Citizenship-based taxation impacts U.S.-connected people, including citizens, green card holders, and others with U.S. ties.
This article explores the complexities of American tax obligations for those living abroad, providing insights for expats and anyone planning to move overseas.
Understanding these regulations helps ensure compliance and minimize tax liabilities while navigating the unique challenges of living outside the United States.
What is Citizenship-Based Taxation
Citizenship-based taxation is a system where a nation taxes its citizens regardless of residency status. This means U.S. citizens and permanent residents must pay taxes to the U.S. on their global income, no matter where they live or earn that income.
Unlike most countries that tax based on residency (including Switzerland and Germany), the United States requires citizens to file and pay taxes even if they reside abroad, ensuring compliance with U.S. tax laws irrespective of their physical location.
U.S. Citizenship-Based Taxation in Historical Context
The concept of citizenship-based taxation dates back to the Civil War. In 1861, President Abraham Lincoln’s administration introduced income tax to finance the war effort, initially targeting residents.
However, by 1864, the government extended this obligation to all U.S. citizens, regardless of residency, to prevent tax evasion by those fleeing abroad. This principle was codified in the Revenue Act of 1913, which solidified the requirement for citizens to report and pay taxes on worldwide income. (1)
Over the years, additional laws, such as the Foreign Account Tax Compliance Act (FATCA), have reinforced these obligations, emphasizing compliance and global financial transparency. (2) These laws also suggest that, despite efforts by various activist groups such as the Association of Accidental Americans (3), the U.S. won’t change its approach to taxation anytime soon.
Taxation Based on Citizenship Versus Residency
Most countries use residence-based taxation, where individuals are taxed based on their residency status rather than citizenship.
In this system, only residents of a country are subject to its income tax laws, regardless of their citizenship. Residence-based taxation simplifies tax obligations for expats, who only need to comply with the tax laws of their host country, avoiding the complexities and potential double taxation faced by U.S. citizens abroad.
This contrasts sharply with the U.S. system of citizenship-based taxation, where all U.S. citizens and permanent residents must report and pay taxes on their global income, no matter where they live.
Does a U.S. Citizen Living Abroad Have to Pay Taxes?
Yes, U.S. citizens living abroad must pay taxes on their worldwide income. All U.S. citizens must file annually if their income exceeds minimum thresholds. They must also report foreign financial accounts through FBAR and FATCA.
With respect to the filing threshold, filing can be beneficial to claim refunds or credits. Finding a reliable expat tax provider who understands and can explain these provisions and reporting requirements is crucial due to their complexity and potential penalties.
For example, the Foreign Earned Income Exclusion (FEIE) allows qualifying expats to exclude up to a certain amount of foreign-earned income from U.S. taxation. On the other hand, the Foreign Tax Credit (FTC) provides a dollar-for-dollar reduction in U.S. taxes owed for foreign taxes paid. Both are useful, but whether one or both should be applied to your particular situation depends on many different factors.
Tax Filing Deadline for U.S. Citizens Living Abroad
U.S. taxpayers should be aware that deadlines and extensions exist to ameliorate the added burden of filing from abroad. Essentially, the tax filing deadline for U.S. citizens living abroad is somewhat flexible. Expats may extend their U.S. tax filing deadline up to three times (June 15th, October 15th, and December 15th*).
It’s worth mentioning that the first extension happens automatically; there is no action required on your end if you reside abroad and intend to file by the June deadline. If, however, you find that you need more time, you will need to formally request it from the IRS using Form 4868. (4)
*Note that the exact date may change if the 15th happens to fall on a weekend or federal holiday.
Common pitfalls and mistakes to avoid
Filing American taxes abroad can be complex, and many expats fall into common pitfalls and mistakes. Here are key points to keep in mind:
- Missed deadlines: Be aware of different deadlines and extensions.
- Unreported foreign income: Always report all foreign income to avoid penalties.
- Overlooking or neglecting to file required forms: Ensure you file FBAR and FATCA if applicable.
- Ignoring tax benefits: Utilize the Foreign Earned Income Exclusion (FEIE) and Foreign Tax Credit (FTC).
- Complex tax laws: Seek professional help to navigate cross-border tax regulations, particularly if you hold investments such as foreign mutual funds.
- Incorrect or inefficient currency conversions: Use accurate rates for all financial entries and seek to mitigate currency risk.
- Poor record keeping: Maintain detailed records of foreign income and expenses.
Using a reliable expat tax provider and staying informed about these requirements can help avoid costly mistakes. Additionally, U.S. expats should set up an ID.me account to more easily access multiple government websites. For more information, refer to our article on how to create an ID.me account and verify it for ongoing use.
Do Non-U.S. Citizens Have to Pay Taxes?
Non-U.S. citizens with ties to the United States, such as green card holders or business owners, often have tax obligations similar to U.S. citizens. If a non-citizen resides in the U.S. for an extended period or engages in business activities, they may be required to pay U.S. taxes on their worldwide income.
One key determinant is the substantial presence test, which assesses the number of days an individual has spent in the U.S. over a three-year period. If the test is met, the non-citizen is treated as a U.S. resident for tax purposes, meaning they must report and pay taxes on their global income, just like U.S. citizens. This can have significant financial implications for non-citizens.
Note that dual citizens who hold U.S. citizenship will generally be required to file an annual U.S. tax return until and unless they renounce their U.S. citizenship.
Strategies for Managing U.S. Tax Obligations Abroad
Managing U.S. tax obligations while abroad often involves utilizing tax credits like the Foreign Earned Income Exclusion and Foreign Tax Credit to reduce taxable income we discussed earlier. Additionally, proactively seeking out a professional U.S. tax preparer specialized in serving U.S. expats is highly recommended.
Investment strategies are essential for minimizing tax liability. In some cases, U.S. expats can benefit from tax-efficient accounts such as certain retirement plans that receive favorable treatment in both the U.S. and their country of residence. In others, certain accounts may prove to be highly tax inefficient, warranting an urgent consultation with a cross-border financial planner.
Indeed, investing in a cross-border financial advisor can help you avoid falling into common financial planning pitfalls. For example, high-earning expats often need to be mindful of the Net Investment Income Tax (NIIT), which imposes a 3.8% tax on investment income at a certain investment income threshold.
By aligning investments with U.S. tax laws and utilizing professional advice, expatriates can effectively reduce their overall tax burden while safeguarding their financial future.
Do U.S. citizens pay more taxes than other countries?
While it may feel natural to assume that because U.S. citizens have more overbearing tax reporting requirements than other countries, they pay more in taxes, the fact is that U.S. citizens do not necessarily pay more in taxes.
In fact, when taken as a percentage of gross domestic product (GDP), total U.S. tax revenue is 5 percent less than 37 other member countries of the Organisation for Economic Co-operation and Development (OECD). (5)
Is it possible to end citizenship-based taxation?
While there are some determined grassroots movements within the community of Americans abroad (particularly accidental Americans), it’s unlikely that citizenship-based taxation will end anytime soon.
Frequently Asked Questions (FAQs)
Does a dual citizen pay U.S. taxes?
Dual citizens are still bound by the citizenship taxation regime, so they must file a U.S. tax return with the IRS every year, as well as related informational returns such as an FBAR. The amount they will pay in taxes to the U.S. though, if any, depends on the foreign tax credits or exclusions they qualify for, as well as the skill with which the tax return is done.
What are the penalties for not complying with U.S. tax obligations?
Failing to comply with U.S. tax obligations can result in serious penalties, including fines, interest charges, and even criminal prosecution for willful evasion. As discussed, non-citizens and expatriates often have complex tax obligations, such as reporting worldwide income, meeting the substantial presence test, or facing the Net Investment Income Tax (NIIT).
Utilizing tax credits, deductions, and strategic investments can help manage liabilities, but professional guidance is often the best way to protect your wealth and stay compliant with U.S. regulations, no matter where you live or work.