Expatriates Face Higher U.S. Tax Burden in 2006
Tax Alert, December 2006
By Scott Hesselink & Jerome Jonckheere
U.S. citizens are required to report all of their worldwide income. As a result of the U.S. taxation of worldwide income, U.S. citizens working overseas (known as “expatriates”) must report their foreign income on their U.S. tax returns. However, expatriates may avoid double taxation on their foreign income by claiming a foreign tax credit (Form 1116) or by claiming an exclusion for citizens living abroad (Form 2555).
The scope of this article does not allow us to cover the topic of the foreign tax credit. Instead, we will focus on the “Expatriate Exclusion” and changes made that apply retroactively to January 1, 2006. Ironically, the increase in taxes for expatriates was included in the Tax Increase Prevention and Reconciliation Act of 2005 (“TIPRA”) as the changes were a tax raiser to pay for other tax benefits. Expatriates that earned the same foreign income in 2006 as in 2005 will find that their 2006 tax burden will increase under the new rules.
The Expatriate Exclusion
The IRS allows an exclusion of $82,400 per year for 2006 (and inflation adjusted in the future) to U.S. citizens that have (a) a bona fide residence overseas or (b) who is out of the United States for 330 days out of a twelve consecutive month period.
Prior to 2006, the exclusion worked very simply and intuitive. If you met the bona fide resident or 330 day rule, your foreign income (up to $82,400) was subtracted from your U.S. taxable income and tax was paid on the remaining taxable income.
The TIPRA changes increased the tax burden by taxing the remaining taxable income using a “stacking rule”. Prior to 2006, any remaining income was taxed starting at the lowest tax bracket rates (i.e., 10%, 15%, etc.). Beginning in 2006, taxpayers must calculate their tax under the stacking rule where remaining taxable income is taxed as if the lower tax rates are applied to excludible income first.
For example, a single taxpayer with $87,400 of foreign wages (and other income equal to his standard deduction and exemption) would have $5,000 of U.S. taxable income if the taxpayer qualified for the entire $82,400 exclusion amount. In 2005, this $5,000 of income would be taxed at the lowest tax rate of 10%. In 2006, the same income is subject to tax at the tax rate applicable to taxpayers with $87,400 of income, i.e. 25%. The result in this short example is that the tax liability increases from $500 to $1,250 due to the use of the higher tax brackets. At higher income levels – or if the expatriate has a spouse with income – the increased taxes become more significant.
Changes in the Taxation of Housing Allowances
Expatriates may also exclude some of their housing allowance from U.S. taxable income.
Prior to 2006, the IRS exempted all housing allowance income over a base amount of $11,894 (calculated as 16% of government pay grade GS-14) with no upper limit.
Beginning in 2006, the base amount was increased to $13,184 (calculated as 16% of the $82,400 exclusion) and a maxium of $24,720 (calculated as 30% of the $82,400 exclusion). As a result, expatriates with high foreign housing allowances will have additional taxable income in 2006 when compared to 2005.
Planning Notes and Ideas
The 2006 changes will effect virtually all U.S. expatriates that qualify for the exclusion. The stacking rule’s impact will depend on the level of other income includible on the expatriate’s return (i.e. significant impact if other income amounts are very high). The addition of a ceiling for housing allowances will impact expatriates in high cost countries like Japan, Europe, and certain areas of China.
Taxpayers who find their tax burden increasing significantly from 2005 may benefit from the foreign tax credit rather than the exclusion. As a general rule, if the tax rate of the foreign country is higher than the U.S. rate, the taxpayer will pay no additional U.S. tax on the income taxed in the foreign country, since it would be fully offset by the taxes paid abroad. However, other factors – principally the taxation of housing allowances in the foreign countries – will make this analysis more complicated.
The material in this publication is based on laws, court decisions, administrative rulings and congressional materials, and should not be construed as legal advice or legal opinions on specific facts.
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