What Types of Foreign Income are Exempt From U.S. Taxes?

Which Types of Foreign Income are Exempt From U.S. Taxes?

What Types of Foreign Income are Exempt From U.S. Taxation?

Unlike almost every other country across the globe, the United States follows a worldwide income tax model for taxpayers who are considered U.S. persons for tax purposes. Even though technically this is referred to as ‘Citizenship-Based Taxation,’ it also includes permanent residents and other foreign nationals who meet the substantial presence test. This can come as a big surprise to foreigners who become US persons for tax purposes and have foreign income. Not only is the foreign income taxable in the United States, but even if the income is exempt from taxes overseas, it may still be taxable in the United States. Let’s walk through the basics of potential land mines involving foreign income and US taxes.

First Worldwide Income Taxation

The United States’ concept of worldwide income and citizenship-based taxation is a bit different than most other countries. In most other countries, a taxpayer is only required to pay tax on their worldwide income if they are considered to be a resident of that country — which typically means that they live there in that country for the majority of the time. For U.S. tax purposes, if the taxpayer is considered a US person for tax purposes then they’re required to pay tax

Is Foreign Passive Income Tax Exempt?

It is not uncommon for a foreign national who becomes a US person for tax purposes to have investments overseas in various assets and accounts. Some common types of foreign passive income may include dividend income, interest income, capital gains, royalties, and real estate rental income. In some countries, this type of income is not taxable — such as in many different Asian countries — and it’s considered tax-exempt abroad. Unfortunately, under the worldwide income tax rules, this type of income is taxable in the United States. But, if the taxpayer already paid foreign taxes on the income coming then they may qualify for a foreign tax credit on their US taxes so that they could limit any double taxation issues.

Is Foreign Earned Income Tax Exempt?

Just as some countries do not tax foreign passive income, other countries do not tax foreign-earned income, such as the UAE. But, just because foreign-earned income may be tax-exempt in a foreign country does not mean it is tax-exempt in the United States.  But, taxpayers who either reside in a foreign country or have paid taxes on foreign income, may qualify for either the foreign earned income exclusion or the foreign tax credits to offset any US tax on foreign earned income. Even if the income was exempt overseas, some taxpayers may still qualify for the foreign earned income exclusion so that the first 120,000 of that income is also tax exempt in the United States.

Is Foreign Pension Income Tax Exempt?

With foreign pension income, it can get very complicated period from a baseline perspective foreign income is taxable in the United States, so that would include foreign pension income. But, depending on whether or not the taxpayer is generating income in a treaty country or not and whether the treaty exempts certain types of foreign pension income such as public pension income, and/or whether the taxpayer qualifies to be treated as a foreign person for tax purposes under a U.S. tax treaty will impact whether or not the foreign income is exempt in the United States or taxable.

How You May Avoid U.S. Taxes

There are some ways a US person might be able to avoid or minimize their U.S. tax liability on foreign income. Here are four common methods.

Treaty Election

If the taxpayer resides in a treaty country, then they may be able to qualify for a treaty election to be treated as a foreign person for tax purposes and only pay U.S. tax on their US-sourced income.

Closer Connection Exception

For taxpayers who were only considered US persons because they met the substantial presence test, if they can show they have a closer connection with their foreign country or countries and/or qualify for other types of exceptions or exclusions to substantial presence then they too would only be taxed on their US sourced income and not their worldwide income.

Foreign Earned Income Exclusion (FEIE)

For taxpayers who work overseas and meet either the bona fide residence test or the physical presence test, they may qualify for the Foreign Earned Income Exclusion and the foreign housing exclusion paired with the Foreign Earned Income Exclusion, taxpayers may qualify to exclude upwards of $120,000 of their income on their U.S. tax return by filing IRS Form 2555. In addition, some taxpayers may also qualify for a housing exclusion which allows them to claim an exclusion for a portion of their housing payments as well. Taxpayers who were filing Married Filing Jointly may each claim the exclusion.

Foreign Tax Credit (FTC)

Taxpayers who have already paid foreign taxes abroad on foreign income may qualify for certain foreign tax credits to offset their US tax on that foreign income by filing Form 1116 to claim foreign tax credits. Noting, that is not necessarily a dollar-for-dollar credit and some taxpayers may have an overpayment which they can carry forward to future years or an underpayment which means they are still required to pay the difference between what they paid overseas on the foreign income and what their U.S. tax liability would be on that same income.

International Reporting Requirements (FBAR, FATCA, and More)

In addition to the tax implications of reporting foreign income to the U.S. Government, Taxpayers abroad also have to report their foreign accounts, assets, and investments on various international information reporting forms each year as well. Failure to file these forms may result in significant fines and penalties.

FBAR Due Date and Extension

The FBAR is used to report foreign bank and financial accounts to the US Government. The Form is due on April 15, but is currently on automatic extension. Therefore, if you did not file the FBAR (FinCEN Form 114) by April 15, you still have until October to file it. And, you do not have to file an extension form such as Form 4868 or 7004 to obtain the FBAR extension — because the extension is automatically granted.

Form 8938 Due Date and Extension

Form 8938 is used to report foreign assets to the IRS in accordance with FATCA (Foreign Account Tax Compliance Act). It is similar (but not identical) to the FBAR. Form 8938 is filed with your tax return and is due when your tax return is due. If you are an individual filing a Form 1040, then the Form 8938 would be due in April along with your 1040 tax return — but if you extend the time to file your tax return, then your Form 8938 will go on extension as well.

Form 3520 Due Date and Extension

Form 3520 is used to report foreign gifts and foreign trust information. The due date for Form 3520 is generally April 15, but taxpayers can obtain an extension to file Form 3520 by filing an extension to file their tax return for that year. Similar to Form 8938, there is no specific Form 3520 extension form required beyond requesting an extension of the underlying tax return.

Form 3520-A Due Date and Extension

Form 3520-A is used to report US ownership of a Foreign Trust. Unlike Form 3520, Form 3520–A is usually due in March and not April. In addition, the rules for filing an extension for Form 3520-A are different as well (subject to the substitute filing rules). In order to extend the due date to file Form 3520-A, the taxpayer must file a separate Form 7004 extension form.

Form 5471 Due Date and Extension

Form 5471 is used to report the ownership of certain foreign corporations. The filing date is the same as when a person’s tax return is due — and if the taxpayer files an extension for the underlying tax return, Form 5471 will go on extension as well. In recent years, Form 5471 has become infinitely more complex — so taxpayers should be cognizant of the different filing requirements and plan accordingly.

Late Filing Penalties May be Reduced or Avoided

For Taxpayers who did not timely file their FBAR and other international information-related reporting forms, the IRS has developed many different offshore amnesty programs to assist taxpayers with safely getting into compliance. These programs may reduce or even eliminate international reporting penalties.

Current Year vs Prior Year Non-Compliance

Once a taxpayer missed the tax and reporting (such as FBAR and FATCA) requirements for prior years, they will want to be careful before submitting their information to the IRS in the current year. That is because they may risk making a quiet disclosure if they just begin filing forward in the current year and/or mass filing previous year forms without doing so under one of the approved IRS offshore submission procedures. Before filing prior untimely foreign reporting forms, taxpayers should consider speaking with a Board-Certified Tax Law Specialist who specializes exclusively in these types of offshore disclosure matters.

Avoid False Offshore Disclosure Submissions (Willful vs Non-Willful)

In recent years, the IRS has increased the level of scrutiny for certain streamlined procedure submissions. When a person is non-willful, they have an excellent chance of making a successful submission to Streamlined Procedures. If they are willful, they would submit to the IRS Voluntary Disclosure Program instead. But, if a willful Taxpayer submits an intentionally false narrative under the Streamlined Procedures (and gets caught), they may become subject to significant fines and penalties. 

Need Help Finding an Experienced Offshore Tax Attorney?

When it comes to hiring an experienced international tax attorney to represent you for unreported foreign and offshore account reporting, it can become overwhelming for taxpayers trying to trek through all the false information and nonsense they will find in their online research. There are only a handful of attorneys worldwide who are Board-Certified Tax Specialists and who specialize exclusively in offshore disclosure and international tax amnesty reporting. 

Golding & Golding: About Our International Tax Law Firm

Golding & Golding specializes exclusively in international tax, specifically IRS offshore disclosure. 

Contact our firm today for assistance.