Choosing Your Arrival Date
For tax purposes, you become a U.S. resident when you actually arrive in the U.S. So if you are about to receive a large capital gain, perhaps from the sale of a home or business, it would be best in many cases to receive this payment before becoming subject to U.S. taxes.
If you have substantial foreign income that will continue while you are in the U.S. for a period of only a few years, it can be beneficial to create a trust or a holding company to accumulate that income for you until after you cease to be a U.S. taxpayer. Matters of this nature need to be planned well in advance, as once you are a resident of the U.S. for tax purposes it is too late, and you should consult an expert in the U.S. tax laws that relate to such matters. Most certified public accountants practicing in the U.S. are not going to be experienced in these special areas of tax law.
One of the best sources of help in setting up offshore trusts and corporations is an American certified accountant who has a large practice in Panama. Marc Harris holds a master's degree in business administration from Columbia University in New York, and completed the certified public accountancy examination at the age of 18. He is believed to be the youngest person in the U.S. to pass the examination.
He opened his Panamanian firm in 1985, after being a consultant with the accounting firm of Ernst & Whinney. His services are highly recommended because he is able to create and administer offshore corporations and trusts with complete compliance with U.S. laws. Often a future American resident uses a tax-haven based advisor who knows the local laws but is not familiar with American tax law requirements and technicalities, and the client eventually gets into trouble, so Marc Harris has a unique ability to bridge the two worlds for his clients. Although based in Panama, he can create and administer corporations and trusts that are registered in all of the popular tax havens.
Even if your stay in the U.S. will be permanent, there is much that can be done to protect your income -- but it must be done before you obtain resident status. Once the "green card" is issued, it is too late to engage in this valuable advance tax planning.
- For more information, write to:
- The Harris Organization
- Attn: Traditional Client Services
- Estafeta El Dorado
- Apartado Postal 6-1097
- Panama 6, Panama.
Tax Treaty Exemptions
Tax treaties with about two dozen countries provide for exemption of U.S. taxation for teachers temporarily employed in the U.S. Normally the tax exemption period is limited to two years. But since other countries only tax on residence, this usually means that the earnings in the U.S. will be totally tax free. So a temporary teaching assignment in the U.S. can be a wonderful tax free way to gain experience, and a position that may enhance your future employment prospects in countries other than the U.S. It will also let you gain a U.S. social security card, which can have some amazing benefits, as we discuss in a later section.
The $70,000 Exclusion
This loophole is known as the foreign-earned-income- exclusion or the "$70,000 exclusion." It can let you maintain your U.S. permanent resident visa while working outside the U.S., and still owe no U.S. taxes. It allows for U.S. citizens and residents 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 section, we'll discuss these tests and give some tips on maximizing tax-free income.
In the tax collector's 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. But since residence for immigration purposes and temporary residence for tax law purposes are different, it is possible to do both.
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 can't 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, which has to be handled very delicately to avoid conflict with the visa status.
After establishing your tax home, you must pass one of two additional tests.
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.
The subjective test, known as the foreign-residence test, is probably easier for most taxpayers to pass, but more dangerous if you are trying to simultaneously maintain your permanent resident visa, although it is not impossible to walk this tightrope without falling off. 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 Internal Revenue Service as 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, and this can get dangerous if you do it for too long since it then raises questions about your intent to maintain your U.S. resident visa status.
Foreign countries (except for the Philippines) 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.
Because of the delicacy of maintaining permanent residence for your "green card" at the same time, we would recommend only using the physical presence test.
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 payments - such as employer-provided meals and lodging on the business premises - are 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 other's 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).
Too many people 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 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.
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.
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. (But see the next section on how you can turn this into a benefit.) 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.
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 rules for calculating this are very complex, and you will need to get a tax manual for the current year to do it correctly.
The Puerto Rico Loophole
Some U.S. taxpayers 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. For immigration purposes Puerto Rico is part of the United States.
Provided that you are resident in Puerto Rico for the entire calendar year, you file a Puerto Rico tax return instead of a U.S. tax return. Puerto Rico taxes all income on a worldwide basis. 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!.
Since the dominant language and culture in Puerto Rico are Spanish, if you are immigrating to the U.S. from a Spanish- speaking country, you may find it preferable to make your base in Puerto Rico instead of the mainland, and have the tax advantages as well. In this case you could be continuously living on tax- free profits from the business. Salary payments would be subject to the Puerto Rican income tax rates, but dividends from the ongoing business would not be.
There are some older tax holiday laws on the books in Puerto Rico that are often overlooked. For example, a ten year exemption from tax for companies engaged in export of a locally made or assembled product. This is often a more useful exemption than some of the manufacturing exemptions which give only a partial exemption in urbanized areas.
Another way to play a different Puerto Rico tax angle is if you are entering the U.S. to operate your own business, and intend to eventually leave the U.S. A foreign corporation with a branch in Puerto Rico is only taxed on Puerto Rico source income. If you create a Panamanian corporation, open a branch for it in Puerto Rico, and accumulate the profits in the corporation, you can then take the money out of the corporation once you are no longer a U.S. (or Puerto Rican) taxpayer. In this situation you would be taxed on the salary you pay yourself out of the corporation, which you would keep as low as possible, and then let most of the money stay as profits.
This angle works particularly well for a consulting or other service business, or for a mail order or publishing business. Since Puerto Rico is within U.S. domestic mail and telephone systems, it can be used as a base for such enterprises very easily. It also works the other way -- the Puerto Rican branch office could be a business engaged in export representation of products to Latin America, since transportation from San Juan, Puerto Rico, to most points in Latin America is very easy with good flight schedules. Some major American corporations have done exactly this -- they created Panamanian sales subsidiaries for their Latin American business, and operate the subsidiaries out of Puerto Rico, from where the sales representatives can easily call on clients throughout the hemisphere.
A Pension From the U.S. Government (even if you are not an American)
If you have ever worked in the United States, and held an American social security card, you paid in social security taxes during the years you were there. Perhaps then you returned to your own country and forgot all about the taxes you paid in those early years of your career.
Well, don't forget about it. Dig up the records and find out how much you paid. If you paid in for ten years, you are considered "fully insured" and become eligible for a pension when you reach retirement age. The pension is based on your American earnings, and is paid regardless of citizenship or residence.
Didn't work quite long enough? That's why you need to check this early. Perhaps you only paid in for 7 years. You can achieve the fully-insured status, and thus a future pension, simply by paying in the minimum tax for another three years. That is only about $200 a year! All you need is a minimal amount of what the American tax law calls "self-employment" income from U.S. sources. Approximately $2200 a year, which perhaps you earn from a consulting fee or selling some of your travel photographs, is all you need to owe the $200 tax for social security. The income tax on this amount will be small or negligible. What you are trying to accomplish is a situation in which you voluntarily file and pay the extra few hundred dollars to achieve fully- insured status.
The rules are complex, and we can't possibly begin to explain them all here, and the exact dollar amounts vary at the whim of Congress. Suffice it to say that the minimum pension is now around $650 a month, so if there is a chance that you are eligible, you want to qualify as soon as possible. Once your ten years at at least the minimum rate are paid in and you have the status, you don't have to pay in another cent to get the pension. (Higher amounts of taxable earnings result in a higher pension, but not at a rate that is going to gain you anything. The value of this idea is in meeting the minimum requirements, to receive the minimum statutory pension.) Unlike many other countries, the U.S. does not have any provision for voluntary payments into the pension fund -- so you must create a situation where you have to pay the social security tax.
Intention is an open ended question, so if you have worked in the U.S. for 7 or 8 years, there is nothing to prevent you from filing U.S. tax returns as a resident for another few years, until you discover that you no longer have the intent to maintain your resident visa. Generally there will be little or no additional tax cost to do this, either because of the tax treaties or because the U.S. income tax has an exclusion for earning up to $70,000 per year while living abroad.
Most U. S. embassies have at least the basic social security information pamphlets. After you have read them, you can explore the specifics of your situation.
Social security payments are subject to 30% withholding tax to some countries, and totally exempt to some because of treaties. This is something to check at the time you start collecting, because you may want to be a resident of a country covered by such a treaty -- particularly if it is a country that does not tax foreign pension payments, and many do not.
About the Author Adam Starchild is the author of over 20 books on business and finance.Copyright © 1993 by Adam Starchild
The Tax Library has reprinted this copyrighted article with the permission of the author.Mention of specific firms is an editorial recommendation by the author and is not advertising for the firms concerned.
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