I would know. I’ve been living and working abroad in Mexico since 2012. Over time I’ve learned to navigate the America’s complicated foreign tax system, but it wasn’t easy. With the help of a certified public accountant (CPA) and enrolled agent (EA), we’ve put together a tax guide for those living and working abroad. By the end, you should be better equipped to navigate U.S. tax liabilities and avoid any broadsides from the IRS.
Disclaimer: This article is an introduction to some of the tax requirements faced by U.S. citizens living and working abroad. It is not meant to replace professional tax services. When in doubt, contact your tax professional.
Qualifying for foreign tax status
Before we dive into the details, it’s important to note that just because you are living and working abroad does not mean you automatically qualify for foreign tax status.
For the IRS to consider your tax home in a foreign country, you must meet either the physical presence test or the bona fide resident test. These tests are the key to deciphering the IRS foreign tax codes. Qualifying for one of them allows for several exclusions and deductions (including health care and housing). But if you don’t meet meet the criteria for either test—and won’t in the foreseeable future—you’ll be filing like everyone else.
Physical presence test
To qualify for the physical presence test, you must be outside of the United States for at least 330 days during a 12-month period. However, be warned that the IRS does not count travel days as time spent in a foreign country, so your vacation in the Caribbean won’t count toward the 330 days.
While the IRS isn’t known for being generous, it does offer some leeway with these tests. Citizens can choose when to start the 12-month count, with the goal of maximizing their exclusions. The IRS lists all the gory details here. Additionally, if a citizen already abroad doesn’t qualify for the physical residency test by the April 15 filing deadline but will in the near future, the IRS grants an extension with Form 2350.
If the applicant doesn’t qualify by June, she can continue filing extensions, according to Stephen Daas, CPA and COO of Global Tax Network.
“You can always extend to October, and if you’re still living oversees, you can extend to December,” he told me. “You get more options. And then sometimes, if you’re trying to get that exclusion and you need to wait until you’re oversees for a full calendar year, you may not file until January. There are different rules depending on the timing of where you’re at.”
Bona fide resident test
The criteria for the bona fide resident test sounds simple at first: You’re a bona fide resident of a foreign country if you live there for “an uninterrupted period that includes an entire tax year.”
But the bona fide resident test isn’t that straightforward. In fact, it’s under more IRS scrutiny since it’s more subjective than the calendar count of the physical presence test. Just because you live in a foreign country for more than a year does not mean you are a bona fide resident of that country. For example, if a construction worker takes on a specific project abroad for more than a year, the IRS won’t consider that person a resident, because the intent isn’t to stay abroad for an indefinite period.
To determine bona fide residency, the IRS looks for where citizens have their strongest connection.
The IRS will determine your tax status based on questions like: Where are your personal belongings? Where are you truly living? Do you have your kids in school in the other location? Do you have financial connections to the other location? Are you being paid there?
According to Daas, the most important factor could be the stamps in your passport. Just ask TWA pilot Tracey Stright, who tried to meet the bona fide resident test but was denied by the IRS in the case of Stright v. Commissioner due to the amount of ties he had to the United States. The IRS ruled his tax home was in the United States despite the fact that he lived in London.
Daas recommends keeping a travel calendar in case of an audit. If you don’t meet the physical presence test, the IRS will look for your strongest geographical ties during an audit. So even if you have an apartment abroad, that’s not going to matter if you’re never there.
Benefits and difficulties
U.S. citizens who do pass one of these tests are eligible for some pretty nice tax benefits. For example, freelancers abroad do not have to pay the Affordable Care Act tax. You are also given automatic tax return extension—you can file by June 15, rather than April 15.
The biggest advantage, however, may be the foreign earned income exclusion, which allows expats to omit the first $100,000 from their income tax liabilities. The exact numbers are $100,800 for 2015 and $101,300 for 2016.
To clarify, “foreign earned income” is any income earned outside the United States. “It doesn’t matter who pays it to you, whether it’s a U.S. company or a foreign company,” Daas said. “It matters where you were when you earned it.”
The exclusion is voluntary and requires filing out a form—Form 2555 or Form 2555 EZ, which is simpler—if you meet certain criteria.
There’s one thing freelancers never get out of, regardless of where they work: the self-employment tax.
At home or abroad, the IRS charges self-employment tax. Fortunately, the IRS doesn’t discriminate between home and abroad in the deductions it allows. And as Daas points out, the deductions that freelancers take at home and abroad are very similar.
However, there is one benefit freelancers back home can’t access: the foreign housing exclusion. This clause, which is part of Form 2555, lets U.S. citizens deduct housing costs like rent and utilities. Cable and TV expenses don’t count, but residential parking does.
The catch? Citizens abroad have to meet a base to qualify. As of 2015, the base is 16 percent of the foreign earned income exclusion. That means international freelancers cannot deduct the first $16,128 of their housing expenses in 2015. Anything after the first $16,128 can be deducted—to a point. The IRS lists the maximum foreign housing deduction and exclusion limits by country in the instructions for Form 2555.
Keep in mind that the IRS expects the data in U.S. dollars, no matter what. Use this currency converter if you need help.
Foreign tax obligations
Lastly, remember that you’re not necessarily in the clear once you pay your U.S. taxes. While there are treaties in place to help U.S. citizens avoid double taxation, Daas stressed that these treaties usually don’t help independent contractors that much.
Tax treaties often cover income tax but not social security tax. The agreements that cover both income and social security are called totalization agreements—and they are few and far between.
Since the social security tax in countries with U.S. totalization agreements is usually higher than the social security tax back home, expats in these countries can often avoid paying the higher taxes for a few years. But in countries where the United States does not have totalization agreements, freelancers could face double the social security tax on self-employment income.
“You could be paying tax in the other country,” said Cavan Glassman, an EA at ExpatCPA. “It’s probably not likely for a freelancer, because you’re not going to be working for someone who is going to withhold. But that’s another aspect of foreign taxation.”
Luckily, there are foreign tax credits available for anyone caught in such a situation.
Another potential issue for freelancers abroad is their foreign bank accounts. The IRS wants to know what you have and where you have it. The IRS also expects American citizens to fill out the Report of Foreign Bank and Financial Accounts (FBAR).
“People don’t often realize that they have to document their foreign bank accounts,” said Glassman. And it’s an expensive error; penalties range from $10,000 to $100,000.
This requirement applies to foreign bank accounts totaling more $10,000 at one time. And it covers all of your foreign bank accounts. So if the sum of your foreign bank accounts combined totaled $10,000 at one point in the year, even if it was just for one day, you are required to report it. Add up your balances, and when in doubt, consult a CPA or EA.
Make no mistake: doing your taxes can suck, and being an expat freelancer doesn’t make it any easier. But once you understand the basics and qualify for foreign tax status, there are some serious benefits to be had. Don’t let the IRS get you down, and you can flourish—legally—while working abroad.