The U.S. tax laws offer one huge tax break to Americans working abroad. If you qualify, you can earn up to $87,600 overseas without paying income tax—or up to $175,200 income-tax-free if you have a working spouse.
Depending on your circumstances, you can legally avoid most (if not all) of your annual income taxes using this strategy.
This small act of IRS generosity, courtesy of the United States Congress, is called the Foreign Earned Income Exclusion (FEIE).
To qualify for these benefits you must:
- Establish a “tax home” in a foreign country.
- Pass either the “foreign-residence test” (whereby you must have established legal residency in another country for an uninterrupted period of at least one year) or the “physical-presence test” (you qualify if you are physically present in a foreign country or countries for at least 330 full days during any period of 12 consecutive months).
- Actually have earned income for work.
- File a U.S. income tax return for each year you live abroad.
This is not a tax deduction, credit or deferral. It is an outright exclusion of the earnings from taxable gross income. There are no income taxes due on this amount earned offshore.
How valuable this tax break is for you depends on your “tax home.” Your tax home is the location of your regular, principal place of business. If you work overseas but maintain a U.S. residence, your tax home is not outside the U.S.
Say you moved to a tax haven like Panama. You buy a new house, and set up your own private consulting business. In doing so, you establish Panama as your “tax home” in the eyes of the IRS.
Let’s assume you do well your first year. After expenses, you make $79,400 selling your consulting services to the local Panamanians. You’re earning money inside the country, so the local Panamanian government would tax you at a maximum rate of 27%. (You also may have to pay a top corporate tax rate of 30%.)
Three things to consider when choosing a haven for tax purposes
1. Does the country impose taxes on foreign investors?
2. Can taxes be easily but legally avoided?
3. Are there tax treaties or tax information exchange agreements with the U.S. in effect?
Ensure that you understand what taxes you owe as well as the strategies for handling them.
You can apply for the FEIE from the IRS. If you qualify, you can exclude that entire $79,400 from U.S. income taxes. That’s a significant savings—even if you still have to pay Panamanian income tax.
However, there are even ways to get around these local taxes. Let’s say you move your business and your “tax home” to a place like Monaco or St. Kitts & Nevis. Both countries don’t charge foreigners income taxes. Let’s say you make $79,400 a year again, and you qualify for the foreign earned income exclusion from the IRS. In that case, you don’t have to pay income taxes on the entire $79,400.
The first thing you have to do is choose a new country that has low or no local taxes. Make sure you check out the local tax situation of any prospective country.
If you choose Costa Rica, for example, the local government will charge you the same income tax as the locals—25% for income and 30% for corporate taxes.
On the other hand, if you choose a place like Andorra with no local taxes, you could use the foreign earned income exclusion to avoid all local and U.S. income taxes.
Everyone’s tax situation is different, so it’s important to speak to a qualified tax professional or attorney once you’ve chosen your country. Make sure he is familiar with international tax reporting rules. Don’t be afraid to ask questions. Could you use the foreign earned income exclusion in your situation? Are there are other tax hurdles you need to know about (such as social security, capital gains, estate taxes)? Don’t move forward unless you’re satisfied with the answers.
If you already live abroad, speak to a tax professional in your current country, and one in the U.S. A professional will tell you if there’s a way you could use the FEIE to cut back on your tax burden.
The next thing you have to do is actually apply for the FEIE. It’s voluntary, so you have to fill out the appropriate parts of Form 2555 with the IRS to make sure you qualify. You’ll find a copy of the form here .
For more information, go to the IRS website.
About the author
Erika Nolan has been the managing director of The Sovereign Society since it was founded in 1998. In 2007, Erika set up N&C International Wealth Consultants, LLC, with a partner. E-mail: editor@sovereignsociety.com .
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