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FISKEN FISCAL FACTS VOLUME 6

Dear Client/Colleague;

The purpose of this edition of the Fisken Fiscal Facts is to provide an Employer Overview of American Expatriate Taxation. The area of Taxation of Overseas Americans is quite complex, so this Overview is NOT an exhaustive treatment. However this Overview should be helpful to employers with American employees posted overseas, wishing to strengthen their knowledge of taxation issues with the IRS and state taxing authorities. Please note that this Overview is NOT intended to provide tax advice. Employers and employees should seek tax advice from appropriate tax professionals when dealing with their own tax situations.

Here is a listing of topics covered in this Overview:

  1. Completion of IRS Form 673
  2. Taxable Payments
  3. Non-Taxable Payments
  4. Overseas Exclusions for Earned Income and Housing
  5. State Compliance
  6. Host Country Taxation
  7. Employer's Role in Providing Tax Assistance
  8. Useful Resources

1) COMPLETION OF IRS FORM 673: If an employee anticipates claiming the Overseas Earned Income Exclusion and/or the Overseas Housing Exclusion, the employee should complete IRS Form 673 for the employer. The employer should then place that completed Form 673 in the employee's personnel records. In many cases the Form 673 provides the employer with the authority to stop withholding all Federal Income Tax from the employee.

However, the employer is still required to withhold both the Medicare and OASDI portions of Social Security Tax for Americans posted overseas. The overseas exclusions are from Income Tax and NOT Social Security Tax.

Also employees with large compensation packages may have some Federal Income Tax exposure, because their base salary when fully loaded for taxable allowances might substantially exceed the $80,000. annualized earned income exclusion. Therefore employees with large compensation amounts might wish to have some Federal Income Tax withheld, even though they have completed an IRS Form 673.

2) TAXABLE PAYMENTS: Here is a listing of various payments made to or in behalf of an Overseas American employee that are considered to be taxable compensation to the employee. Please note that these payments are typically subject to the Social Security Tax. Thus they are normally included in Box 1, Box 3 and Box 5 of the IRS Form W2 (Employees Annual Wage Statement).

  • a) Base salary
  • b) Post differentials
  • c) Housing allowance
  • d) Educational allowance
  • e) Rest and Recuperation Air Transportation
  • f) Flat payment for settling in with NO ACCOUNTING to employer
  • g) Flat payment for moving expenses with NO ACCOUNTING to employer
  • h) Flat payment for storage expenses with NO ACCOUNTING to employer

3) NON-TAXABLE PAYMENTS: Here is a listing of various payments made to or in behalf of an Overseas American employee that are considered to be NON-TAXABLE to the employee.

  • a) Initial Air Transportation to begin assignment
  • b) Return Air Transportation upon successful completion of assignment
  • c) Moving expenses paid directly to a third party-e.g. moving company
  • d) Moving expenses reimbursed to an employee, wherein the employee has provided AN ADEQUATE ACCOUNTING to the employer
  • e) Storage expenses paid directly to a third party

4) OVERSEAS EXCLUSIONS: There are 2 types of Income Tax Exclusions available to American staff posted overseas: the Overseas Earned Income Exclusion and the Overseas Housing Exclusion.

American citizens are taxed on their worldwide income. They are required to file USA tax returns reporting their worldwide income, even if they will exclude some or all of that income by use of Overseas Exclusions. Therefore, an American employee living overseas will file a Form 1040 (U.S. Individual Income Tax Return) reporting all the employee's income for the year. If the employee qualifies for Overseas Exclusions, the employee would calculate those Overseas Exclusions on the IRS Form 2555 (Foreign Earned Income). The Form 2555 is then attached to the employee's Form 1040.

To take the Overseas Exclusions, the employee must QUALIFY under either the PHYSICAL PRESENCE TEST or the BONA FIDE RESIDENCE TEST.

To meet the PHYSICAL PRESENCE TEST, the employee must be physically present in a foreign country or foreign countries for at least 330 full days during any period of 12 months in a row. A full day means the 24-hour period that starts at midnight.

To meet the BONA FIDE RESIDENCE TEST, the employee must reside in a foreign country or foreign countries for an interrupted period that includes an ENTIRE CALENDAR YEAR.

Here is a working example of a hypothetical employee named Lotta Flair qualifying under the PHYSICAL PRESENCE TEST. Lotta is an American citizen posted overseas to Latacunga, Ecuador. Her first full day overseas is 1 July 2006. During her "OVERSEAS YEAR" of 1 July 2006 through 30 June 2007, Lotta MUST spend 330 full days outside of the USA. She can travel to countries other than the USA without affecting the 330 foreign day total. Stated another way, during her "OVERSEAS YEAR" Lotta can not spend more that 35 days in the USA.

Here is a working example of how Lotta would qualify for the Overseas Exclusions under the BONA FIDE RESIDENCE TEST. Lotta continues her employment with the employer in Ecuador through 30 June 2008. Therefore at 31 December 2007 Lotta has resided in a foreign country for the ENTIRE CALENDAR YEAR of 2007. Thus on her Tax Year 2007 IRS tax return, Lotta could qualify under the BONA FIDE RESIDENCE TEST.

A prime advantage that the BONA FIDE RESIDENCE TEST has over the PHYSICAL PRESENCE TEST is that more USA days are permitted under the BONA FIDE RESIDENCE TEST. For example there is no 35 USA day limit under the BONA FIDE RESIDENCE TEST.

The first type of Overseas Exclusion is the EARNED INCOME EXCLUSION. The annual amount of that Exclusion is $80,000. (US). Please note that this Exclusion amount is annualized. Using the example of Lotta Flair above, in Tax Year 2006 Lotta could claim an Earned Income Exclusion of up to $40,000. (calculated $80,000 x 50%) since Lotta was overseas for just 6 months of Tax Year 2006.

The second type of Overseas Exclusion is the HOUSING EXCLUSION. The amount of that Exclusion is calculated on the differential between Housing Expenses Paid and a Base Housing Amount. The Base Housing Amount is provided each year by the IRS and has been running roughly about $12,000.per year. As a hypothetical working example, if an American overseas employee paid $20,000. for annual housing expenses, the employee could take $8,000. (calculated $20,000-$12,000.) as a HOUSING EXCLUSION. Please note that HOUSING EXCLUSION is annualized. Therefore if the employee does not live overseas for the entire Tax Year, the employee must pro-rate the amount of the annual HOUSING EXCLUSION. It is also important to note that the HOUSING EXCLUSION is in addition to the EARNED INCOME EXCLUSION. Thus an employee with a large compensation package which includes a significant amount of Housing Allowance might take both the EARNED INCOME EXCLUSION and the HOUSING EXCLUSION.

5) STATE COMPLIANCE: Americans when they live in the USA are RESIDENTS of a state for the state income tax filing purposes. When Americans move overseas they are still linked to a state in the USA for income tax filing purposes. In effect overseas Americans are DOMICILED in a state. Therefore an American employee living overseas is required to file a state income tax return with the state in which the employee is domiciled. Here are some state income tax compliance considerations.

First, some states DO NOT have an income tax. Therefore no state income tax filing is required. Examples are Florida and Texas.

Second, many state jurisdictions that do have a state income tax accept the Overseas Exclusions. These are classified as "Federal Conforming States for purposes of the Overseas Exclusions". Examples are Maryland, Virginia and Washington DC.

Third, there are a few state jurisdictions that do have a state income tax but DO NOT accept the Overseas Exclusions. One example is Massachusetts.

Should the employee wish to consider changing his/her state of Domiciliary while living overseas to either a state which has no income tax or to state which accepts the Overseas Exclusions, here are some factors that states use in determining Domiciliary:

  • a) state of voter registration. This is a key factor.
  • b) state of driver's license. This is a key factor.
  • c) prior state income tax filing history
  • d) location of real estate owned
  • e) location of bank accounts
  • f) location of investments accounts
  • g) location of Home Leave Post
  • h) location of family ties
  • i) state of library card
  • j) state of burial plot

6) Host Country Taxation: It is possible that an American employee living abroad will be subject to the income tax of the Host Country. Conceptually an American Taxpayer should NOT be taxed twice on the same income. Thus if an American overseas employee is subject to USA income tax and Host Country income tax on the same income, that employee is permitted to take a Tax Credit on income that is double-taxed. The protocol for taking that credit is to complete the IRS Form 1116 (Foreign Tax Credit). That Form 1116 is then attached to the employee's IRS Form 1040.

Please note that if the employee takes the Overseas Exclusions on the employee's IRS Form 1040, the income that has been excluded through the use of the Overseas Exclusions is NOT eligible for the Foreign Tax Credit since that income has NOT been taxed by the USA.

7) Employer's Role in Providing Tax Assistance: It is typical employer policy to NOT provide tax advice directly to its overseas American employees. However recognizing the complexities of Expatriate Taxation, some employers sometimes make Tax Assistance available to eligible employees. Here are some examples:

  • a) Preparation of individual tax returns. For an eligible employee, the employer will arrange preparation of IRS, USA state, and Host Country individual tax returns.
  • b) Reimbursement for tax planning or tax preparation services. For an eligible employee, the employer will reimburse for tax planning or tax preparation services, up to a defined dollar limit.
  • c) Orientation session at US Headquarters with an Expatriate Taxation Specialist. For an eligible employee, the employer can arrange an individual orientation session with an Expatriate Taxation Specialist up to a defined time limit when the employee is at US Headquarters.
  • d) Providing the employee with the name and communication coordinates of Expatriate Taxation Specialists.
  • e) Providing the employee with Useful Resource information, such as that appearing in Section # 8 below.

8) USEFUL RESOURCES: Here is a listing of useful resources for overseas American employees. Please note that all IRS forms and publications can be accessed through the IRS Website of www.irs.gov

  • a) IRS Publication 54(Tax Guide for U.S.Citizens and Resident Aliens Abroad)
  • b) IRS Form 2555 (Foreign Earned Income)
  • c) IRS Instructions for IRS Form 2555
  • d) IRS Form 1040 ( U.S. Income Tax Return)
  • e) IRS Form 2688( Application for Extension to file Form 1040)
  • f) IRS Form 2350 ( Application for Extension to meet the Overseas Exclusions)
  • g) IRS Form 2848 ( Power of Attorney Authorization for IRS Representation)
  • h) IRS Form 8842 ( Change of Address Notification to IRS)
  • i) IRS Form 4506 ( Request for copy of Prior Year IRS Tax Return(s)
  • j) IRS Form 1116 ( Foreign Tax Credit)
  • k) IRS Instructions for Foreign Tax Credit

Hopefully this Employer Overview of American Expatriate Taxation is helpful. Feel free to call or E-mail if you have any follow-up questions. My communication coordinates appear in the signatory section below.

Best,
Bernie Fisken

Bernard J. Fisken, President
Fisken & Company, Taxation and Financial Management Consultants
7437 Arlington Road
Bethesda, MD 20814
301-907-3173 Tel
301-907-6772 Fax

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