Whether you retire early, take a sabbatical, or just take vacay, when you travel abroad there’s often multiple great opportunities to turbocharge your 4x4 FIRE framework “save” pillar.
One: overseas destinations often have lower cost of living compared to home, so you save on daily spend.
Two: when booking overseas flights, you can often arbitrage your miles & point redemptions for outsized value (we covered some juicy strategies in Episode 17).
Today, we deep dive on a third way: hacking your expat taxes.
In this week’s podcast, I talk with expat tax CPA (US) Grace Taylor about how to be strategic with tax optimization as an expat.
What you’ll learn:
- Key tax issues affecting expats – whether you’re a company employee, digital nomad, or early retiree
- How the foreign earned income exclusion works
- How state residency rules interact with expat tax strategies (and how to optimize)
- For digital nomads: strategies for using an LLC/S-Corp to optimize taxes
- Key rules re: foreign tax credits
Have you ever filed taxes as an expat? Was your tax bill lower vs. non-expat years? What other questions about expat taxes and FEIE do you want answered? Let me know by leaving a comment.
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My guest today is Grace Taylor.
Grace is the principal owner of Gracefully Expat, a tax practice focusing on U.S. tax for expats and digital nomads.
Before starting her own expat tax practice, she spent a decade at one of the “Big Four” accounting and tax firms.
She’s originally from Canada, but has lived in the U.S. and Ireland, and is now location independent, speaking regularly at conferences and events around the world for digital nomads.
Grace, thanks so much for joining us today to share insights, tips, and strategies all about U.S. taxes for expats.
Grace Taylor 1:53
Thanks, Andrew. Super happy to chat with you.
Andrew Chen 1:56
I’d love to start just by learning a little bit more about your background in terms of how you got into becoming an expat and an expert on expat taxes.
Grace Taylor 2:06
Yeah, absolutely. As you said, I’m originally from Canada, but I graduated from the University of Washington in Seattle, and that’s where I started my career.
And it was just by chance that I ended up in the expat tax specialty. I graduated actually during the recession and then just took whatever they offered me. And it happened to be in a “Big Four” firm, specializing in their expat tax practice, which I didn’t know at the time was a real niche area.
At the time, what we were working with big corporate global mobility programs. And I’d say some of your listeners might even be familiar with those in their own organizations.
These would be the big companies that send their guys on expat assignments around the world, and then they hire the likes of the “Big Four” firms to help them with their taxes.
But what I learned in that experience was that it wasn’t just corporate mobility individuals that need this type of tax work. Really it’s any American expat, whether they’re moving on their own or maybe they fall in love with someone abroad or start a business somewhere else.
And it really adds a level of complexity to their taxes that, frankly, not a lot of practitioners have the ability to deal with.
So that’s where I realized, after I was ready to move on from the “Big Four,” that there was really some space to operate independently. And that’s what I’ve been doing for the last few years.
Andrew Chen 3:31
So with that, as a segue, what are some of the major tax issues and deductions and rules that someone living abroad should know about?
And to make it concrete, I would love to talk through three different personas in terms of the kind of tax issues that each one might face: an overseas employee, an overseas business owner, and an early retiree.
And we can jump into the details of each progressively, but let’s just start with an overseas employee, a U.S. citizen who was working overseas for an international office of their company, where their income is predominantly from their salary.
They’re still doing things they would do in the U.S., like making 401(k) contributions. Maybe they’re earning dividends or capital gains of their investment portfolio. Basically, they’re just living the same life that they were living, but they’re just overseas.
What are some of the tax issues that they should be aware of?
Grace Taylor 4:19
Exactly. That’s a great place to start. And I would say that probably your listeners would be maybe that bit more savvy than the average person.
But what I like to start out with when I’m talking to anybody about this is to make sure that people understand that simply by virtue of being a U.S. citizen, no matter where you live, no matter where you work, no matter how long you’ve been living outside the U.S., you’ve always got to file a U.S. tax return.
And it always has to include 100% of your worldwide income. That’s one thing that people sometimes aren’t familiar with.
So with that as our baseline understanding, the overseas employee is probably one of the more simple scenarios. But I’ll introduce one potential variable even when it comes to that individual.
But let’s say that someone is working for a U.S. employer, but they’re stationed in a foreign country.
The first thing they need to be aware of is, are they going to be subject to tax in that foreign country? Because it just adds something to our analysis when we’re determining how we’re going to report their income on the U.S. side.
But at a baseline, when you are a U.S. citizen living and working abroad, there are a couple of tax provisions that you can potentially take advantage of. And the one that’s probably the most well-known is called the Foreign Earned Income Exclusion or FEIE.
And basically, this states that if you are residing outside the U.S. and you meet one of two tests to claim it, which we can talk about, you can basically exclude up to around $100,000 from ordinary income tax per year.
And so to give a simple example for how to visualize this, it works the best really for people who are stationed in lower tax jurisdictions.
So let’s say you’re working over in the UAE where there’s no income tax. In this case then, your $100,000 of U.S. earned income is completely tax free in the U.S. as well as in your host location.
And then from there, obviously, if you’re paying generally less foreign tax than the U.S. tax would have been, then probably the foreign income exclusion tends to work out the best.
And then the other provision really is just the simple ability to claim foreign taxes as a credit to offset U.S. taxes.
So my really simple rule of thumb is for the person who is stationed in a country with a relatively higher tax rate, like for example, most of Western Europe, generally speaking, what we’ll do in those cases is just take the foreign taxes that they paid.
Let’s say they’re living in France and they pay an average tax rate of 35%, maybe 40% even. We just take that and we use that to offset the U.S. tax because the U.S. tax is reduced down to zero essentially. The net result being he’s just paid that higher tax rate to France.
So that’s a real quick and dirty overview. But do you want to maybe ask any questions on the basis of that?
Andrew Chen 7:32
Yeah. In clients that you’ve consulted with in the past, are there particular issues or deductions or credits that you’ve seen that maybe are not ones that are super obscure, but ones that are surprisingly applicable to many people, if not everyone?
The Foreign Earned Income Exclusion, I definitely want to talk about that in some detail momentarily. The credit for taxes paid to a foreign government.
I’m just curious. Are there other things that folks in this scenario, the expat employee, should be aware of?
Grace Taylor 8:12
Now, I think that the one thing that the expat employee needs to be aware of that a self-employed person or a person who’s doing the move on their own independently doesn’t have to think about is, is your employer helping you with any of this tax stuff generally?
And that can take a couple of different shapes and forms.
One is the more traditional expat assignment package really where they might be what would be called tax equalized.
It was more common when I started my career, I think, than it is now. But I think still for some top level execs, this is the package that allows them to take the foreign assignment without having any impact to their net stay-at-home tax.
Under this scenario, albeit the fact that the French tax in that example might have been higher, the tax equalization package generally will make a calculation to state that the net tax to that individual will be as though he never left the U.S.
So for that individual, he really doesn’t have to worry about the French tax because the company is going to pick it up for him. And all of these other expat provisions, if there is any tax benefit to them, the company generally keeps those as well.
So he’s on what we call a stay-at-home equalized package. But again, that’s less common than it once was, I think. And now a lot of companies are offering some type of tax support that is in between a full equalization.
They might provide, for example, a consultation with somebody from a “Big Four” firm, which is great. And I would encourage people to take advantage of that benefit whenever they have it.
And then they might also provide tax preparation support as well. That would be fairly common.
And let’s assume then that the individual is responsible for their own tax, so they can benefit from any of these provisions.
Honestly, the main one really is the foreign income exclusion and/or the foreign tax credit. The tax for all of your other income stays exactly the same as it did when you were living in the U.S.
So your capital gains are taxed the same. All your investment income is taxed the same. If you have rental properties, that stays the same.
One other thing that you might consider is, depending on what state you live or lived in, have you maintained your state tax residency or have you broken your state tax residency? And that could be a whole other topic, but that’s just one other thing to keep in mind.
Andrew Chen 10:41
That’s a really interesting question. What causes somebody to break state tax residency?
Grace Taylor 10:47
That’s a big question, and it differs depending on each state.
In general, most states allow for if you have really permanently made your home base outside of that state, such that we would say that what’s referred to as your domicile has shifted outside of that state. And depending on your other facts and circumstances, it may be possible to break your residency in that state.
Some states are harder to break residency than others. And really some states, it’s difficult to prove domiciled outside of the U.S.
A lot of states would say that “Okay, we’ll accept that your domicile moved from California to New Mexico when you moved your family and you moved your house and all of that stuff, changed your voter registration, changed your driver’s license.”
But particularly California, because they’re really one of the most difficult on this, when you move from California to China, California is more likely to want to make the case that you haven’t really shifted your domicile. You’re probably going to come back to California when you’re done with this overseas assignment.
So then we look at really getting deep into that individual’s facts and circumstances to see what is the most appropriate treatment.
Andrew Chen 12:06
Gotcha. So let’s say somebody does break their state domiciliation. What is the tax implication for that, at least at a state tax level, assuming the state does tax?
Grace Taylor 12:18
Generally speaking, if you’re from a state that does allow you to break your residency and you have done so based on your total overall facts and circumstances, then what we do really is in the year that you moved from that state abroad, we file a part year or a non-resident state tax return in that year.
And that basically tells that state that you’ve moved out and they are not going to look for a tax return from you next year. And it’s really as simple as that.
And then the exception to that would be if the person still had, let’s say, a rental property in that state, they would still file a non-resident return for that rental income, but they would not report their worldwide income.
Andrew Chen 12:58
Okay. Good to know.
In terms of breaking state domiciliation, when we look at the facts and circumstances, is that just looking at all the markers that would indicate that you do not intend to return?
Maybe California is a difficult case, but let’s say in some other state, would I be looking at did I not renew my driver’s license? Did I not renew voter registration?
Did I sell my house and all the things that I would do to indicate that I don’t intend to return, as opposed to keeping all those things and staying current on payments of property taxes or whatnot? Is that how that analysis is done?
Even if, in the long term, I intend to return to the U.S. I just simply for now am moving abroad indefinitely, with no plans to return. But I do intend, at least in my old days, to return to the U.S.
Grace Taylor 13:51
Right. And that’s an important distinction to make as well. A lot of it does center around intent, and the rules for each state are different.
Some states are going to focus more on the number of days, and other states are going to focus more on other factors.
One factor that tends to be a pretty constant one is do you have a place of residence available to you in that state?
If you have your home and you choose not to rent it out for whatever reason, and you choose not to sell it, and it’s sitting there available for you to just come back to whenever you want, most states are going to say, “That’s it. You’re still a resident.”
But if you’re renting out that property, then normally that’s not a barrier to otherwise breaking your residency if your other facts and circumstances support it.
And some states, it is important to not take that extra step to renew your driver’s license or your voter registration stating your residence in that state. And other states, it’s not as determining a factor. So it does differ from place to place.
But what you said about intent is important as well.
Generally speaking, if your indefinite or indeterminate intent is to be outside of the U.S. for as long as it works, and then when you come back, maybe you come back to your state of previous residence or maybe you move somewhere else, you’re just not sure, then usually I would say that that would also be reasonable that you could make the case that you’ve broken your state tax residency.
But if you know that “I’m just doing this for 18 months, and then I’m coming right back to my home address, and my kids are going back to the same school,” that would be a more difficult case to say that you’ve really broken your residency for that intervening period.
Andrew Chen 15:35
For sure. Is it possible for somebody to break residency and essentially be stateless?
Grace Taylor 15:41
Yeah, absolutely. There’s really nothing that’s wrong with that. Sometimes people have this idea that they have to be a resident of a particular state, and it’s just simply not the case.
Just as for anyone who had moved out of the U.S. from a state that doesn’t have a state income tax, obviously they don’t have to file any state tax return anyways. But it’s just the same as for someone who doesn’t happen to be a resident of any state at that time.
Then when they moved back to the U.S., if they reestablished residency in a state that had a state income tax, then they would start, of course, filing at that point.
Andrew Chen 16:13
Got it. Okay, cool. So let’s move to the second persona, which is an overseas business owner.
This would be somebody like fulltime digital nomads, like folks that you specialize in tax consulting for, or a self-employed U.S. citizen abroad who is working full time on their business.
And here I’d love to talk about two sub-cases.
One case would be a sole proprietor who has no business entity, so they don’t have an LLC or anything. Maybe they’re just a freelancer. And the second case would be a digital nomad or a small business owner who does have a business entity like an LLC.
It would be great to discuss the tax differences between these two, as well as for the entity person, is there any implication to be aware of regarding the LLC being a U.S. LLC versus a non U.S. LLC?
Grace Taylor 17:00
Yeah, absolutely. That’s excellent.
And where the previous example would have been what I would have focused on in my “Big Four” career, this is now what I focus on primarily in my practice now.
The first example, this is really what I would say most people, when they start, they move right into this particular use case, which is self-employed sole proprietor. No business entity. Maybe they’re freelancing and they just happen to be doing that from abroad.
And course, it’s very possible nowadays. People are working online, whether it’s ecommerce or whether it’s freelance writing or consulting or affiliate marketing, whatever it may be. So people are just taking that income stream and they’re using that to really fund a lifestyle wherever they want to.
For that individual, a lot stays the same with our previous expat example, with one significant difference, and that is primarily related to the self-employment tax.
The Foreign Earned Income Exclusion, I mentioned it before, but I didn’t focus on it. I’d like to focus on it now.
I said that it applies to ordinary income tax only. I specifically said that because federal ordinary income tax is what we’re used to looking at on our 1040s with the different tax brackets, the different rates that apply to it if you’re married filing jointly or single, etc.
The self-employment tax, people who are self-employed will be aware of this. But sometimes people become location independent at the same time they start a self-employed income stream as well. And it comes as a complete shock to them that the self-employment tax is calculated separately.
And the reason it is (some of your listeners will be aware of this) is because it’s related to Social Security and Medicare. And the rate at which self-employed individuals contribute to self-employment tax is essentially both the employee and the employer portions of Social Security and Medicare.
So it works out to around 15%, whereas the employee portion would have been 7.65%. And it’s withheld from his W2, so he doesn’t really notice it. But the self-employed individual, he has to pay this either on a quarterly basis, ideally, or at the end of the year when he files his return.
That’s all to say that, even though the first $100,000 of earned income is still eligible for the foreign income exclusion, if our self-employed friend here qualifies, it doesn’t get him out of self-employment tax.
The rule of thumb for him is, let’s say he makes less than $100,000, he still has to budget for at least 15% of self-employment tax that he’s going to owe every year.
Andrew Chen 19:43
I see. And is your recommendation here that the freelancer be paying this quarterly? Like they’re basically doing budget, actual calculations regarding their earnings as the year passes and they’re paying along the way?
Or how does that work?
Grace Taylor 20:03
That would be ideal. And if people ask me, when they start out, I get them set up on a schedule to pay these quarterly.
Sometimes people come to me after the fact. And it’s not the end of the world, but unfortunately, sometimes you have to break the news that because you didn’t pay quarterly, now you have a bigger amount to pay all in one go, as well as (and this is where it really starts to hurt) you can be subject to underpayment penalties.
They’re not so excessive that you should lose sleep over them, but it could be an extra couple of hundred or even a couple of thousand dollars of penalties that you otherwise didn’t need to pay.
So, ideally, yes, what we do is we make an estimate of how much you earned each quarter. And it doesn’t have to be perfect, but if you want to err on the side of caution, you maybe pay a little bit more, and you just pay that on the quarterly payment deadlines. And that gets you out of the underpayment penalties.
Andrew Chen 20:56
Got it. So freelancers are still able to avail the Foreign Earned Income Exclusion tax credits, but additionally they have to now also be thinking about self-employment tax and ideally paying those along the way.
So then if we think about a small business owner or a digital nomad who does have an entity, maybe a U.S. LLC or a non U.S. LLC, does the picture change at all? And if so, how?
Grace Taylor 21:22
Yeah, that’s a great question. It’s a really logical next step that most of my clients actually go through as well.
They start out with no entity. They’re just seeing if it works. Maybe get a bit of traction.
Maybe the business starts to scale, and then they start looking more seriously at what are their structuring options.
And exactly as you said, a U.S. single member LLC is probably the most common choice for people.
One thing about the single member LLC that I always like to just clarify and make sure that everyone is talking about the same thing is if you are a single business owner and you open a single member LLC and you don’t make any tax elections, meaning these elections have to actually be physically filed with the IRS.
If you didn’t do that, then you have basically the same tax answer as the sole proprietor because the single member LLC is a disregarded entity, so it doesn’t file its own tax return and it just goes right on your Schedule C, just as though the entity didn’t exist.
It’s a good idea still to have for liability purposes, to keep your personal and your business finances separate. You can open up a business bank account.
I like single member LLCs in general. But just so people know, when you say LLC, it’s not obvious how the tax is going to be treated just when you say LLC.
So a single member LLC with no elections, same as the sole proprietor. Nothing changed.
A single member LLC that has elected to be taxed as an S corp, let’s say. Then, of course, the S corp has to file a tax return, an 1120S, but it’s still a pass-through entity.
So the S corp itself doesn’t pay any tax, but the actual tax treatment to the owner can differ.
And it depends a lot on your business type at this stage, but probably a lot of your listeners will be familiar with just the general advantages of an S corp for someone who is self-employed. And really, it’s that you’re able to essentially pay yourself a salary from the business and then separate out some additional earnings from the business that are separate to your salary.
And this is a broader discussion, but just for people to know, it’s really again related to the Social Security tax and the self-employment tax. So you’re basically able to pay yourself a salary that’s subject to the full Social Security and Medicare. And then the additional profit in the business, if there is any, isn’t.
And that can work for expats as well. And then I’ll pause and just let you ask any questions.
But the other thing, which is I think a much bigger discussion, is do you have a foreign entity? And this is an area where I do an awful lot of work as well.
And sometimes a foreign entity can make an awful lot of sense, but it comes with a lot more tax complications. And it has to be taken into serious consideration to make sure that that structure is actually going to work for that specific business type.
Andrew Chen 24:28
I see. What are some of those complications or considerations that folks should bear in mind?
Grace Taylor 24:34
Well, first and foremost is when you have a foreign business entity, there are additional filing requirements that have to be taken really seriously because failure to file any of these foreign related forms (I’ll give you a list of the most common ones) can come with some really punitive penalties.
And almost worse than the penalties can be the fact that failure to file or filing an incorrect one of these foreign related asset or account reporting forms can actually leave your tax return open to audit indefinitely.
So it’s something that really should be taken quite seriously indeed and should really only be undertaken under the advisement of someone who knows these forms really well.
A quick list would be if you have a foreign corporation, you’re looking at Form 5471. If you have a foreign partnership, there’s a separate form.
If you have foreign bank accounts or other foreign financial assets, those are separate forms. There’s an FBAR form or a Form 8938.
I’m just listing these quickly so if they ever see them come up, they know to take it seriously.
Andrew Chen 25:49
Yeah. This is great.
Grace Taylor 25:52
But essentially, if you determine that a foreign corporation is the right structure for you, keep in mind that getting this Form 5471 prepared and filed correctly is absolutely mission critical.
And what it also means is, unfortunately, your tax compliance is going to be just that bit more expensive and onerous every year. But I think getting the right people on your team, it’s not something that should put you off it if that is the right structure for your business.
Andrew Chen 26:25
Creating a non U.S. LLC, how common is that in the folks that you encounter?
Grace Taylor 26:32
What I see is the general level of savviness and knowledge out there is just always increasing, which I think is great. Accordingly, I think that more and more people are finding out, if that is the right structure for them, exactly how to make it happen and to get it done in the right way.
I think I might be a little bit biased because I deal with people who know enough to seek out the right advice, but I do see more and more people coming to me and asking me, “Is this right for me?” And then we can have that discussion.
To give a really simple example or a use case of it is someone who might have an ecommerce business. And for various reasons, selecting which country to have this non U.S. entity in is also another discussion.
But once they’ve chosen the right country to set up that business entity in, and they’ve weighed the pros and cons of it, there can be some benefits on the U.S. tax side for that.
Because essentially, what it can allow you to do, if your business type supports it, is it can allow you to pay yourself a salary from the foreign entity that’s eligible for the foreign income exclusion.
But because that foreign entity is not a U.S. reportable entity in and of itself, it doesn’t have an obligation to pay Social Security withholdings. But because you are an employee of that entity, you’re not considered as self-employed either.
So in a nutshell, that could be one of the reasons why someone would pursue this.
Andrew Chen 28:14
I see. Do you typically find that people make the election to create a non U.S. entity more for tax reasons, more for business reasons, or about even?
Grace Taylor 28:25
That’s a really good question. I would say it’s about even because if it’s only for tax reasons, we would have to be really sure that it’s still going to be the right entity for the business in the long term.
I deal with a couple of different large groups of people, and one of them is really truly location independent, so they could essentially pick any jurisdiction that makes sense to form this entity in.
But then my other contingent would be people that, for business, personal, family reasons, they really do have roots in a particular location. And sometimes it’s essential to have a foreign corporation to purchase the kind of property that you want access to in that country.
Or sometimes it’s for inheritance purposes in that country. Whatever the in-country reasons behind that are, then of course, we address that on the U.S. return.
Oftentimes, for someone in that camp of people, it can be essential to have a good tax person in the foreign country as well.
Andrew Chen 29:31
Gotcha. For somebody who is operating with a U.S. LLC or U.S. entity, do you provide any recommendation regarding what state to file or to register the LLC with that might be most beneficial? Or does it even matter?
I’m in California, so I know it’s pretty expensive to maintain a California LLC. It’s $800 or $900 or something like that per year, which, if you’re starting out, could be consequential.
And there are other states that don’t charge anything or charge very little, or have just better anonymity rules around who you list as the managing member and stuff like that.
But I’m just curious. From a tax perspective, do you recommend certain states that are more beneficial than others to create an LLC with?
Grace Taylor 30:24
That’s a great question. And again, this is from the perspective of someone who is no longer really a US-based individual, is not based in a particular state.
Because sometimes there’s the whole foreign qualification issue of, if you’re a California resident and you have a Texas LLC, that LLC probably has to foreign qualify in California. And why go through that effort?
But if you’ve made a clean break from a particular state of residency, or you’re a resident of a non-income tax state in the first place, then you’re absolutely right. You could pick any state you want really. And the answer I tend to ask is really just don’t pick a state that makes your life more complicated.
So if you’re not a California resident, I don’t see a lot of reason to have a California LLC. I think there are other options that are lower cost, lower administrative burden, better anonymity.
A couple of the states that I suggest that people look at.
I think Wyoming has a lot of advantages. I think Nevada does as well, Texas as well. Florida for some people.
Those would be the top four handful that I tend to see most people. And most people narrow it down, honestly, to Wyoming or Nevada.
Andrew Chen 31:41
Gotcha. Helpful to know.
A moment ago, you were talking about S corps, and I was curious. Do you find, for tax purposes, that some digital nomads or small business owners will create an S corp and then pay themselves a very minimal salary so as to reduce their Social Security and Medicare taxes, and then keep the profits mostly in the business and run their business expenses through that?
Is that a common strategy?
Grace Taylor 32:12
It can be tempting for people to do that. But there are a couple of pitfalls that you really need to be aware of.
When you talk about expenses, absolutely all of your business expenses are coming out before your salary or in your profits. So that’s a given and there’s nothing that’s at all risky or vague about that.
But then when it comes to what you have left over, how you separate that out between your salary and your business profits, generally speaking, because the IRS knows that this is what people are up to, I suggest people not be too aggressive on this. And they really should pay themselves something like a reasonable salary for their work.
In other words, if you think about it from the perspective of if you had to hire someone to replace you, how much would you have to pay them? I bet you they wouldn’t do it for $20,000 a year.
So something in the realm of reasonable without going overboard and thereby negating the whole purpose of the S corp itself. I think that normally there’s a reasonable middle ground that people can come to.
But absolutely, I do sometimes see people try to be maybe a little bit too aggressive. And then I often suggest, “Let’s dial that back.”
An example of where I think that it’s not essential to pay yourself necessarily a market rate salary is in the early years of a business. When you’re just starting out, you may not even have the reliable cash flow to pay yourself a salary every month.
In that case, it’s not necessary to say, “Well, my salary would have been $7000 a month, but I barely made $3000 some months.” In those early years, that’s where you’re really just getting the business off the ground.
But once you’re reliably cash flowing, then I’d say try and pay yourself something that’s in the realm of reasonable because the risk if you don’t is the IRS can potentially ask you to go back and reclassify and therefore charge you penalties on the underwithholding of the Social Security and Medicare.
Andrew Chen 34:17
Good safety tip. How do you define reasonableness? Is it reasonable in terms of what it would cost to replace you with another expat like you or reasonable to the local cost of labor?
Because if I’m an expat in Thailand, the cost of labor is going to be different than if I’m a resident of New York City.
Grace Taylor 34:39
That’s a really good point. And that’s really just one of the factors. And unfortunately, the IRS hasn’t given us any firm guidance, and there’s no real formula that we can look at.
It differs depending on what industry are you in, what it is that you’re actually doing, the overall numbers involved in the business as well. So there’s a lot of things at play.
But I take your point that the local person to replace you, they wouldn’t get paid as much as you do. But you yourself, you bring your years of education and experience. You wouldn’t accept very much less than that.
So that’s one thing where if that were the only factor, we could have a discussion about it and see what we thought the risk might be. But I would just suggest that there’s other factors to consider, including what is the industry.
Because, for example, someone like myself, a lot of my work just involves me personally doing consulting. It’s hard to make the case that that’s not really my value.
Whereas if I was running an ecommerce business and the business itself is generating these profits based on the sales, my role as a manager has less direct causation to those profits. So it might be easier to make the case that I’m really only spending 10 hours a week on this and my salary is adjusted accordingly.
Andrew Chen 36:06
Got it. Super helpful discussion regarding overseas expats who are running a small business or digital nomads.
If we shift to the third persona, this would be somebody who is essentially a retiree or an early retiree living abroad. Maybe they’re doing occasional consulting to supplement their income, but it’s really just for fun. They’re mostly living off retirement savings or rental income or other passive income.
How should this person be thinking about expat taxation?
Grace Taylor 36:36
That’s a great question.
First of all is the Foreign Earned Income Exclusion, that “earned” word is actually crucial. And what it means is that the passive income, whether it’s from your rental properties, whether it’s from your investments, and indeed your Social Security and your pension distributions, those are not considered earned income.
None of those sources of income are eligible for the foreign income exclusion. So basically what that means is, from that perspective, everything still gets reported on your U.S. return, just like it would if you had stayed in the U.S.
The difference that sometimes arises is, if you are residing in a country that has an income tax, and let’s assume that country considers you a tax resident and proposes to tax you on your worldwide income, then we have the question of does that country have a treaty with the U.S.?
And if so, is there a treaty provision that determines which country has the right to tax your Social Security and your pension distributions? That can get actually quite complicated.
I have a number of clients who are Americans, but they are retired and living in Canada. And there’s obviously a tax treaty with the U.S. and Canada. And so under that treaty, each of their sources of income, we need to determine which country has the first right to tax it and then apply the credits accordingly.
So that can get a little bit complicated.
Andrew Chen 38:01
Got it. So somebody who essentially is in this persona has minimal earned income or maybe no earned income. They’re not really going to avail the Foreign Earned Income Exclusion.
They would still get credit, right, for any foreign taxes they pay?
Grace Taylor 38:16
Yes, indeed. And then the question again is, if they’re residing in a country with a treaty, then we look to the treaty. Otherwise, it really is depending on the source of the income.
If their rental property is in the U.S., that’s U.S. source income. The U.S. is not going to allow a foreign tax credit for that.
So if, by some reason, you need to report that U.S. rental income in Mexico or Panama, then you have to look to Mexico or Panama to get the credit for that because the U.S. is not going to allow you a credit.
Andrew Chen 38:48
I see. So you could be in a situation where you’re paying double tax.
Grace Taylor 38:54
Hopefully not because one country or the other should allow a credit.
Generally speaking, the rule of thumb is when the income is arising from a foreign source, then the U.S. will allow a credit for it. If the income is arising from a U.S. source, we really have to look to the foreign country.
But if you have a good tax representation in the foreign country, perhaps Panama doesn’t tax U.S. rental income at all and then it doesn’t become an issue.
Unfortunately, sometimes we really do have to get that granular and we have to look at the dividend income versus the interest income versus the rental income and each of those particular tax treatments in both countries.
Andrew Chen 39:35
So my understanding is relatively fewer countries tax on a worldwide basis. And so if I’m an expat that’s living in a country that does not tax on a worldwide basis, how much do I really have to worry about being foreign taxed on things like my U.S. rental property or my U.S. stock portfolio? Or are those things really not subject to taxes in that foreign jurisdiction?
Grace Taylor 40:05
Now, that’s a really good question. And that’s an important distinction to make when we’re talking about worldwide taxation.
Most countries don’t worldwide tax their citizens, but most countries do worldwide tax their residents.
The key distinction there is if you’re living in a country with what’s called residence-based taxation, which, frankly, is most of the rest of the developed world, Ireland where I am right now, Canada, and most of the developed countries really have this basis of residence-based taxation.
So regardless of my citizenship, when I’m a resident of Ireland, I need to report my worldwide income in Ireland.
Some countries, Panama is one actually, have what’s called a territorial-based taxation. And those countries, generally speaking, only tax income debts arising from the source within their country.
So that’s what you have to figure out. Based on your country of residence, what’s the treatment on the ground? And then once we know that, then we can look at how it’s mitigated on the U.S. side.
Andrew Chen 41:08
I see. So let me try to tie this up, just to summarize.
Citizen, I can be in or out of the country. Resident means I’m inside the country.
And it sounds like in most jurisdictions, if I’m within the four corners of the country, if I’m inside the country, even if I’m not a citizen, I’m required to report my worldwide income, including for my U.S. rental properties, my U.S. stock portfolio, which may have nothing to do with the foreign jurisdiction. I still have to report that to the local tax authorities.
And for those non-earned income sources, no foreign earned income exclusion is available to me. But any tax I pay, I should be able to get a credit from one side or the other.
However, if it’s U.S. source, no credit from the U.S., but hopefully through treaty, credit from the foreign jurisdiction, and vice-versa. If my income was earned abroad, usually I’ll get a credit from the U.S. side.
Is that correct? Did I summarize that correctly?
Grace Taylor 42:07
Yep. That’s perfect. That’s exactly right.
So then for a lot of my individuals, especially people who have moved around a lot and then are thinking about home basing somewhere, what becomes really crucial is have you met the definition of what’s considered a tax resident in that country?
Sometimes it’s based on number of days. Sometimes it’s based on number of days plus other factors like having a place to live.
So knowing whether or not you’ve become a tax resident in another country is absolutely crucial to be on top of.
Andrew Chen 42:39
I see. Are there general residency requirement guidelines that you could suggest? Also, is residency evaluated by the foreign jurisdiction and the U.S. at the same time or just the foreign jurisdiction?
Grace Taylor 42:55
That’s a great question.
The first quick rule of thumb is most countries use something like a 183-day test. It’s not applied uniformly across the board, and it does differ based on location. But in general, 183 days is about six months.
Most countries who have a residence base of taxation will consider you a tax resident when you spend more than that number of days per year in the country.
And for most people, that also requires having some type of immigration status in that country, because most of us, just based on our passport, we can’t just spend six months of the year in Spain unless we have an actual visa to live in Spain. So that’s one other factor of it.
In terms of who determines it, it’s interesting because a lot of it is really self-determined, unless or until you fall onto their radar for some reason.
Because I only practice U.S. tax, I just suggest to people, if we’re at all unclear about it, we need to find some good in-country tax support and get a clear determination of it.
Because what you wouldn’t want to do is be an accidental resident of another country, have that come to light years down the line, and then potentially have years of a mess to clean up. That would be a worst case scenario.
So I suggest to people, be on top of that and monitor it, so that if you’re going to become a resident, you’re aware of it and you can do it in a very intentional way.
Andrew Chen 44:32
Got it. I was curious. We were talking earlier about earned income, non-earned income.
For early retirees who may be taking advantage of Roth conversions, they slowly march dollars from pre-tax or tax-deferred accounts over to tax-free accounts. Are those conversions considered earned income?
Grace Taylor 44:56
They aren’t. And it’s because really that income was earned in the prior year, so now it’s arising in a different kind of bucket.
One area, though, actually where this might be interesting to people who can take advantage of it, because let’s not forget that in addition to the foreign income exclusion, you also have your standard deduction. Now we know for married couples, that’s $24,000 plus per year, so it’s not insignificant.
So one area where I suggest to people, let’s consider it, if it makes sense otherwise, is, let’s say all of your earned income is under the $100,000 approximate threshold for the foreign income exclusion. That’s fine. We’ve still got that $24,000, assuming they’re married, to play with.
So if you made a Roth conversion that was underneath that threshold, then it could essentially be totally tax-free if they didn’t have other non-earned income that was eating up their standard deduction. So it is something to consider in that regard.
Andrew Chen 45:59
You mentioned that it’s not considered earned income because it was earned in a prior year. So it’s only considered income for tax purposes at the point of conversion. Does that mean that in the foreign jurisdiction, it’s not considered income at all?
Grace Taylor 46:17
That’s a really good question. And I would never presume to know the answer to that in another country without speaking to someone in that country.
Andrew Chen 46:26
I know this may not be representative, but just so we can have some mental model. In Ireland where you are, is that how one would think about that? That it is income or not?
Grace Taylor 46:40
Generally speaking, I think possibly not, but I wouldn’t ever say that yes or no because I don’t practice tax in Ireland, even though I live here. Of course, I consult with an Irish tax professional.
Some countries look at what you filed in the U.S. And other countries look at each particular source of income and treat that how they treat it really.
For example, some countries actually allow you to make tax-free contributions to a 401(k). Other countries actually don’t.
And if you were a resident of that other country and you had your 401(k) contributions that were subtracted out of your W-2, some cases, unfortunately, in that other country, we have to actually add those back.
So it really depends on how that country treats that particular source of income.
In the case of a Roth conversion, I think that it’s possible that a country could consider that that income actually arose in a prior year. The fact that it had a U.S. tax-deferred treatment in that prior year is irrelevant to that foreign country.
That could potentially be the answer, but you would want to find out for sure.
Andrew Chen 47:49
I see. So you could be in a situation where the U.S. allows you to adjust your gross income to your AGI because of a 401(k) contribution, but a foreign jurisdiction would not recognize that as an excluded income for tax. They might still tax you on that, essentially.
Grace Taylor 48:09
Yeah, that’s right.
Andrew Chen 48:10
And you would still get a credit for that from the U.S.?
Grace Taylor 48:16
Yeah. Essentially, what you’d have to do, and it gets tricky in those cases because sometimes what we have to do is we have to prepare a draft U.S. return, give that to the guys in the foreign country, they prepare a return, and then based on the tax that they calculate, we then redo the U.S. return, applying that tax as a credit. So that is how it works sometimes.
And then another interesting thing about the foreign tax credits. And this is especially just for people to be aware of if they’re in a higher tax country and they are claiming the foreign tax credit.
In the example where the foreign taxes are higher than we can utilize on that year’s U.S. return, they do carry forward. So that’s just one thing to keep in mind. Those excess credits carry forward for up to 10 years.
So it is still important to really report the full amount that you paid in the year because that excess is going to carry forward. And who knows? You might be able to utilize it in a future year.
Andrew Chen 49:07
Interesting. If you have excess credits and then you move back to the U.S., so you’re no longer abroad, can you still apply those on subsequent years within the 10-year timeframe?
Grace Taylor 49:17
Yeah, absolutely. And that’s actually one strategy that I really like to make sure that people are aware of.
The big caveat with that is you need to have foreign source income to apply those credits against.
How that worked when we had the guys who were on those expat assignments is maybe they would have equity comp and maybe they would have bonuses. And maybe those equity comp and bonuses would have been sourced back over the previous two years or five years or however much time.
So then we could say, of that five-year sourcing period for the stock award, three of those five he was working in London, and now he’s back in New York. So three-fifths of that stock award is foreign source. We use the foreign tax credit carry forwards in those years.
For an individual who doesn’t have that kind of complex compensation structure, we have to also think about the fact that, are you making business trips abroad?
And if you are, actually, this really isn’t applicable to most people unless they have foreign tax credits to use up in this way. But those business trips, whether it’s two weeks a year in China, that’s foreign source income.
So what we can do is just we can take, let’s say, 2/52’s worth of your annual income and call that foreign source and use that foreign tax credit to soak up against that income.
Andrew Chen 50:38
I see. So that characterization of foreign source income for your two-week business trip, that would just be something that’s represented in your U.S. tax return, right?
Because I’ve taken business trips abroad and I don’t file foreign tax returns for those trips.
Grace Taylor 50:54
No, you don’t. And that’s right. And you really don’t need to in almost every case.
Yeah, you’re exactly right. This is literally just a representation on the U.S. return.
And we include a form that says basically, “Here’s the foreign source income.” We include our own calculation of how we determine that foreign source income.
But really, in 99 times out of 100, the IRS doesn’t ask us for it. And then we just use that foreign tax credit against that small portion of foreign source income.
Andrew Chen 51:21
Got it. Okay, cool.
The last question I wanted to ask regarding Foreign Earned Income Exclusion is there’s this thing called the stacking rule which I think folks should understand. Can you help us understand what exactly that is, how it should work, and what to be aware of?
Grace Taylor 51:38
Yeah. That’s a great point.
And really, this applies more for people who either have income that is not excluded under the foreign income exclusion, or they have earned income in excess of the foreign income exclusion.
And essentially, what it means is this. It means that the exclusion comes out of your lower tax bracket. And so any income in excess of that is subject to the same breaks that it would have been if the exclusion hadn’t applied.
So an individual who makes $200,000 of earned income, he excludes the first $100,000 because of the foreign income exclusion. The $100,000 that’s not excluded, that’s subject to the higher rates rather than the lower rates.
And that applies to his non-earned income as well. So if that level of income puts him into a rate that taxes his capital gains at a different rate, that’s the rate that applies as well.
Andrew Chen 52:37
Got it. Are there any other last tidbits or things that folks should know about how the Foreign Earned Income Exclusion works that you’d want to call out?
Grace Taylor 52:50
I would just remind people that it does require that you actually claim it on a tax return. So you do need to file the form, ideally timely. But if you didn’t actually file it timely, we can sometimes have scope to go back and amend.
But sometimes people think that “Because my income is excluded, I don’t have a filing requirement.” That’s not the case at all.
And then other than that, I would suggest that if you have a more simple situation, sometimes you can DIY it. As your situation gets more complicated, I think it becomes more important to bring on appropriate tax professionals.
Andrew Chen 53:26
Okay. All right.
Well, Grace, thank you so much for taking the time to chat with us. This was super insightful, really useful tips on things to just keep in mind and be aware of when you’re overseas and you’re thinking about how to deal with U.S. taxes and foreign taxes.
Where can people find out more about you and your work and services?
Grace Taylor 53:45
Yeah, absolutely. Thank you. And I will just say that it’s really been a pleasure.
And I’m so excited that there’s an increased combination of knowledge in the location independent and the financial independence community, because I think that the two really support each other in such a powerful way for the people who can make that work for their lifestyle. So I’m delighted that people like you are out there putting that information together.
If people want to contact me, they can find me on my website, which is gracefullyexpat.com. I’m @gracefullyexpat on all the social medias, so people can send me an email or just get in touch with me over at Twitter, Facebook, Instagram, all of that stuff.
Andrew Chen 54:21
Cool. All right.
Well, we look forward to seeing you abroad someday. And hopefully, folks can find your tax services and consultations useful as well. Thank you so much.
Grace Taylor 54:31