Episode24 - Us Expatriate Tax Planning
In ABCast Episode 24 – US Expatriate Tax Planning Janathan Allen discusses important tax issues from the perspective of a US expatriate. One of the first and most important thing to know for any US taxpayer is the United States taxes its citizens on all income they earn worldwide. US expatriates who remain US citizens (do not renounce their citizenship) remain US taxpayers. Unfortunately, many US expats (and even US taxpayers in general) believe one does not have to report offshore income to the IRS and California. This simply isn’t true.
Jan
Welcome to AB Cast, integrating Legal Tax Accounting and Business Solutions. I’m Jonathan Allen.
This episode is Expatriate Tax Services, Part 1
Neil
Jan, as we begin our conversation about US expatriate tax services, I guess one of the most important facts to establish upfront is that the United States is one of the only countries in the world that taxes its citizens on income that they earn worldwide. And many US expats fail to realize that when they leave the United States, they’re still required to report their income and file a tax return even if they’re under whatever minimums they may have as an exclusion. And if you’re an American citizen and you’re earning income worldwide, it doesn’t matter if it’s offshore, it’s taxable income. So, from the perspective of the expatriate, what concerns you most about where the conversation usually starts?
Jan
Primarily the lack of focus that individuals have when they leave the country as to their responsibilities to pay taxes, to report and pay taxes in the US isn’t debated and it certainly isn’t diminished.
Neil
And even for our listeners that understand that US taxes worldwide, they may not realize that also applies to the state of California. So an expat might not just have a tax obligation to the IRS. They might also have a state tax obligation as well, correct?
Jan
Yes. The state tax requirements are of course going to vary from state to state. California happens to be an aggressive state, but what ends up occurring is if there are still ties to any state for an expat, there is a potential for the applicability of filing a state tax for that individual.
Neil
And that’s especially true in the case of, for example, retirement, taking a retirement income or withdrawing from a 401k that you built here in the states.
Jan
Absolutely.
Neil
Great. A note for our expat tax filers that the due date for their tax returns is April the 15th. This year there is an automatic extension, by the way, for all expat filers, and the extension for this year is June 17th, 2024. Each year it’s going to change based on the calendar, but generally you get about a three month automatic extension just because you’re an expat Jan.
If they fail to file as an expat, what are the risks that they face?
Jan
Well, of course that’s really dependent on the type of income that they have. So, if you are an expat and you are outside of the United States and you have for example, a job and you have income, the failure to file is probably the most difficult computation because what ends up occurring is it’s not necessarily the failure to file, but it’s the failure to disclose foreign income.
Neil
Yes.
Jan
So, because you’re living outside the United States because you have a job that is foreign income and to the taxpayer’s benefit, there are ways to mitigate and eliminate some of the tax liabilities that occur with foreign income, which occurs in two different areas. One is the foreign earned income exclusion, and the other is the credit for foreign income taxes paid on income that may be taxed in the United States. The issue that we’re finding is that there are some tax preparers out there that believe you can take both on the same income. And on the last couple of inquiries that we’ve had, I’ve found that when I look over the tax returns that are being filed, they’re being filed erroneously. You get one or the other, you don’t get both. And generally it is to the taxpayer’s benefit. If they’re working in a country with a higher tax rate than the us, it’s generally better to use the tax credit and not the foreign earned income exclusion.
Neil
So the foreign earned income exclusion, often referred to as an FEIE right now for 2024, that exclusion stands at $126,500. Along with that responsibility tax filing comes the responsibility of FBARs and IRS form 8938. Can you tell us about those two, the FinCEN form 114, FBAR, and then form 8938?
Jan
Well, the FinCEN form 114 (FBAR) is really a form for the Department of Justice. It’s not a Department of Treasury form because the information that occurs and is applied, and when we submit those forms, it’s not submitted to the IRS, it’s submitted to the Department of Justice. So, IRS form 8938 is almost duplicative of the information on FBAR, FinCen Form 114, but that is the form that is filed with the Department of Treasury. So two forms, same sort of types of information going to different departments of the US Government.
Neil
So the 8938 goes to the IRS?
Jan
It does.
Neil
Okay. Do most expats in your experience understand they need to file both?
Jan
No, and I think there’s a lot of confusion about that. There’s been a lot of information dissemination relating to the FBARs, but not as much about the 8938, which is really the form that files the information relating to the foreign income with the Internal Revenue Service as opposed to the DOJ.
Neil
So one of the challenges that an expat is going to face that they may not realize is the way that we do accounting here in the United States is kind of unique when compared with most of the rest of the world. And that really comes true in PFIC investments. It comes true in accounts. Can you talk a little bit about what an expat needs to know about how we account versus how they account in England and countries around the world?
Jan
Well, what ends up happening is most tax law really, and at least in the United States and probably the rest of the world as well, is really underwritten by generally accepted accounting principles. The issue is that generally accepted accounting principles vary by country. So, for example, the types of income recognition that occur in the United States are not necessarily duplicated. For example, in Europe, and I’ll give you a case in point, when we invest here in the United States and we have mutual funds and people can open up checking accounts and they’ll be super saver accounts, and the banks themselves will go back and invest in, for example, mutual funds. At the end of the year, you get that large 1099 form that is a tax reporting form that really reports tax, will report taxes, any taxes that were paid, but it primarily gives you the interest income, the dividend income, and any gain or loss that occurred within that mutual fund during the year.
That doesn’t mean that you’ve pulled those investments out, it just means that’s how the investments perform during the year. And in the United States, that’s taxable in the year in which it occurs. That’s not true in Europe. So what ends up occurring is you can invest in a mutual fund in Europe, the same type of fund, same type of gains, interest dividends, but it’s not reportable in Europe until you actually sell or end up doing something with that particular investment that triggers the actual cash transaction. So, where it’s recognized here in the states as it occurs in Europe, a taxable transaction doesn’t occur until you liquidate. So, what happens from a tax perspective here in the states is tax preparers are required to duplicate that mutual fund computation in a European or a foreign mutual fund so that it duplicates what type of information would be obtained here in the United States
Neil
By duplicating it, you’re saying we’re going to take those reports and basically recreate a US model of those holdings from scratch.
Jan
And that’s precisely what happens. So depending on the types of transactions that have occurred in that particular mutual fund, it can be very time consuming and it certainly is very expensive for the taxpayer.
Neil
Yeah. What are some of the challenges? A lot of expats own their own small business. What’s it like to own a foreign business when you’re a US taxpayer?
Jan
Well, I would split that into two different comments. One is if you are a US citizen and you have a foreign or an interest in a foreign company, or if you are an expat living outside of the United States and you have a US company, so there’s sort of two different angles. If you are a US citizen and you have an interest in a foreign company, then there is an additional foreign reporting requirement, and that’s form 54 71, assuming that the entity is a limited company, because again, in Europe, the types of entities that we have here in the United States are not duplicative. There are no LLCs, there are no S corps. What they have in Europe are things known as limited companies,
Neil
Which many people mistake as like an LLC or some other form of S corp.
Jan
Yes. And it’s not deemed to be a corporation for US purposes. And so, under 5471, that’s where the income and the balance sheet are reported. And that income, whatever net income or proportion of income that’s owned by that US taxpayer will be reported on the US tax return as income, whether it’s distributed or not. So that’s an interesting lay in terms of foreign ownership. But I had a really interesting case the other day. A taxpayer had come in and they were having difficulty with their taxes and the wife was working in China. Now she wasn’t in China, she was actually based in Japan, because if you know anything about the Chinese economy, it’s very difficult to get currency out of China into any other place in the world. It’s just the currency restraints that are imposed by the Chinese government. So this woman was working in Japan, so they had been working with an individual who advised them to create an S corp in the United States.
So part of her income that was coming from China would go to Japan, and that was applicable for foreign earned income because she was actually outside of the country earning income from a foreign company in a foreign country. She was living in the rest of that income when it was sent back to the United States into the S corp, suddenly lost its foreign component because there is no foreign component for corporations. As an S corp, you don’t identify US income and you don’t identify foreign income. It’s income. So what ends up occurring is that foreign earned income suddenly morphed into US income. So now you have the issue of whether or not the taxes, those foreign taxes that were paid on that income are creditable through the S corp to the individual. And I will tell you now they aren’t. Wow. And the foreign earned income exclusion doesn’t count. You can’t utilize that against that S corp income either because it is no longer deemed to be foreign income. It becomes US-centric income because it’s in a US entity, it’s passed to a US taxpayer. It’s now effectively connected income with the states.
Neil
How about an expat that owns a business in a foreign country?
Jan
Yeah. We see a lot of that. And what ends up occurring is that’s the 5471 solution. Again, as a US individual, you are still required to those foreign earnings through foreign US tax purposes, essentially as a deemed dividend for any income that may be earned via that foreign entity.
Neil
Very good. Another trap, if you will, for us expats, is the concept of a foreign trust or a grantor trust.
Jan
Oh, heaven Forbid.
Neil
It seems like this is a great idea. It’s absolutely not. Can you share why?
Jan
Yeah. I’ve had a lot of discussions about foreign trusts because of course, here in the United States, we sort of harp on the notion that in order to put together an estate plan, it’s really crucial to start with it with an instrument that helps to protect assets, and that’s a trust. So when people leave the United States, of course the presumption is, well, I should create a foreign trust. The issue is that as a US taxpayer, when you are the settler that is the creator of or the beneficiary of a foreign trust, any income that flows through that trust is taxed in the US at a tax rate of 55%. So foreign trusts are a no-no for whether you’re a US expat or whether or not you have assets and other places in the world, there are better ways to control and minimize taxes and mitigate risk than foreign trust because foreign trust can be an incredibly expensive lesson.
Neil
And that raises one of the central greatest benefits we provide to many of our US clients as well as those that are international. And that’s transactional planning. If you were just going to summarize the art and science of transactional planning, especially in this context, how does it apply?
Jan
It’s like a game of chess. There’s lots of pieces and there’s lots of differing moves. The question is aligning it so that it’s in the taxpayer’s best interest. And so, what we do here in the firm is we combine the tax accounting and legal elements, and we consolidate any sort of issues that they have, whether they’re domestic issues or whether they involve foreign assets. And we create a plan that really goes back and harmonizes those three elements, tax accounting and law. And we’ve called that transactional planning because it’s the transactional planning between the individual and any entities that they own or any trust that they have or any investments that they have, and how it is that those assets may be held and what types of entities they’re held in. There’s a fascinating way to go back and put together unique solutions for each individual depending on the types of assets that they have and where they hold them.
Neil
From my chair, one of the coolest things about this is it’s not just a matter of protecting your assets and reducing risk and minimizing tax implications. I love the idea that you can shift income and losses year to year if you structure the transactions right and the entity’s right, so that you can basically defer income and pay taxes on it later if you need to or accelerate it. Talk to us a little about that element of time that most people miss.
Jan
Well, that comes down to the tax planning, and that really evolves out of the differing types of entities that we can utilize in terms of holding assets. So you can hold a company, and in the United States there are LLCs and S corp, and there are C-Corp. And lots of accountants, CPAs advise their clients to create an S corp. And the reason that they advise them to do that is because the income flows through to them like it would in a partnership or an LLC so that the income is taxed at the individual level, not the corporate level,
Neil
corporate tax
Jan
But what happens is oftentimes because the US taxes, the individual, the LLC and the S corp all on a calendar year basis, so there’s no way to go back and do any effective tax planning. But if you have a C corporation and there’s a reason to go back and have something rather than a calendar year end, you have the opportunity to use a fiscal year end. So you can bump C corp out to have a fiscal year end begin, let’s say in April and end in March. And what that does is it allows us in that fiscal year end to accelerate or decelerate income and our expenses so that the reporting amount flowing through to the individual can be varied based on effective tax planning. So it’s a utilization of the timing of when it is an entity or an individual’s tax that allows us for some of the greatest tax planning opportunities simply based on time.
Neil
It’s a good place to break. And Jan, we’re looking forward to part two of this conversation about tax planning for expatriates. Thank you, Jan.
Jan
You’re welcome. Learn more about our integrated legal tax accounting and business solutions, and visit alan baron.com or call 8 6 6 6 3 1 3 4 7 0 to schedule a free consultation.
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