Day 11: Step #5, Understanding The Tax Implications Of Your Move Overseas

Can You Benefit From The Foreign Earned Income Exclusion?

Dear Student,

The truth, as I explained yesterday, is that, depending on your circumstances, international tax planning may be a non-issue for you.

If you are truly retiring overseas and intend to live on Social Security or other income alone, the move should be a tax-neutral event… and no tax planning is called for. Most jurisdictions don’t tax Social Security or pension income, so, again, if this is the extent of your nest egg, you’ve got it easy on this front. You can take the day off. No lesson required… and no homework to accomplish!

If, however, you’ll be bringing anything beyond Social Security or pension income with you when you relocate overseas, then you need to address the question of taxation, and, as I suggested yesterday, you need to address it on two fronts—both back home (in the States, if you’re an American) and in your new jurisdiction of residence.

Note that I’m assuming full-time residence; if you’re planning to go overseas only part-time, then, again, you’re off the hook today, because, again, no tax planning is necessary.

If, though, you’re planning to relocate full-time, and you’ll be bringing more than Social Security or pension income with you, then new tax issues can develop, depending on where your money will be coming from.

Today, let’s address the tax implications associated with earned income.

Earned income is just that—money you earn. Specifically, I’m talking about wages you receive for services you perform.

And here’s the exciting thing about earned income for the American abroad: The first US$112,000 (2022) or so of it can be tax-free.

Here’s something else exciting: While earned income is money you earn… it isn’t necessarily money you earn from someone else. You can earn it from yourself.

Here’s how this can work:

Say you’re an American, and you intend to pay for your new life overseas (in full or in part) by launching a business, say a laptop-based consulting business.

You can use a foreign corporation, in a zero-tax jurisdiction, to legally and legitimately reduce or even eliminate any U.S. tax on the income you earn from that business.

Your first line of defense as a U.S. expat is the Foreign Earned Income Exclusion (FEIE), which excludes from U.S. income tax the first US$104,100 (2018) of wage or self-employment income earned by a U.S. citizen residing in another country (double it to 208,200 for a couple). Technically, you’re residing abroad if you’re outside the U.S. for at least 330 days during any 365-day period or a “tax resident” of a foreign country for a calendar year. Tax residency can be hard to define.

However, this is only the start of strategies available to you as an American abroad to reduce or even eliminate your annual tax bill.

For example: You can use the Foreign Earned Income Exclusion to reduce or even eliminate U.S. federal income tax on wages paid by either a U.S. corporation or a foreign corporation. Realize further that it doesn’t matter if you are the owner of the corporation… the FEIE applies as long as you are an employee of the company, even if it is your own company.

You reap the benefits of the FEIE if you’re self-employed, as well, operating a small business outside the States, say, or working as an independent contractor for a U.S. or foreign corporation but performing your work, again, outside the United States.

Remember, though, that the FEIE applies only to federal income tax. If you’re using it as the beginning and the end of your international tax management strategy, you’re still liable for Medicare, Social Security, and FICA … which amount to about 7.5% a year. And your employer is required to match your Medicare, Social Security, and FICA contributions, so your situation is costing him about 7.5%, as well.

Plus, if you’re self-employed abroad but operating without a corporation, you’re liable for 100% of FICA and Social Security…and you can suffer a reduction of your FEIE based on business expenses you claim.

In other words, the Federal Earned Income Exclusion is a great start. But, again, you can do more as an American abroad to mitigate your U.S. tax bill.

To maximize the tax benefits of residing abroad and (legally) minimize your total tax obligation in the United States, here’s what you want to do:

First, form an offshore corporation in a zero-tax jurisdiction, register that company with the IRS, and open a foreign bank account in its name.

Second, draw a salary of up to US$104,100 (2018) from that foreign corporation. As long as you qualify for the FEIE, and the company’s income is derived from active, not passive, business, you will have no U.S. federal income tax liability on this income.

Voilá. The properly registered and domiciled as foreign corporation is not responsible for Medicare, Social Security, or FICA.

Furthermore, you are now not self-employed; you are an employee of your offshore corporation, and therefore not subject to self-employment taxes, either (that is, no Social Security, no Medicare, no FICA).

Plus, all the expenses of the offshore corporation are now additional deductions and do not reduce your Foreign Earned Income Exclusion.

Furthermore, operating this way, you might be able to retain some or all of the offshore corporation’s earnings in excess of the FEIE. Careful planning in this area can allow the deferral of U.S. income tax on active business income inside the corporation.