You Need Not Necessarily Pay
“The most important tool in the U.S. expat’s tax toolbox,” writes Our international tax guru this Tax Day, “is the foreign-earned income exclusion (referred to in tax-planning circles as the FEIE or ‘the exclusion’).
“If you qualify, the FEIE allows you to exclude up to US$87,600 in 2008 foreign-earned income from U.S. federal income tax.
“All U.S. citizens and residents who earn more than US$8,450 (single) or US$16,900 (married filing a joint return) in a year must file a U.S. personal income tax return no matter where you reside.
“You must file, but that does not mean you must pay tax. One of the many benefits for an American of living or retiring abroad is that, once you’re a foreign resident, you’re eligible to take advantage of the FEIE.
“The exclusion applies to foreign-earned income only–that is, wages or self-employment income (independent contractor earnings, for example) you receive for services you perform while living outside the United States. Wages can come from a U.S. corporation or a foreign corporation, including an offshore corporation, and it does not matter if you are also a shareholder or owner of that foreign corporation.
“Note, though, that earned income does not include interest, dividends, or other investment or passive income.
“The key is to qualify. Bottom line, you qualify for the exclusion in one of two ways:
“1. The 330 Day Test. To qualify for the FEIE using the 330 Day Test, you must be outside the United States for 330 days out of any 365-day period. It does not matter if the 330 days are over two calendar years (between Nov. 1, 2007, and Oct. 31, 2008, for example), and you can avail of a special extension to file your tax return to give you time to meet this requirement.
“2. The Bona Fide Residency Test. In this case, you achieve foreign residency by moving to another country and making it your ‘home.’ You can intend to return to the States in the future, but you must move to the foreign country for an ‘indefinite’ or ‘extended’ period of time that must include one full calendar year.
“The 330 Day Test is fact-based, while the Residency Test hinges on your intentions and is therefore more difficult to use and to prove. I recommend relying on the 330 Day Test in the first year you claim the exclusion. Then you can move to the Residency Test.
“For, the Bona Fide Residency Test is one of the most misunderstood and misused sections of the U.S. tax code. You are a bona-fide resident of another country if you move there and make it your home. You show this, typically, by filing and paying taxes in that country.
“The perfect example of a U.S. foreign resident is a person who moves to a foreign country, does not intend to return to the States, files and pays taxes in the new country, obtains a long-term visa that allows him to work in that country, sells his U.S. home and buys one in the foreign country, and who relocates with his family.
“Of course, though, few cases are perfect.
“For example, a husband might move to France to work there indefinitely, leaving his family in California. Maybe he returns to the States for 40 days per year to visit and intends to return again full-time as soon as financially possible.
“In this case, the American in question has a good chance of being allowed the exclusion, assuming he is physically outside the States for at least one year, but it’s not guaranteed, and the determination by the IRS would depend on many facts and factors.
“Note that simply being out of the States for a full calendar year does not make you a resident of a foreign country. For example, if you go to a foreign country to work on a construction job for a specified period of time, say 14 months, you ordinarily would not be regarded as a bona-fide resident of that country, even though you’re living and working there for one tax year or longer. The length of your stay and the nature of your job are only some of the factors taken into consideration.
“If the residency test is so complex…you may be wondering…why should you use it? The biggest reason would be if you want to be able to spend more than 35 days a year in the United States.
“Furthermore, once you qualify as a resident of a foreign country, you remain a resident of that country until you give up that residency. With the 330-day test, you must be out of the country for 330 days of each 365-day period. In other words, the determination is made year by year.
“Plus, with the residency test, you can qualify for all or only part of a year. Here is an example from the IRS website:
“‘You were a bona-fide resident of England from March 1, 2006, through Sept. 14, 2008. On Sept. 15, 2008, you returned to the United States. Since you were a bona-fide resident of a foreign country for all of 2007, you also qualify as a bona-fide resident from March 1, 2006, through the end of 2006 and from Jan. 1, 2008, through Sept. 14, 2008.’
“Also note that, if you’re married and you and your spouse both are residing abroad, you each can take advantage of the foreign-earned income exclusion. Meaning you could be able to exclude up to your first US$175,200 of foreign-earned income from U.S. tax.”
Finally, the foreign-earned income exclusion is use it or lose it. If you don’t file your returns year by year, you can’t later go back and try to claim the exclusion. You’ll be required to pay U.S. tax on all your worldwide income for any year in which you failed to file.
P.S. Remember: The foreign-earned income exclusion applies to U.S. tax only. As an American abroad, you can have a local tax obligation, as well, in the country where you’re residing.
However, choose a zero-tax jurisdiction as your place of foreign residence…earn no more than US$87,600 in foreign income each year…and you could reduce your overall tax bill to nothing.
P.P.S. The top three zero-tax jurisdictions right now are: Panama, Belize, and Uruguay.
“I have spent quite a bit of time in Panama the past few years, and I really like what I see. However, Ecuador also appears to be very appealing, with a lower cost of living, more diversity in landscape, and much of what Panama offers, except for the banking and business community in Panama City.”
— Mark, United States
When we moved from Paris to the Americas last summer, we chose Panama for the following reasons:
- Panama City offers top-tier choices for international schooling, including a French school that is administered not by the Panama Ministry of Education but by the French Ministry of Education. Our 8-year-old son had been attending school in Paris for four years. We were delighted, therefore, when we discovered the Paul Gauguin school in Panama’s capital.
- After more than a dozen years researching and scouting global real estate investment opportunities, my husband, Lief Simon, wanted to develop land of his own. He determined that Panama’s Pacific coast, along the western edge of the Azuero peninsula, offers the greatest potential for this right now.
- After 23 years running the International Living publishing business, I wanted to launch a publishing concern of my own (you’re reading the early fruits of this effort in these dispatches). France is no place to start a business. Panama, on the other hand, is one of the best places in the world to indulge your entrepreneurial inclinations.
- We’ve been doing business in Panama for more than a decade. We’ve established a local infrastructure of resources and contacts we knew we could rely on to help support our business and investment efforts. Plus, after all these years spending time in this country, we have good friends here.
These are our primary reasons for choosing Panama over the other options in this part of the world (including, yes, Ecuador, but also Nicaragua, Belize, Uruguay, and Argentina, all of which we also considered seriously).
In addition, we had one reason in particular for not choosing Ecuador: I don’t do well at high altitudes. Over all the years I’ve spent time and done business in Ecuador, I’ve never acclimated. Invariably, I’m sick in bed the first few days of every visit.
For another point of view, I put this Ecuador versus Panama question to Latin America Correspondent Christian MacDonald.
Christian knows this part of the world well and chooses to spend much of his time in Ecuador. “Why?” I asked.
“I would recommend Ecuador over Panama as a place to live,” Christian explains, “because the cost of living is lower and the cost of real estate is dramatically lower. The weather is better. The pensionado programs offer equal benefits (assuming Panama’s includes half-off international flights, as Ecuador’s does).
“I’d also give Ecuador the edge for privacy and banking secrecy, although Panama has done a much better job at promoting these benefits.
“I’d put the two countries even for accessibility. Ecuador has the advantage of nonstop flights to Europe, while Panama is closer to the U.S. by more than two hours.
“But doing business is another matter. Panama’s banks are stronger and more stable. Their business infrastructure is mature and leading edge. Their banking products and options for structuring a business are great, and there are loads of qualified professionals to help you.
“I have no business experience in Panama, but I can tell you that, in Ecuador, doing business can be difficult…and the bigger the business, the more difficult it becomes.
“I know small business owners who are content, except for the awkward tax system. But big endeavors are tough for expats. I had a friend who was part of a forestry project in Ecuador, but he gave up. What drove him out was the dishonest business ethic in this country and the inability of business associates to keep their word, to meet their commitments, to tell the truth, and not to steal from you.
“So, yes, I agree with this reader’s assessment on Ecuador’s beauty and low costs…and I agree, as well, with the credit he gives to Panama’s banking and business community. The bottom line is that if I were recommending a place to live, I’d choose Ecuador. But if business or investment were my primary concern–including development and forestry–I’d choose Panama.”