When I first started filing tax returns, I barely had to worry about foreign income reporting. The most common thing I would see was foreign investment income on an investment statement and that was usually easy to report and then I just had to make sure to complete form 1116 for the Foreign Tax Credit. But with the rise in global commerce and the increase in remote work and self-employment, US citizens living abroad has become slightly more common. And with the increase in foreign income earned comes an increase in the need for understanding the regulations around report that income and the complications that can arise from not doing so correctly.
For the most part, if you are a U.S. Citizen or resident living or traveling outside the US, you are required to file and pay taxes the same as if you were living in the U.S. You must report income and pay the taxes on that income whether it is foreign or domestic, also known as your worldwide income. If you receive income in a foreign currency, you will need to translate that income into U.S. dollars in order to report the amount earned.
You can find the U.S. currency translations here https://www.irs.gov/individuals/international-taxpayers/foreign-currency-and-currency-exchange-rates
Gross income of course includes money, but also goods, property, or services that are not considered tax exempt that you receive as payment. This includes payments received for work, rent, investments, or other interests.
The most common form of foreign income is going to be your standard W-2 income for American citizens living abroad but working for a US-based company. Payments received can include wages, but can also include pay differentials, which are taxable, as well as, cost of living allowances or travel allowances, which are tax-free. Your employer should include a pay differential on your W-2 form. A pay differential is a monetary incentive for working outside the United States that most people working abroad receive.
Cost of living allowances should not be included in gross income, nor should lodging provided to you as your principal residence outside of the United States. Amounts paid by the US government for household expenses are taxable. If amounts are withheld from your pay to cover these expenses, you cannot exclude or deduct those amounts from your income. Other allowances that should not be included in gross wages on your form W-2 are:
- repairs to a leased home
- education of dependents and special situations
- motor vehicle shipment
- transportation for medical treatment
- traveling, moving, and storage
If you volunteer for the Peace corps the following will need to be included on your W-2 form:
- allowances paid to your spouse and children while you're training the United States
- living allowances designated by the director of the Peace corps as basic compensation
- leave allowances
- readjustment allowances or termination payments
Travel allowances and living allowances such as housing, utilities, food, and clothing are not considered taxable.
If you are US citizen or resident alien of the United States and you live abroad, you're a taxed on your worldwide income however you may qualify to exclude some of your foreign earnings up to a certain amount. You may also be able to exclude or deduct certain foreign housing amounts. These deductions are primarily based on whether you physically live in the foreign country during a tax year. You can always use the IRS interactive tax assistant to help you determine whether or not you qualify for the foreign income exclusion here: https://www.irs.gov/help/ita
If you're self-employed you may qualify for the foreign earned income exclusion. This will reduce the amount of taxes paid on your regular income but will not reduce your self-employment tax. As a self-employed individual you may also be eligible to claim the foreign housing deduction, but not the foreign housing exclusion. More importantly, income received from customers outside of the United States, whether you are living foreign or domestic, must be reported on your return. The IRS will know if you do not report these payments and failure to do so will result in large penalties and interest.
Foreign investment income is the most common foreign income I see. It is usually on a consolidated investment statement and a lot of times the taxpayer is not aware of it. It primarily includes dividends and interest received from stock invested in foreign business. This income obviously needs to be reported on the tax return, but then it usually qualifies the taxpayer for the foreign tax credit, which is a credit allowing the deduction of foreign taxes paid.
Under the Bank Secrecy Act, taxpayers who own foreign bank accounts most report those accounts to the US Treasury department even if the accounts do not generate any taxable income. You should report any foreign bank accounts electronically by the normal filing deadline using the Report of Foreign Bank and Financial Accounts (or FBAR). You are allowed an extension to October if you cannot meet the April filing deadline. You must also report virtual currency transactions to the IRS on your tax return. These transactions are taxable by law.
Failure to file an FBAR or filing an FBAR late can result in huge monetary and even criminal penalties. It is very important that you file this report on time. If, for whatever reason, you file the report late or fail to file it all be sure to file as soon as possible before you are contacted by the IRS. This is one of the main areas of the tax code where the IRS does not mess around. For each foreign bank account, you'll want to keep records with the following information: name on the account, the account number, the name and address of the foreign bank, the type of account, and the maximum value during the year.
If you are a US citizen or a resident alien living overseas you are allowed an automatic two-month extension from your regular filing deadline without requesting an extension. If you cannot meet the two-month extension deadline, you can request an additional extension by the normal October 15th deadline. Even if you are allowed an extension, you will still have to pay interest on any taxes not paid by the regular due date of your return.
Even if you're living outside of the US, it's important to file your tax return on time and to pay your taxes due. Failure to do so can result in huge penalties and the IRS can even revoke your passport and make it difficult for you to travel.
Make sure to keep detailed records of any foreign income that you receive. This may be one of the areas in which a tax professional is almost always necessary. The tax laws regarding foreign income change constantly and they're very difficult to navigate, but, with a trusted advisor, you won't have to worry about compliance.
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