It’s easy to miss things when filing taxes, like foreign source income. However, such an oversight can result in hefty penalties. As an expat, this has consequences to your bank account, so this is something you should never overlook.
In this blog post, we’ll discuss some key things about foreign source income you should know and why they matter when filing taxes.
1. You can reduce tax liability from foreign income with FEIE and Foreign Tax Credit.
The Foreign Earned Income Exclusion is a tax benefit that allows you to exclude a certain amount of your foreign-source income from U.S. tax.
If you meet the requirements set by the Internal Revenue Service (IRS), you can deduct some or all of the income you earned overseas during that tax year using IRS Form 2555. The limit on this deduction changes yearly to reflect inflation.
Meanwhile, the Foreign Tax Credit is a non-refundable tax credit applied to income tax payments made to a foreign government. The IRS sets the foreign tax credit you can claim to the lesser amount between foreign taxes paid and the U.S. tax liability on the foreign income.
So, if you paid $350 of foreign taxes, and on that same income, you would have owed $250 of U.S. taxes, your tax credit will be pegged at $250.
2. You can get civil penalties if you fail to comply with FATCA.
The Foreign Account Tax Compliance Act (FATCA) requires foreign financial institutions and certain non-financial foreign entities to report foreign assets held by their U.S. account holders.
Under FATCA, foreign financial institutions must provide the IRS with information regarding their account balances, transaction receipts, and withdrawal history. If they fail to comply with this, the IRS will withhold 30% in taxes on any income they earned through their U.S. financial assets.
FATCA also requires any U.S. taxpayer who owns foreign financial assets with a value that exceeds a certain amount to report the existence of said assets to the IRS. Failure to comply will prompt the IRS to impose a 40% penalty, calculated and based on the unreported income.
3. When you file your tax return, pay attention to additional requirements.
In Schedule B, Part III of IRS Form 1040, there are additional requirements you need to comply with if you had over $1,500 of taxable interest or ordinary dividends; had a foreign account; or received a distribution from, were a grantor of, or a transferor to a foreign trust.
In particular, if you have a financial interest in or signature authority over a financial account (such as a bank account, brokerage account, or securities account) in a foreign country, you are required to file FinCEN Form 114 (Report of Foreign Bank and Financial Accounts).
Meanwhile, if you received a distribution from, or were the grantor of, or transferor to, a foreign trust, you need to submit the IRS Form 3520 and IRS Form 3520a.
4. The total income taxed covers both earned and unearned income.
The amount you are taxed on includes both earned and unearned income from foreign sources. The IRS considers wages, salaries, bonuses, commissions, tips, and net earnings from self-employment as earned income.
Meanwhile, unearned income includes capital gain distributions, taxable interest, and ordinary dividends. It also covers unemployment compensation, taxable social security benefits, pensions, cancellation of debt, annuities, and distribution of unearned income from a trust.
Your earned income should be reported on line 7 of IRS Form 1040, interest and dividend income on Schedule B, income from rental properties on Schedule E, and so on, depending on the type of income you are reporting.
5. Late filing of tax returns may be allowed in some instances.
The IRS has put in place the Streamlined Filing Compliance Procedures for taxpayers who might not have been aware of their Report of Foreign Bank and Financial Accounts filing obligation. This scheme lays down the process for submitting late and/or amended returns. It likewise provides terms for resolving delinquent taxpayers’ tax and penalty liabilities.
Delinquent international information return procedures are likewise available to taxpayers who failed to file the required international information returns (such as the Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts or Form 3520) on time.
You must have reasonable cause for failure to file your international information returns to qualify for this arrangement. Also, you must not be under a civil examination or a criminal investigation by the IRS and have not been contacted about delinquent returns.
Pay attention to filing policies
By being aware of the filing procedures and requirements, you can spare yourself from potential penalties. Therefore, compliance with IRS policies should be on top of your priorities so you can avoid an unnecessary financial blow that may drain your bank account.
Tax Samaritan is a tax solutions expert that offers tax resolution services and assists expats with their foreign source income through proper accounting.