There are countries that don’t require their citizens to pay income tax, and a few that tax their citizens even when they live and work in other parts of the world. The United States is one of the few nations that obligate its people to pay taxes regardless of their residence.
Dealing with income taxes is tricky enough for citizens living in the U.S.; and even more so for those that live outside the U.S. This is where the expatriation tax comes into play. The tax resolution industry for expats or U.S. citizens residing on foreign soil shows that there are very few experienced professionals that can help with expatriate tax filing, compliance, and other tax-related issues.
In this article, we’ll take you through the history of tax for expats, the key highlights, and how it evolved to help you completely understand the U.S. tax system.
The Expat Tax Timeline
On August 5, 1861, during the early stages of the American Civil War, President Abraham Lincoln imposed the first federal income tax. Congress and Lincoln agreed to levy a 3% tax on annual incomes reaching more than $800.
While Congress revoked Lincoln’s tax law in 1871, in 1909, they passed the 16th Amendment. It was signed in 1913 and remains as the federal tax system used today.
The Amendment also required individuals liable to the annual tax, including luxury item owners, to submit a list of their income and taxable property. Failure to submit on or before the deadline entailed a fine of 25% of the tax due on top of their estimated tax worth. All federal salaries were not subject to taxation under the 1864 revision.
The income tax system couldn’t get substantial support after the end of the Civil War. In 1872, it was repealed.
Congress passed the Wilson-Gorman Tariff, reintroducing income tax. But this time, the provision evaluated a lower percentage of 2% for incomes of more than $4,000. However, the law was short-lived, as it was ruled unconstitutional by the Supreme Court the following year.
Years later, Congress pushed for a resolution for the 16th Amendment. Here is a text from the Amendment about collecting income taxes:
The Congress shall have the power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.
While conservatives back then wanted to abolish the idea of such an amendment legislating income taxes, it was ratified by several states in February 1913. From here, the 16th Amendment—the first nationwide income tax provision—was implemented.
The new income tax, which is the basis of the modern U.S. taxation system, applied to all U.S. citizens living in the country or abroad. It is now the primary source of revenue of the Federal government.
The Revenue Act of 1924 or the gift tax was introduced to stop the rich from transferring their wealth while they were still alive.
Another event in 1924 led to the culmination of the 16th Amendment: a case of a U.S. citizen residing in Mexico was brought to the Supreme Court, ruling that taxing U.S. citizens living in a foreign land for their global income was constitutional. Since then, no attempts from lawmakers to abolish the taxation for non-resident citizens have been made.
In 1966, Congress made changes to the tax code to urge foreign investment in the country. The Foreign Investors Act provides significant tax advantages to non-resident non-citizens. This marks the beginning of people relinquishing their citizenship.
Before this, non-resident non-citizens who made money from U.S. sources must pay the same tax rates as American citizens. But with the modification, foreign investors get to enjoy the many tax benefits following this rule. The benefits, such as tax-free interest on bank deposits, were limited to non-citizens living outside the country.
Sometime in the mid-1990s, many wealthy U.S. citizens turned expats received scrutiny and media attention for selling out their citizenship to retain their wealth. They made the most of their accumulated wealth as U.S. citizens, then renounced it due to the taxation rules in the country.
In 2005, a new law drew the Foreign Earned Income Exclusion to inflation, reducing the tax benefits of U.S. citizens working abroad. This was when U.S. citizens overseas saw a considerable increase in their taxes due to net changes. Because of this, many groups of U.S. citizens working abroad protested to have the previous legislation reinstated.
In the Heroes Earnings Assistance and Relief Tax Act of 2008, a provision required an exit tax for individuals leaving the U.S. or expatriating citizens.
4 Expat Tax Laws You Should Know
The U.S. tax history and the provisions in it are as overwhelming as they sound. In addition, there is a lot of complex and confusing information that would call for a tax professional’s help, especially for expats.
Still, it pays to be aware of the expat tax laws that have been implemented over the years, including the bills currently pending approval. Below are four U.S. expatriate tax laws you need to know.
1. The Tax Increase Prevention and Reconciliation Act 2005
The Tax Increase Prevention and Reconciliation Act of 2005 (signed in 2006) introduced new income tax rules for U.S. citizens living and working abroad. The act increased the maximum exclusion amount to $82,400 in 2006 from the previous $80,000. It also stated that to qualify for the foreign earned income deduction, an expat must meet two requirements:
- Have a tax home in their country of residence
- Be a U.S. citizen who resided outside the U.S. for an uninterrupted period covering a complete tax year or be a U.S. citizen or resident venturing in another country for a minimum of 330 full days in any 12-consecutive-month period
2. Foreign Tax Credit Changes 2007
The U.S. Foreign Tax Credit enables expats to get a credit or itemized deduction for their income tax. This is structured to relieve non-resident citizen taxpayers from double taxation because of their global income source.
The foreign tax credit applies to non-resident citizens who settle their taxes on a foreign entity’s foreign investment income. They can use the tax credit to lower the amount of their income tax liability. It’s important to note that you will not be eligible for a foreign tax credit if:
- You did not pay the tax
- The tax is not a legal foreign tax liability
- The tax was not enforced on taxpayers
- It is not an income tax
3. The Heroes Earnings Assistance and Relief Tax (HEART) Act 2008
In 2008, President George W. Bush signed the Heroes Earnings Assistance and Relief Tax (HEART) Act 2008, also known as the “HEART” Act. The law holds mandatory and optional terms that provide tax relief for and affect the retirement plan benefits of individuals performing qualified military service.
U.S. employers conducting federal contract work for the government while using foreign subsidiaries to pay their U.S. employees working on foreign soil must pay their Social Security and Medicare taxes on the employees’ behalf.
There’s a provision in the legislation that ensures individuals who renounce their U.S. citizenship or green card pay an “exit tax.” The same federal tax rules apply for the appreciation of assets if they would sell them as American citizens or residents. Hence, their assets will be sold for their fair market value before the individuals expatriate or discontinue their permanent residence.
4. Foreign Tax Credit Modification Bill 2010
In 2010, President Barack Obama signed legislation refining the foreign tax credit. The Foreign Tax Credit Modification sets a new ceiling on the foreign tax amount paid with regards to tax code Section 956, which opposes the use of foreign tax credits when foreign income is not obligated for taxation concerning covered asset acquisitions.
The modifications on Foreign Tax Credit were urged to eliminate the expat tax gaps that motivate corporations to ship jobs abroad.
Living the Expat Life: Know Your Tax Obligations
All American citizens living in the nation or abroad must settle, submit, and pay their tax dues. For expats, this means being on top of tax obligations in both your country of residence and the U.S. It can be challenging to keep up with the tax forms and filing process; that’s why you must learn and understand your tax responsibilities to avoid hefty fines.
Are you confused about how expat taxes work? Many expats are, and that’s understandable. That’s why you must turn to tax resolution services to get the assistance you need and ensure that you remain tax-compliant. Tax Samaritan provides top-rated tax services. For any expat tax-related concerns, reach out to Tax Samaritan and have your questions answered.