Qualifying individuals must report income earned in foreign countries on their US tax returns. The penalties for noncompliance are steep. Chugh CPAs, LLP CPA and Team Lead Neha Karnwal discusses important factors including:
- Who must pay taxes on their foreign income.
- Reporting thresholds.
- Avoiding double taxation on your foreign income.
- Tax credits and exclusions available, and whether you qualify.
- And more.
Learn more about claiming foreign assets on your US tax returns.
Who Must Report Foreign Income
Certain individuals must report their foreign income earned on their United States tax returns, whether they reside in the US or abroad. These individuals include US citizens and US resident aliens. Reporting rules for foreign assets differ.
Individuals are US resident aliens if they are either green card holders, or they meet the substantial presence test. Individuals are substantially present in the US if:
- They are physically present in the US for at least 21 days during the calendar year, and
- 182 years in the three-year period including the current year.
- You must consider all the days you were physically present in the current year, one-third of the days in the preceding year, and one-sixth of the days physically present in the second previous year.
Threshold for Reporting Foreign Income on US Taxes
US citizens and resident aliens must report their foreign income on their US tax returns if they meet certain reporting thresholds. In 2020, the gross income threshold for unmarried individuals under 65 was $12,400. This means that individuals must disclose their foreign income on Form 1040 if their gross income was more than $12,400 in 2020. These thresholds differ for assets and accounts.
Even if you did not receive a form like a W-2 for foreign income, you still need to file.
There are serious penalties for not correctly reporting your foreign income, including financial charges, higher taxes, higher interest, and imprisonment.
You will need to report your foreign income on your US tax return where you report your US income. The amount you are taxed on includes unearned and earned income from foreign sources. Earned – Wages, salaries, net earnings from self-employment. Unearned – investment, rent, interest, dividends.
Avoiding Double Taxation on Foreign Income
Income earned abroad may be subject to taxation in the foreign country as well. Double taxation is defined as taxing the same source of income multiple times, in the United States and one or more foreign countries.
Luckily, there are two different ways to avoid paying taxes on the same income twice: by claiming the Foreign Earned Income Exclusion or the Foreign Tax Credit. The Foreign Earned Income Exclusion (FEIE) is applicable only to earned income, while the Foreign Tax Credit (FTC) applies to both earned and unearned income.
What is foreign earned income?
- Professional fees paid for personal services rendered.
It does not include any personal service you render to a corporation that distributes its earnings and profits rather than reasonable compensation. Distribution of earnings and profits is not considered income.
Unearned income is gained from investments, such as taxable interest, dividends, capital gains, retirement income, and more.
Foreign Earned Income Exclusion (FEIE)
To qualify for the Foreign Earned Income Exclusion (FEIE), you must have a tax home in the foreign country where you earned the income. Simply having a home address in a foreign country does not necessarily mean that country is your tax home. To determine whether a country is your tax home, consider whether the foreign country hosts your:
- Business or employment.
- Family, economic, and personal ties.
- Foreign bank account.
- Foreign driver’s license.
- And more.
In addition to having a foreign tax home, you must respond “yes” to either the bona fide resident test or the physical presence test to qualify for the FEIE.
- Bona fide resident test: Have you spent at least one calendar year in the foreign country, and do you intend to remain there indefinitely?
- Physical presence test: Have you spent at least 330 days in the foreign country or countries out of the previous 12 consecutive months?
The FEIE only applies if you are a qualified individual who meets all requirements to claim the exclusion and you file a tax return reporting the income. Under the FEIE, qualifying individuals can exclude up to $108,700 of foreign earned income from their US taxable income in tax year 2021.
Foreign Tax Credit (FTC)
Those who do not qualify for the FEIE may be able to claim the Foreign Tax Credit (FTC) for taxes paid in a foreign country on earned and unearned income.
To qualify for the FTC, you must have paid or owe income taxes in the foreign country on your foreign income.
The FTC reduces your US tax liability. If you paid less income tax in the foreign country than you would owe in the US, then you must pay the difference in the US. If you paid the same amount in the foreign country that you would owe in the US, then no taxes are due in the US. If you overpaid, you are entitled to a foreign tax credit in the United States to be used against future foreign income. You can carry back the foreign tax credit for one year or carry it forward for ten years.
How to Choose Between FEIE and FTC
If you elect to claim the FEIE, then you cannot take the FTC for taxes you paid on the income you exclude in the US. No double-dipping is allowed.
Either the Foreign Earned Income Exclusion or Foreign Tax Credit may be better for you based on your individual situation. It is important to consult with your accountant to understand what you qualify for, and which option will save you the most money on your taxes.
Avoid expensive penalties for noncompliance. Work with your trusted Chugh CPAs, LLP professional to remain compliant with foreign income reporting requirements.