U.S. Taxpayer Obligations
As a U.S. citizen or resident, it's essential to understand your tax obligations, particularly if you earn income or live abroad, intend to live outside the United States, or plan to travel internationally for an extended period of time.
U.S. Taxation on Worldwide Income: Citizenship Based Taxation
The United States is the only country in the world that taxes its citizens and residents on their worldwide income, regardless of where they live, and where the tax rate varies based on their level of income.
Unlike most countries, the United States practices a unique tax system that taxes its citizens and residents on their worldwide income, regardless of where they live or work. This is known as "Citizenship based taxation," a phenomenon
only practiced in two countries around the world: the United States of America and Eritrea. This system of taxation means that whether you earn money from investments, employment, or business activities within the U.S. or in another country, you are required to report and pay taxes on that income to the Internal Revenue Service (IRS).
For instance, if a U.S. citizen works in Thailand or Italy and earns income there, they must report that income on their U.S. tax return. As a result, US Citizens and Residents may have to pay significant taxes to the United States despite residing in another country. It is important to note that they may decrease this tax liability significantly by utilizing the Foreign Earned Income Exclusion (FEIE).
Residency, Territorial, and Citizenship Based Taxation: The Uniqueness of the U.S. System
Understanding the different approaches to taxation is crucial for individuals and businesses navigating the global financial landscape. Countries employ various tax systems to determine how income is taxed, each with its own implications for residents and non-residents.
The three primary systems—territorial-based, residency-based, and citizenship-based taxation—reflect diverse philosophies and administrative practices. Territorial-based taxation, favored by most nations, focuses on taxing income generated within the country's borders, simplifying tax obligations for those living abroad. Residency-based taxation, on the other hand, taxes individuals based on their residency status, applying a more comprehensive approach to global income.
In stark contrast, the U.S. implements a citizenship-based taxation system that taxes citizens and permanent residents on their worldwide income, regardless of where they reside. This system, known for its complexity and broad reach, requires careful navigation of both U.S. and international tax laws.
Territorial-Based Taxation
Most countries adopt a territorial tax system, which means they levy taxes only on income earned within their borders. This approach simplifies tax obligations for residents and citizens, as they are only required to report and pay taxes on income generated within their country. For individuals living abroad, this system means that foreign-earned income is generally not subject to taxation by their home country. Territorial taxation is attractive for international business and investment because it reduces the complexities and potential double taxation associated with foreign earnings.
Residency-Based Taxation
Residency-based taxation is a system where a country taxes individuals based on their residency status rather than the source of their income. In this system, residents are taxed on their global income, meaning all income earned anywhere in the world is subject to tax in their country of residence. Non-residents, on the other hand, are generally taxed only on income sourced within the country.
To determine tax residency, many countries use a “183-day rule,” where individuals who spend more than 183 days within a country in a given tax year are considered tax residents of that country. This rule helps to establish a clear threshold for residency and ensures that individuals who spend a significant portion of the year in a country are subject to its tax laws. If you are deemed a tax resident, you must report and pay taxes on both domestic and international income. Conversely, non-residents are only taxed on income with a direct connection to the country, such as income from local sources or activities.
Citizenship-Based Taxation
The U.S. employs one of the most far-reaching taxation systems in the world, known as citizenship-based taxation. This distinctive approach is characterized by its complex compliance requirements and an extensive reach, which is expected to grow further with the additional resources allocated to the Internal Revenue Service under the Inflation Reduction Act.
Under this system, U.S. citizens and permanent residents are taxed on their worldwide income, regardless of their country of residence or where the income is earned. This means Americans living abroad must navigate both U.S. tax laws and the tax regulations of their host countries, resulting in a more complex and potentially burdensome tax experience. The U.S. system's broad scope often leads to significant compliance costs, particularly given recent increases in resources allocated to the Internal Revenue Service under the Inflation Reduction Act.
The only other country in the world that has implemented a "Citizenship based" system of taxation is Eritrea, an Eastern African country which has a 2% tax on all Citizens abroad which is used to fund the dictatorial government which has ruled since independence from Ethiopia in 1993. This"diaspora" or "expatriation" tax is known to be imposed on those who emigrate from the country and it is allegedly enforced by violence and blackmail.
Reporting Requirements: FATCA, FBAR, and More
U.S. citizens and residents earning income abroad are not only subject to taxation but also must comply with various informational reporting requirements. These include:
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Foreign Account Tax Compliance Act (FATCA):
- FATCA was enacted to combat tax evasion by U.S. persons holding accounts and other financial assets offshore. Under FATCA, foreign financial institutions must report information about financial accounts held by U.S. taxpayers to the IRS. U.S. taxpayers with foreign financial assets exceeding certain thresholds must file Form 8938 (Statement of Specified Foreign Financial Assets) with their annual tax return.
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Foreign Bank Account Report (FBAR):
- U.S. persons with a financial interest in or signature authority over foreign financial accounts exceeding $10,000 at any time during the calendar year must file an FBAR (Foreign Bank Account Report), FinCEN Form 114, with the Treasury Department’s Financial Crimes Enforcement Network (FinCEN). The FBAR is separate from the tax return and must be filed electronically by April 15, with an automatic extension to October 15.
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Other Informational Reports:
- Depending on the type and amount of foreign income or assets, additional forms may be required. These could include Form 5471 for U.S. persons with ownership in foreign corporations, Form 8865 for interests in foreign partnerships, and Form 3520 for reporting certain foreign trusts and gifts.
Implications and Considerations
Failing to comply with these reporting requirements can lead to substantial penalties. For example, a willful failure to file an FBAR with FinCEN can result in fines of up to $100,000 or 50% of the foreign account balance.
Thus, it is imperative for U.S. citizens and residents living or earning income abroad to stay informed and seek professional tax advice. The intersection of U.S. and foreign tax laws can be complex, but proper planning and compliance can help mitigate potential issues.
Conclusion
The U.S. system of taxing citizens and residents on their worldwide income is unique and comprehensive. While it ensures that all U.S. persons contribute to the national treasury, it also brings about significant reporting obligations through mechanisms like FATCA and FBAR. By understanding these requirements and seeking appropriate guidance, U.S. taxpayers can navigate their international tax obligations more effectively.
Della Torre Law, PLLC
