How the IRS Calculates Americans’ Foreign Income

How does IRS know about foreign income of US citizens? Why is the US tax authority called an octopus that has entangled the whole world with its tentacles? Is it true that the foreign income of US citizens cannot be hidden, so there is no question of whether to pay or not to pay in principle? Is it possible to reduce taxable foreign income in legal ways?

All these difficult questions concern not only US citizens but also foreigners who permanently reside in the USA. And there are no simple answers. We have to admit that the IRS works exceptionally efficiently, counting not only domestic but also foreign income of US citizens.

IRS USA

It’s easier to answer the first question. How does IRS know about foreign income of US citizens? There are two main tools for that. The first is a tax return (Form 1040). This is a modest 2-page document, which many US citizens and almost all foreigners are frankly afraid of. The tax return assumes that in Form 1040 (and additional forms FinCEN 114 and FATCA 8938), the US citizen will indicate foreign income. Most Americans do that because very famous personalities came across on tax evasion or fraud, including the most famous gangster in the United States, Al Capone (Alphonse Gabriel “Great Al” Capone).

Those Americans who forget to report foreign income face the ubiquitous FATCA (Foreign Account Tax Compliance Act). FATCA obliges banks, payment systems, and other financial institutions to inform the IRS. All these institutions enforce the law and count the foreign income of US citizens as carefully as possible because falling under financial sanctions and blocking correspondent accounts in USD is, in fact, a sentence to a bank without the right to appeal.

At the same time, Americans who are forced to indicate foreign income can receive a tax deduction, but even this does not reduce the acute dependence of US citizens on the all-powerful IRS and the mandatory 1040 declaration. And the FATCA law does not allow to relax even those citizens who tried to hide income abroad. The rule remains unchanged. If you have income (whether domestic or foreign), fill out a return and pay taxes.

What foreign income is taxed by the IRS?

In terms of taxation, the US is not the most convenient country to live in. In any case, you need to fill out a tax return. You can try to get a tax deduction, but before April 15, the tax on foreign income must be paid.

Essential points on foreign income taxation in the US:

  • It is mandatory to pay taxes on foreign income. In the United States, taxes depend on citizenship, but not on the place of residence or the jurisdiction in which income is received. There are exceptions to this rule, but they do not change the overall picture.
  •  There is no tax exemption for US citizens in the general case. The IRS has provided several tax-reducing tools (income exclusion, foreign tax credit, tax deductions), but they do not completely exempt from taxes.

Foreign income subject to the IRS taxes:

  • Wages. Wages include any income paid to you for services or goods sold.
  •  Interest. Interest includes income on deposits in foreign banks.
  • Dividends. Dividends include payments on foreign shares owned by US citizens.
  • Rental income. Any foreign income resulting from the rental of a house, apartment, or other property is taken into account.

Foreign income that the IRS does not include in the taxable base (hence, you do not need to pay taxes on it):

  • Previously excluded value of meals and lodging furnished for the employer’s convenience.
  • Pay you received as a US government employee.
  • Recaptured and unallowable moving expenses.
  • Annuity or pension payments, including Social Security benefits.
  • Payments received after the end of the tax year following the actual tax year in which you performed the services that resulted in earned income.
  • Amounts included in your income because of your employer’s contributions to a nonexempt employee trust or a nonqualified annuity contract.

US citizen’s housing expenses subject to exclusion from foreign income:

  • Rent.
  • Renovation.
  •  Utilities (telephone, mobile phone, and Internet expenses are not included in the deduction).
  • Property insurance.
  • Non-refundable security deposits and rental payments.

US citizen’s housing expenses subject to withholding tax on foreign income on a general basis:

  • Real estate purchases (including mortgage payments).
  • Home improvements (interior, appliances, luxury goods).
  • Expenses that the IRS classifies as extravagant.
  • Payment for the services of domestic servants (gardeners, maids).
  • Deductible taxes and interest (mortgage interest).

How to report foreign income to the Internal Revenue Service?

Everything is standard here. Form 1040 is mandatory not only for US citizens living in the country but also for those whose permanent residence is outside of it. Sometimes, you will need to add FinCEN Form 114 (FBAR, Report of Foreign Bank and Financial Accounts) and FATCA Form 8938 to your tax return.

We will not now analyze these forms, the features of filling them out, and the rules for legally reducing taxes on foreign income in detail. This topic is extremely complex and individual. Therefore, if you are interested in tax exemptions, optimizing foreign income, the rules for filling out a tax return, and the practical application of a tax deduction, please contact our experts and discuss all your questions in an individual consultation.

The most important points on the topic:

  • Freelancers and the self-employed are required to pay taxes on foreign income. In some cases, self-employment tax liabilities may arise.
  •  It is challenging to understand all the intricacies of calculating the tax and determining the taxable base. Therefore, if you receive foreign income, we recommend hiring a competent US tax expert.
  • Submission of incorrect reporting threatens severe sanctions. You can even formally become a tax evader, not trying to save on paying taxes but by making mistakes in the tax return.

Is it possible to reduce overseas income tax?

There are ways to do this, but you need to be well versed in US tax law. The tax on foreign income is not a constant value, and there are two ways to get a kind of discount. These are Foreign Tax Credit (FTC) and Foreign Earned Income Exclusion (FEIE).

Their essence lies in excluding foreign income from the taxable base and providing a tax credit for the amount that has already been paid to the receiving country. But choosing between FEIE and FTC is not as easy as it might seem. And if you make a mistake, you may face extremely unpleasant surprises on future tax returns.

Therefore, we recommend you to be extremely careful and remember that by providing tax breaks on foreign income, the United States thereby reduces its own income. It is not difficult to assume that the tax authorities will not give you gifts, especially if you are claiming a tax deduction. One of the IRS functions is the maximum possible exclusion of such benefits.

US Foreign Tax Credit

If your foreign income originated in a country with tax treaties with the United States, you pay tax in that country, after which the amount will be deducted from the US tax base. In other words, Foreign Tax Credit can be called compensation for taxes paid. The document you file with the IRS (there is no automatic foreign tax credit in the US!) is called Form 1116.

Foreign income and methods of its exclusion

This method is often used by expats to avoid double taxation, but it is also not easy. First, Foreign Earned Income Exclusion does not work automatically. Secondly, there are requirements for the minimum number of days that the applicant for the deduction must spend outside the United States. Thirdly, you will have to prove the connection between you and the country of temporary residence. Another condition is filing Form 2555 along with the standard US tax return (even if all of your income is foreign income that you want to exclude).

How to reduce foreign income when filing a US tax return and not violate IRS rules:

  • The maximum possible deduction is adjusted every year and depends on inflation. In 2021, the amount was USD 108,700, and in 2022 – USD 112,000.
  • The deduction amount may be increased beyond the limit if you have incurred housing expenses.
  • Husband and wife can reduce foreign income tax independently of each other.
  • The IRS does not consider passive income (interest and dividends) an exception.

FATCA – the US tax octopus

FATCA is the second most important source of information for the IRS about foreign income of US citizens. It is called the octopus that has entangled the whole world, and there is some truth in this. All bank transactions of US citizens become known to the IRS, so the question of hiding foreign income does not even arise.

Interestingly, FATCA-related tax information exchange agreements are actively signed by countries that do not have the warmest relations with the United States. The reason for this is simple. Refusal of FATCA at the national level threatens severe financial sanctions and blocking of dollar accounts, which is unacceptable for most countries worldwide.

At the same time, not the US tax authorities (IRS) will control the implementation of FATCA but other countries. These countries receive the corresponding obligations after the signing the agreement. With this alignment, the foreign income of US citizens becomes the IRS object of attention with almost no alternative. Either the US citizen will tell the fact of its existence (tax return), or the bank in which they have an account will do it.

Who refers to US Persons, information about which (including foreign income) must be transferred to the IRS:

  • US citizens.
  •  US residents (these are completely different categories, especially for tax purposes).
  •  Legal entities registered in the USA.
  • Trusts (if US persons can control it or its decisions).
  • Deceased individuals who were US citizens/residents during their lifetime.

Even a person with a regular phone number in the USA can be recognized as a US person.

Who refers to Foreign Financial Institution (FFI) for the purposes of FATCA in the USA:

  •  Organizations engaged in banking or similar activities.
  • Organizations carrying out depository activities.
  •  Investment structures.
  •  Insurance structures.
  • Structures that are part of holdings.

FATCA requires all FFIs to collect information on all of their clients, not just those classified as US Persons. The same statement is true for non-financial foreign entities (NFFE) (both active and passive).

After studying the details of the FATCA Law and the principles of the IRS, a seemingly paradoxical conclusion can be drawn. In short, with the adoption of FATCA, the presumption of innocence principle accepted worldwide (a person is innocent until the court proves otherwise) was replaced with a reverse one. The IRS/FATCA principle states that individuals and legal entities are required to prove their non-involvement in tax obligations to the United States.

In other words, the foreign income of all citizens outside the United States, regardless of their citizenship and resident status, may be of interest to the IRS. And if you want to avoid problems with USD accounts, you will have to cooperate with the IRS almost without fail.

Conclusions and recommendations

Even US citizens themselves admit that the tax issue for them is one of the most difficult in everyday life. It is impossible to work in the USA and not pay taxes on income. Conditional exceptions are US offshore states and territories. These are the US Virgin Islands, the Commonwealth of Puerto Rico, Wyoming, and Delaware.

The situation becomes even more interesting when the IRS begins to study the foreign income of a US citizen or a US person. To protect its tax interests, the US government launched FATCA, which automatically turned all US non-citizens into potential IRS clients. Although this statement seems to be a joke, there is a massive amount of truth in it.

Therefore, if you have foreign income or the slightest indication that the existing income may be recognized as foreign for FATCA purposes, be sure to find out your actual status and possible obligations to the IRS. And remember that having a USD bank account, doing business with US Persons, and even citizenship/tax residency in an offshore jurisdiction can result in you becoming a debtor from the IRS point of view. And thanks to FATCA, it has quite legal grounds for this.

Our business services in the USA:

If you are interested in such issues as foreign income, tax deductions, filing a tax return, legal tax optimization, and determining the boundaries of the IRS / FATCA powers, please contact our experts at info@offshore-pro.info to discuss the terms of an individual consultation. 

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