Late Expat Tax Returns: How To Win With the IRS

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American expats have been caught in the IRS crack down on unreported foreign income and bank accounts. Several high profile non expat cases have resulted in jail time for taxpayers failing to report large amounts of income on their tax returns. However, many expats have found that IRS treatment has been fairly forgiving. This is because many American expat tax returns should include either or both of two benefits that may reduce the expat’s tax to zero: the foreign earned income exclusion and the foreign tax credit.

The Foreign Earned Income Exclusion allows an American expat to exclude up to $92,900 of income in 2011 using Form 2555, with no tax on that income. The exclusion is for the amount of salary, bonus, commission, or other earned income earned for services outside the USA, up to the limit each year. This limit for 2011 is the number of days during a qualifying period that are in the tax year times $254.52 per day.

Basic requirements: To qualify for the foreign earned income exclusion for a day, the expat must have a tax home in one or more foreign countries for that day. He or she must also meet one of two tests, either:

1. be a bona fide resident of a foreign country for a period that includes the particular day and a full tax year, or
2. be outside the USA for any 330 of any consecutive 365 days that include the particular day.

Bona fide resident: An American expat is a bona fide resident of a foreign country if he/she is legally entitled (under that country’s law) to live there, and actually does live there. If the expat has a visa that prohibits residency, he or she is not a bona fide resident. If he/she files a nonresident tax return in that country for a year, he/she is not a bona fide resident of that country for that year. Example: May lived and worked in China from 2008 to May 1, 2010. She took three months of extended R&R traveling in the USA, and returned to China August 1, 2010, for a new job. May made $95,000 in 2010. If May had a resident visa for China, she could get the full $92,900 exclusion, and her taxable income would be zero after her personal exemption. If she did not have a visa that permitted residence, she might only qualify for a partial exclusion under the 330 day test.

330 of 365 Days: The physical presence test is easy to say but can be hard to count. No particular visa is required. The American expat need not live in any particular country, but must live somewhere outside the USA in order to meet the 330 day physical presence test. The American expat merely counts the days outside the USA. A day qualifies if the day is in any 365 day period during which he/she is outside the USA for 330 full days or more. Partial days in the USA are considered USA days. 365 day periods may overlap, and every day is in 365 such periods (not all of which need qualify).

An additional housing exclusion is also available to expats. The housing exclusion is available only to American expats who qualify for the foreign earned income exclusion. The exclusion is for housing expenses in excess of $40.72 per day, with a limit that varies by location. If Jerry the single guy earned $106,000 and qualified for the Form 2555 exclusion for the whole year and spent $18,000 on housing, he could exclude $92,900 plus $3,136 of housing expenses. His taxable income would be $106,000 less exclusions of $96,036 less his personal exemption of $5,800, and less the standard deduction of $3,700, for a net taxable of only $464. Since the exclusions are off the bottom, not off the top, so Jerry’s tax rate is 31%, and his tax is a whopping $144

Foreign Tax Credit: In addition to the exclusion, American expats can claim a credit for foreign income taxes. Individual income tax rates in many countries are much higher than U.S. tax rates. Expats living in those countries may find that the exclusion does nothing for them, because the foreign tax credit eliminates their taxes in the USA. The credit is dollar for dollar, not a deduction. The credit is limited each year to the amount of income tax in the USA before credits on foreign source income. This limitation is computed separately for passive income (interest, dividends, rents, royalties, and gains on property producing such) and for other income. Excess credits can be carried over to other years.

Example: Fred and his wife, both Americans, live in Elbonia, where taxes are high. His wife has no income. Fred has $225,000 of income, all of which is subject to 25% Elbonian tax (about $56,000). Fred has some deductions. His U.S. tax before credits is $47,000. Fred’s net U.S. tax is zero, since the foreign tax credit exceeds his U.S. tax. Fred doesn’t care about the exclusion.

Late Tax Returns: May, Jerry, and Fred are required to file tax returns with the IRS even though they have no tax. If they don’t, the IRS can come after them and try to assess tax. If Fred didn’t file a U.S. tax return, the IRS can’t do much: he has no tax. If the IRS contacts him, he can file a return and claim the credit. Unless the IRS can prove he willfully failed to file, that’s the end of the story: no tax, no penalties.

For May, if she qualifies for the foreign earned income exclusion, the story can also have a sort of happy ending: no tax, no penalties. (Most taxpayers don’t think any ending involving the IRS is really happy.)

Jerry’s story may have an unhappy ending, though. If Jerry files a tax return, even a very late one, before the IRS comes calling, the ending will be at least sort of happy, too. But if the IRS contacts him first, the ending could be very unhappy. To claim the foreign earned income exclusion, you must elect to claim it by filing Form 2555. Once elected, the exclusion stays in effect unless revoked. The election must be made on a timely filedoriginal or amended tax return. However, an election can be made on a late return in only one of 4 situations: there is no tax due after the exclusion (and all credits), the return is only a year late (disregarding extensions), the IRS has not discovered that the election is late, or the IRS gives permission for a late election. The IRS gives permission only on application to the National Office, which is a very involved process with big fees (IRS and likely professional) involved.

Jerry could be in a fix if his return is more than a year late and the IRS has contacted him. He owes tax even with the exclusion. If Jerry elected the exclusion 10 years ago, he’s safe unless he revoked it. Otherwise, the IRS may impose about $20,000 of tax, and assess penalties of $5,000, plus interest. Jerry has two ways out: find some deductions or credits that don’t get eliminated under the exclusion rules but do eliminate his tax, or apply to the IRS for permission to elect late (an expensive proposition in itself).

American expats have another filing obligation: they must report foreign bank or securities accounts on Form TD F 90-22.1. The form is filed separately from tax returns, and can be very easy. For expats with lots of accounts, it can be long but easy. The penalties, however, are not easy, and can involve jail time and/or big dollars. The TD F form must be filed by June 30 after each year. If a taxpayer with over $10,000 in foreign bank and brokerage accounts didn’t file, the IRS can waive penalties on showing of “reasonable cause.” For expats with little or no tax due, the IRS has been easy to convince that there was reasonable cause.

What’s the solution for you? File now before the IRS comes calling. Claim the foreign earned income exclusion if it benefits you. Claim the foreign tax credit. Keep your income tax in the USA low or zero. File the TD F form. And mostly, get the professional help you need.

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