The $70,000 -- and More -- Offshore Loophole: Tax Planning For Foreign Employment If you're a typical cash-poor American, you could increase your standard of living dramatically if you could avoid throwing away 40% or more of your income on taxes each year. Thousands of Americans are doing that right now, and many more can. It's one of the clearest provisions in the tax code. In 1989, a congressman who visited Americans living in Europe told them that if the average American knew about this tax loophole, Congress would have to repeal it. As you will learn in this chapter, the loophole actually is broader, and allows you to earn far more tax-free income, than even most expatriates realize. The loophole is known as the foreign-earned- income-exclusion or the "$70,000 exclusion." It allows for U.S. citizens who live and work outside the U.S. to exclude from gross income up to $70,000 of foreign- earned income. In addition, an employer-provided housing allowance can be excluded from income. There are other tax breaks available: Each member of a married couple working overseas, for example, can exclude salary of up to $70,000. That's a total of $140,000, plus housing allowances. It is important to note that this is not a deduction, credit, or deferral. It is an outright exclusion of the income from gross income. Naturally, to get these benefits you have to meet certain requirements: * You must establish a tax home in a foreign country. * You must pass either the "foreign-residence test" or the "physical-presence test." * You must have earned income. In the rest of this chapter, we'll discuss these tests and give some tips on maximizing tax-free income. Home is where the money is In the IRS view of the world, your tax home is the location of your regular or principal place of business. That is, the tax home is where you work, not where you live. Take a look at what happened recently to one taxpayer who did not check the rules carefully. He is a flight engineer who lives in the Bahamas, but all his flights originate from Kennedy Airport in New York. The Tax Court ruled, not surprisingly, that his tax home is in New York, not in the Bahamas. The flight engineer does not qualify for the $70,000 exclusion. But the definition goes further for the foreign- earned-income exclusion. This is a trap that catches many Americans overseas who think they are earning tax free income. If you work overseas and maintain a place of residence in the United States, your tax home is not outside the U.S. In other words, to qualify for the foreign-earned-income exclusion you have to establish both your principal place of business and your residence outside the United States. This trap catches a number of construction and oil workers. These workers generally work on a construction site or oil platform for three to six months. They get a few weeks or months off. Many of them make the mistake of leaving their family and personal possessions at their U.S. home and visiting this home during their vacations. They canžt use the offshore loophole because they never establish a tax home outside the United States. They maintained a place of residence in the United States. You need to sell or rent your U.S. home and establish a primary residence outside the United States. After establishing your tax home, you must pass one of two additional tests. Counting the days The more straightforward test is the physical presence test. To pass the test, you must be outside of the United States for 330 days out of any 12 consecutive months. The days, of course, do not have to be consecutive. That sounds very simple, but there are a number of smaller rules that can complicate it. Few people begin their foreign assignments on Jan. 1 and end them on Dec. 31. Thus for most people, the first and last 12 months of their overseas stay will occupy two tax years. This requires them to prorate their income and the $70,000 exclusion for those tax years. In addition, to count a day as one spent outside of the United States, you must be out of the United States for the entire day. There are exceptions for traveling days and days spent flying over the United States if the flight did not originate there. The IRS has a number of rules on counting days. If you are going to travel back and forth between the United States and foreign countries and if you want to try to pass this test, you'll have to learn the rules and count days very carefully. An easier way? The subjective test, known as the foreign- residence test, is probably easier for most taxpayers to pass. You must establish yourself as a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire taxable year, and you must intend to stay there indefinitely. If you do not pass this test, you are considered by the IRS a transient, or sojourner, instead of a foreign resident, and will not qualify as a foreign resident. According to the tax law, your residence is a state of mind. It is where you intend to be domiciled indefinitely. To determine your state of mind, the IRS looks at the degree of your attachment to the country in question. A number of factors, none of them decisive or significantly more important than the others, are examined. The bottom line is that you establish yourself as a member of a foreign community. The factors include the following: Sleeping quarters: A transient is more likely to sleep in a hotel; a resident likely owns housing or signs at least a year-long lease. Personal belongings: The more you take to the foreign country, the more you seem to be establishing a foreign residence. Leaving most of your personal belongings in temporary storage in the United States indicates an intention to keep that country as your residence. U.S. property: Owning a U.S. residence that you leave vacant is a sign of an intention not to establish a foreign residence. But selling or renting your U.S. residence indicates an intention to establish a foreign residence. Local documents: It is helpful to obtain a foreign driveržs license and foreign voter registration when possible. But maintaining your U.S. license and voter registration won't kill your chances. Local involvement: You should show involvement in local social and community activities to the same extent you were involved in such activities in the United States It is also helpful to let U.S. club memberships lapse while you are overseas, or to join similar clubs overseas. If you want to keep U. S. memberships in clubs that are hard to rejoin, see if you can convert them to a non-resident membership for the duration. (You may save on dues as well.) Foreign taxes: Foreign countries tax on the basis of residence. If you claim exemption from local taxes because you are not resident in that country, the IRS will conclude that you are a U.S. resident and do not qualify for the foreign-earned-income exclusion under the foreign-residence test. Thus some people prefer to qualify under the physical-presence test rather than under the foreign residence test. With the physical- presence test, you might be able to claim that you are not a resident of the foreign country and thereby exempt from their taxes. At the same time, you can claim exemption from U.S. taxes. Bank accounts: This does not seem to greatly affect residence status. But if your case seems to be borderline, it is a good idea to open at least a local checking account even if a U.S. account is maintained. Many U.S. expatriates maintain U.S. accounts because it is easier to have their U.S. employers deposit paychecks directly in the U.S. account. Permanent address: You will occasionally complete documents, such as passport applications, that ask for a permanent address. It is best to list a foreign address or some address of convenience, such as a friend's or relative's, from which your mail can be forwarded. Once your foreign residence is established, you must show that it is for an indefinite duration. If you have plans to return to the United States after a definite time has passed, you are not a foreign resident. In deciding whether or not the foreign residence is indefinite, the IRS generally looks at your employment contract. (Note that it is permissible to have a vague intention to return to the U.S. someday. But if you have in mind a definite limit to your foreign stay, you will have problems establishing that you are a foreign resident.) Generally, if your employment contract lasts for one year or less, that is an indication that you have a definite intent to return to the United States after a short period of time. You would not be able to qualify as a foreign resident. But if the contract is indefinite, open-ended, can be renewed, or is likely to lead to a new job, you probably can qualify as a foreign resident. It is best to have a contract that does not pertain to a definite project. If there is no written contract, the IRS will examine the nature of the job, the employer's personnel manual, and any other facts that indicate the intentions of you and your employer. After establishing the residence, you can make occasional trips to the United States for business or vacations without losing your foreign-residence status. Just be certain that the trips are temporary, and that you do not disturb any of the factors that qualify you as a foreign resident. Which income to exclude Once you have qualified for the offshore loophole, you must identify the kind of income that qualifies. Not all income qualifies for the exclusion -- only foreign-earned income. Foreign-earned income is income paid for services you have performed in a foreign country. This includes salaries, professional fees, tips, and similar compensation. Interest, dividends, and capital gains do not qualify. Self-employed people must adhere to some additional rules. Professionals who do not make material use of capital in performing their services can qualify all of their net income for the loophole. But when both personal services and capital are used to generate income, no more than 30% of net profits will be considered eligible for the exclusion. Note that for self-employed individuals and for partners, the net income is the amount that is applied toward the exclusion limit, not the gross income. Other types of income that do not qualify for the loophole include the following: employer-provided meals and lodging on the business premises, pension and annuity payments, income paid to employees of the U.S. government or its agencies, non-qualified deferred compensation, disallowed moving expense reimbursements, income received two years or more after you earn it. But some of these paymentsžsuch as employer-provided meals and lodging on the business premisesžare tax-free under regular U.S. tax rules and retain that status. This is one way you can earn more than $70,000 tax- free. The $70,000 limit on the offshore loophole applies to individual taxpayers. So if you are married, you and your spouse potentially can exclude up to $140,000 of foreign-earned income. But you cannot share each otheržs limit. For example, if one of you earns $80,000 and the other earns $30,000, you exclude only $100,000 on the return ($70,000 plus $30,000). Don't close the loophole Too many U.S. expatriates inadvertently close the offshore loophole. There are several ways of doing this. One way is not to realize that the provision has requirements that must be met. Many Americans assume that since they are living overseas, everything they do is free from U.S. tax. That's not so. You've seen some examples of that in this article already, and there are other regulations for taxpayers in different situations. Special situations include not being overseas for the full year and receiving advance or deferred payments of income, bonuses, and other special income items. It is well worth your while to discuss the matter with a tax attorney or accountant who understands the offshore loophole. Go over your situation and your plans in detail before leaving the United States. That way, you'll be sure to qualify for and make maximum use of this loophole. Another way people close this loophole is by not filing tax returns. To get the exemption, you must file a tax return and claim the exemption on Form 2555. The IRS has had success in recent years contending that anyone who does not file the return loses the loophole, even if he meets all the requirements. Be sure you file the return and properly claim the loophole. The loophole exempts your foreign-earned income from tax, but it does not exempt you from the filing requirement. Recent tax laws, plus some heavy criticism from the General Accounting Office, have caused the IRS to increase its monitoring of U.S. citizens overseas. The IRS now reviews passport applications and renewals to ensure that you not receive or renew a passport unless your tax returns are filed and paid up. The IRS is also looking for expatriate Americans and informing them of their tax obligations. It is estimated that about two- thirds of expatriate Americans are not filing any U.S. tax returns, and the IRS aims to change that. Be sure to file your tax returns. Tax credit option Instead of excluding income from taxes, you can take a deduction for foreign taxes paid on the income. But the foreign tax credit can get complicated, and in almost all cases, you'll find that it makes more sense to exclude income than it does to take the credit. But if your foreign-earned income exceeds the $70,000 limit, look into taking the credit for taxes paid on the income that exceeds the exclusion amount. Beware those other taxes The disappointing part of the $70,000 exclusion is that it applies only to federal income taxes. The Social Security tax might still apply to salaried employees, and the self-employment tax might still apply to self-employed individuals. The self-employed, for example, still figure their net self-employment income on Schedule C. The net income up to $70,000 still is excluded from gross income. But it also is used on Schedule SE to compute the self-employment tax. For salaried workers with U.S.-based employers, the employer is supposed to withhold Social Security taxes. Possible exemptions are discussed later in this chapter. Expanding the loophole -- exempt more than $70,000 The $70,000 offshore loophole is generous, but savvy taxpayers know how to make it even more generous. In many situations, you can exclude or deduct foreign housing costs. You have an option here. You can deduct your housing costs to the extent that they exceed a base amount. Or if your employer reimburses you for the excess, the reimbursement can be excluded from income. To get the write-off or exclusion, you must meet the same tests as for the foreign-earned income exclusion. That means either establishing a foreign residence or meeting the physical-presence, test as well as establishing a foreign tax home. The all-important base housing amount is 16% of the salary of a federal government employee with the grade of GS-14, Level 1. You use the salary that was effective on Jan. 1 of the year you became eligible for the housing loophole. If you are not eligible for the loophole for the entire year, the base amount must be prorated, just as the income exclusion is prorated in that situation. When your employer pays or reimburses you for qualified housing expenses, you can exclude from income the amount of the employeržs payments that exceed the base housing amount. The employer's payments that qualify can be made in any of the following forms: part of your salary; reimbursements for housing, the education of your dependents, or tax equalization, or employer-provided meals and lodging that are not excluded from income under the regular tax rules. Any of these kinds of expenditures also qualify for the exclusion if they are made directly to a third party instead of to you. If you and your employer agree that a part of the payments received is for housing, but you have no firm agreement as to how much is for salary and how much is for housing, you still get to use the housing exclusion. The excludable amount is your actual housing costs minus the base housing amount. The exclusion cannot exceed either your foreign- earned income or the employer-provided payments for housing expenses. In addition, the exclusion for housing expenses is applied before the foreign-earned- income exclusion. The effect of this is to make it harder to excluded housing expenses against non-earned income, such as dividends and interest. Suppose you are self-employed, or suppose your employer does not provide payment or reimbursement for housing expenses. In these cases, instead of excluding the amount from income, you can take a deduction for the excess housing expenses if you meet the same eligibility rules as for the exclusion. The deduction is computed the same way as the exclusion. You subtract the base amount from your total qualified housing expenses, and then you subtract any employer-provided payments for housing expenses. Whatever is left over is your deduction. The deduction cannot be more than the difference between your foreign-earned income and the combination of the foreign-earned-income limitation ($70,000) and any exclusion you take for housing expenses. In other words, your foreign-earned income must be above the exclusion limit of $70,000 in order for you to take the deduction. If you cannot deduct the expenses, you might be able to deduct some of them the following year if your foreign-earned income exceeds the limit. Consult your tax advisor to see if you qualify. A few limits The exclusion or deduction for housing expenses applies only to reasonable housing expenses. The IRS gives no clear-cut definition of reasonable. Most tax advisors say that if your foreign housing is of the same standard that you were used to in the United States, it should be considered reasonable. The following types of expenses qualify for this loophole: * Rent * Fair rental value of employer-provided housing * Utilities, except telephones * Insurance on real and personal property * Occupancy taxes that are not normally deductible under U.S. tax law * Non refundable lease fees * Rent for furniture and accessories * Repairs * Parking fees The following types of expenses do not qualify for this loophole: * Capital expenditures, such the costs of purchasing, constructing, or improving a home * Purchase cost of furniture and accessories * Domestic labor * Mortgage-principal payments * Depreciation * Interest and taxes that normally are deductible * Deductible moving expenses * Pay-television subscriptions The second overseas home loophole A few taxpayers are able to exclude or deduct the expenses of two homes outside the United States. To do this, you must show that the location of your tax home, or principal residence, is subject to adverse living conditions. That is, the living conditions must be "dangerous, unhealthful, or otherwise adverse." If the location of your tax home is in a state of war or civil insurrection, you are living in adverse conditions. A different kind of adverse condition is when the employer's business premises are a drilling rig, construction project, or similar operation; the taxpayer lives there; and it is not feasible for the taxpayer's family to reside there. In this case, a second overseas home can be established for the family, and the expenses qualify for the exclusion. If you think you might qualify for one of these exclusions, consult a tax advisor. There have been numerous regulations, cases, and rulings in regard to these matters. The tax advisor should be able to make sure you meet the requirements for maximum tax benefits. Like the foreign-earned-income exclusion, the allowance for housing expenses is determined separately for spouses. The Social Security offshore loophole Not many people know this but the U.S. has agreements that exempt overseas workers from either the U.S. Social Security tax or that of the adopted nation. Most developed countries have some form of social security tax. The problem for many U.S. expatriates in the past was that many foreign social security taxes are far broader and have far higher rates than does the U.S. Social Security tax. In some countries, it is equivalent to our income tax, with rates above 30%. The agreements, known as totalization agreements, dictate that U.S. citizens who are temporarily working overseas are subject only to the U.S. Social Security tax and are exempt from the host countryžs tax. The United States has signed such agreements with 12 countries so far: Belgium, Canada, France, Germany, Italy, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, and the United Kingdom. A much larger number of countries will exempt you from paying the local social security tax, without a treaty, provided you present both proof that your employment is temporary, and that you are covered by U.S. social security. To be exempt from the host country's tax, you must qualify as a "detached worker." A detached worker is one whose assignment in the host country is expected to last five years or less. The wording differs somewhat in each treaty, so be sure to have that checked out before accepting a foreign assignment. If you are not a detached worker, you are exempt from U.S. Social Security tax and are subject to the host country's tax. The treaties also work for self-employed individuals. Many U.S. employers who send their employees overseas do not even know about these treaties; this ignorance prevents employees from minimizing taxes on their foreign assignments. To qualify for the exemption, you must obtain a certificate from the U.S. Social Security Administration before the foreign assignment. You can apply for a certificate and get other information about these agreements by contacting the Social Security Administration, Office of International Policy, P.O. Box 17741, Baltimore, MD 21235. Pamphlets about agreements with individual countries are available from the same address. The Puerto Rico Loophole Some U.S. citizens find tax benefits by establishing residence in Puerto Rico. Since Puerto Rico is a commonwealth of the United States and has a similar tax system, the United States exempts income earned in Puerto Rico if you establish a bona fide residence there. A residence is established as in the case of the foreign-earned-income exclusion: You must establish a permanent attachment to Puerto Rico and demonstrate an intent to stay there indefinitely, but in addition Puerto Rico requires that the residence be for the entire calendar year in question. If you qualify, under Section 933 of the tax code you can exclude from U.S. income tax all income derived from sources within Puerto Rico. (Note that this exemption is all Puerto Rican-source income, not just earned income.) But this exclusion will prevent you from taking otherwise allowable deductions on your U.S. income tax for the income earned in Puerto Rico. Also, interest paid by Puerto Rican branches of U.S. banks does not qualify as Puerto Rican income. You should check out the Puerto Rican tax situation before trying to qualify for this provision. You will be subject to Puerto Rican taxes, and Puerto Rico is not a tax haven. You might, in fact, find the country a tax liability, as its rates are now generally higher than in the U.S. The one particularly interesting exception, however, is that dividends paid from a Puerto Rican company that has a tax holiday (such as the ten year exemption granted to new factories) is free of Puerto Rican tax. One U. S. couple owned a small manufacturing business in Puerto Rico. In the tenth year, they sold the business, but not the corporation, and paid a liquidating dividend from the corporation. Just before the tenth year, they established residence in Puerto Rico, and maintained it for the entire calendar year in which the liquidating dividend was paid. Total exemption from tax on the final payout!. The State and Local Tax Loophole The United States government taxes all its citizens, wherever they live in the world. Most foreign countries tax only their residents or domiciliaries. If a British citizen moves to the Cayman Islands and establishes residence there, he is not subject to British taxes. States in the United States tax the way foreign countries dožbased on residence. Therefore, when you establish a residence outside the United States, you avoid its state and local income taxes. For residents of high-tax states, this is not a minor consideration. Around one-third of some people's U.S. tax bill is made up of state and local taxes. Take this into account when deciding whether or not to take advantage of the offshore loophole. But states have a broader definition of residence. Some states require you to sever all contacts in order to cease residency. The Foreign Tax Loophole U.S. taxes are only part of the picture. Unless you move to a no-tax haven, you must examine the tax code of the host country to determine your tax obligations there. Again, most countries tax on the basis of residence or domicile. The rules vary from country to country, but usually someone who has established a place of abode in a country for more than six months is a resident or domicile. This often means that you can be considered a resident of two countries at the same time and can be subject to taxes in both countries. Or you can be considered a resident of no country. Different degrees of residence are taxed differently. For example, the United Kingdom uses the terms "domiciled" and "ordinarily resident", along with "resident." Someone who is domiciled in the United Kingdom is taxed in the United Kingdom on all worldwide income. Someone who is ordinarily resident or resident, but not domiciled, might be taxed only on the income derived from U.K. sources. The rule is similar in Ireland, and a lot of countries whose tax laws derived from the United Kingdom. We cannot survey the rules of all countries, though some are profiled in this report, but you should be aware of this potential problem and consider it before deciding to take advantage of the offshore loophole. You might find ways to eliminate taxes from both the United States and the foreign country in question, or you might find ways to drastically limit the overall tax bite. Another consideration is the double-tax convention, or tax treaty. The United States has tax treaties with about two dozen major countries. The intent of the treaties is to ensure that individuals and businesses are not fully taxed by two countries on the same income. But in many cases, the treaty can offer a more substantial advantage than that by reducing the total tax bill from what it would have been had only one country-in absence of a treaty-had taxed the income. Your tax advisor should check any treaty before you make a decision about the offshore loophole. See the chapter on tax treaties for more detail. The Home Sale Loophole If you want to qualify as a foreign resident, selling or renting your home is recommended. But selling the home is not always required, and many expatriates retain their U.S. homes because they plan to return someday. Expatriates who sell their homes after returning, however, could have some problems. Take a look at one IRS ruling: A taxpayer purchased a house in Washington, D.C., in 1969 and used it as a personal residence. He was transferred out of the United States in 1982 and had someone house-sit until he returned to the United States in 1986. He sold the home in 1987 and moved to New York City. He planned to exclude from gross income $125,000 of the gain on the sale, since he was over age 55. But there was a problem. The tax law requires that you own the home and use it as your principal residence for at least three out of the five years that immediately precede the sale. Since the taxpayer was out of the country for most of that period, the house did not qualify as the principal residence, and he could not exclude the gain (Letter Ruling 8825021). He could have avoided the problem by staying in the D.C. home for at least another two years, or he could have deferred the gain by purchasing a new home in New York City. He chose to rent an apartment. He could have sold the home before leaving the country, deferred the gain by rolling the sale proceeds into a home in the foreign country, and then tried to qualify gain on the sale of that home for the $125,000 exclusion when his foreign assignment ended. But he did not properly plan for his foreign assignment, and he lost the tax benefit. A similar problem occurs when people sell their U.S. homes before taking an overseas assignment. To defer the gain, you normally need to buy a new home within two years. Civilians have 4 years if overseas and military members have 4 years (stateside or overseas). This replacement period is suspended while military members are stationed outside the United States. Note however, that the replacement period, plus any period of suspension, cannot last more than 8 years after the sale of the home. So if you are gone more than four years and do not purchase a foreign residence, the gain is not deferred. You can defer gain by purchasing a foreign residence, since there is no requirement that the replacement residence be located in the United States.