It is easy for anyone to assume that they are no longer obligated to pay taxes or file tax returns once they leave the United States. It might well be the case for citizens of other countries, but not citizens of the US, who owe a duty to pay taxes on their income from any part of the world, so long as they remain citizens of America.
There are, however, several ways and offshore strategies to reduce your taxes from income earned abroad. Our focus here would be on Foreign Earned Income Exclusion, which is often described as the cornerstone of any plan to minimize the taxation of a US citizen’s income legally.
So, what is the FEIE, how does it work, and how can it be used to reduce your tax?
FEIE and how it works
FEIE is the most significant legal tax reduction for US citizens living overseas as expats or digital nomads. The excludable amount is adjusted per year to reflect the rising cost of living. For instance, in 2015, an individual was allowed to exclude up to $100,800, whereas in 2021, the figure currently stands at $108,700. The FEIE is the US’ version of tax non-residency procedures deployed in many countries where, in Australia, for example, the government imposes an exit tax on citizens opting to reside abroad, which is also the final tax until they return. Unlike what you have in these countries, the US system expects you to pay taxes from abroad consistently. But the good news is–You have FEIE to the rescue!
The category of people who benefit the most from tax reduction through FEIE are:
- Digital nomads
- Regular travelers
- Persons practicing the flag theory (the idea of diversifying finance by going wherever you are treated best)
- Location-independent business owners who can move their business offshore by using an offshore company, and
- Someone who has a job in a country whose taxes are lower than that of the United States or has no tax at all
Meanwhile, it is important to clarify that the FEIE is not a total exemption from tax liabilities but simply an exclusion of a given sum from earned income derived from services or jobs undertaken while living outside the U.S.
According to the IRS, ‘Foreign earned income’ is divided into active and passive.
The active income is the income received for performing a service. It is active because it involves material participation and a reasonable degree of intentionality. Active could come from wages earned at a job, tips, salaries, and commissions, either as an employee or an independent contractor. The company must be abroad, even if it is US-based. To qualify for the FEIE, you must complete and submit form 673 to your employer. Suppose you meet all the requirements to be eligible for the exclusion; your employer will exclude up to the maximum amount of the federal income tax allowed under the FEIE and foreign housing credit from any wages earned while living abroad in the specified tax year.
If you are a US employer or you work for one, you can also create foreign assignments to benefit from the foreign income exclusion. However, you should note that only employees will be allowed to use form 673. Though the idea of an employee might be pretty tricky, the IRS defines an employee as someone who works at a time and place dictated by the employer, who in turn provides the employee with tools needed to complete the job and directions for how the work should be done.
On the other hand, Passive income is earnings derived from a rental property, limited partnership, or other enterprises in which a person is not actively involved. These include passive activities like forex trading, cryptocurrency trading, capital gains, pension income, social security benefits, which cannot be excluded from federal income tax.
However, professional stock traders and real estate investors may benefit from excluding their passive income as active income. Notably, many US expats have renounced their US citizenship to escape this tax liability, especially when it weighs heavily on their finances.
Income Categories that are not Qualified for FEIE
As listed by the IRS, you will be ineligible for the FEIE if your income falls under any of the following categories:
- Pay for services rendered in the international waters
- Payment received as a military or civilian employee of the U.S. government
- Pay received after the end of the relevant tax year, even if you rendered the service during the tax year
- Meals and lodgings that are excluded from income if furnished for the convenience of the employer
- Contractors and employees working in specific combat zones
If you have never filed and paid your taxes as an expat, you can take advantage of the Streamlined Procedure 2014 that allows expats to file for past years and still claim FEIE on the grounds that failure to file in the past was not intentional.
The FEIE process might be a lot for you to handle for you. However, at Tax Goddess, we are passionate about handling your FEIE (and other dealings with the IRS) and making sure you sleep well at night without having to worry.
Headed by Shauna A. Wekherlien (CPA, Masters in Taxation, and Certified Tax Coach), Tax Goddess Business Services®s P.C. is a tax and accounting firm that specializes in tax reduction, audit assistance, and accounting services. As a top 1% CPA in the US, what sets us apart from other CPA’s is our cutting-edge system in which our team of professionals, we are a team of experienced tax professionals who will work with you to develop a customized plan to reduce your taxes while creating the most-effective financial plan possible. Over the past twenty years, we have helped individuals and business owners from across the US keep more of their hard earned income by saving a total of $423,984,402 and counting. You can book a free consultation here to discuss all tax related queries and get expert advice from our tax professional. Book here Also, our YouTube channel is a goldmine for tax updates and tax reduction strategies. Watch clients' success stories here. Subscribe to our newsletter to stay updated with the secret strategies that we share.