship and acquire citizenship of the other country. The downside to this move if that a person loses all the benefits of being an American abroad. The upside is that the IRS no longer has jurisdiction.
According to Koroghlanian, this could be an option for retirees who have settled elsewhere. “During retirement, it’s going to be much the same system as long as the retiree is keeping U.S. citizenship,” she says. “Some decide to give up U.S. citizenship, but as long as they keep it, they have the responsibility to file and pay U.S. income tax on their worldwide income.”