As our economy becomes more global, even for smaller companies, it is quite possible that a business owner may find it necessary to send certain employees on long-term assignments to perform work. Sometimes these assignments are permanent or are so long that the expatriate employees do not retain much in the United States. These expatriate employees often pay taxes in the foreign country and are completely unaware that they have a filing obligation to file a U.S. individual income tax return.
The reality is that U.S. citizens and residents are subject to U.S. income tax on their worldwide income, even on foreign income taxed by another country. IRC §61(a). U.S. citizens and residents who are considered expatriates, file a different kind of income tax return that is due on June 15. Any taxes owed by an expatriate are due April 15, the same time as typical U.S. individual income taxes. Expatriates can obtain extensions to file to October 15 and December 15, if needed.
Even though the foreign income is subject to U.S. income tax, there is some relief to help avoid double taxation. Taxpayers typically have two forms of income: earned income and unearned income.
Earned and Unearned Income
An expatriate employee has earned income upon receipt of money for personal services. This includes employee wages, self-employment income, independent contractor pay, etc. An expatriate in this situation can exclude up to a certain amount of wages from U.S. income taxes. The amount excluded is indexed for inflation and for 2020 that is $107,600 ($105,900 for 2019). Unearned income does not qualify for the earned income exclusion. Examples of unearned income include interest, dividends, rents, and royalties.
Independent contractors or self-employed individuals who earn income in a foreign country still need to pay U.S. Social Security and Medicare taxes at a rate of 15.3%. The only exception to that requirement is if there is a totalization agreement between the U.S. and the foreign country in which that the employee resides. A totalization agreement between two nations means that each citizen employee would continue to have their employer pay into the social service program of the home country and thereby not be responsible for both. Not all countries have these agreements with the U.S.
Foreign Tax Credits
The intention of the foreign tax credit is to prevent double taxation for U.S. citizens and residents by permitting a credit against U.S. income tax for certain taxes that are paid to a foreign country, even if that income will not qualify for the Foreign Earned Income Exclusion. Although the allowable foreign tax credit cannot exceed the U.S. income tax liability in any given tax year, it can result in zero U.S. income tax. Additionally, foreign income tax credits cannot be used to reduce the Social Security or Medicare taxes on net earnings from self-employment.
Even though these rules sound complex, rest assured that your tax professionals at Calvetti Ferguson understand how to work through the complexity and maximize the benefit for your tax situation. It is possible to use both benefits on the same tax return. Many employers who have expatriate employees want to compute the tax cost of sending their employees to work in another country. We can help with that and with the U.S. income tax filing for the affected employees so that your company and employees can focus on your core business.