Foreign Earned Income Exclusion – An Expat’s Tax Escape
Reduce… Even Eliminate Your Tax Burden With the FEIE
Most U.S. expats realize that the United States taxes its citizens on their worldwide income.
They understand, too, that every U.S. citizen must file a U.S. tax return every year, regardless where he chooses to reside.
What many don’t recognize, though, is that an American abroad can use a foreign corporation, in a zero-tax jurisdiction, to legally and legitimately reduce U.S. tax on his business income.
Your first line of defense as a U.S. expat is the Foreign Earned Income Exclusion (FEIE), which excludes from U.S. income tax the first US$101,300 (that’s the figure for 2016) of wage or self-employment income earned by a U.S. citizen “residing” in another country. (Technically, you’re “residing” abroad if you’re outside the United States for at least 330 days during any 365-day period.)
However, this is only the start of strategies available to you as an American abroad to reduce or even eliminate your annual tax bill.
For example: You can use the FEIE to reduce or even eliminate U.S. federal income tax on wages paid by either a U.S. corporation or a foreign corporation. Realize further that it doesn’t matter if you are the owner of the corporation… the FEIE applies as long as you are an employee of the company, even if it is your own company.
You reap the benefits of the FEIE if you’re self-employed, as well, operating a small business outside the States, say, or working as an independent contractor for a U.S. or foreign corporation but performing your work, again, outside the United States.
Remember, though, that the FEIE applies only to federal income tax. If you’re using it as the beginning and the end of your international tax management strategy, you’re still liable for Medicare, Social Security, and FICA… which amount to about 7.5% a year. And your employer is required to match your Medicare, Social Security, and FICA contributions, so your situation is costing him about 7.5%, as well.
Plus, if you’re self-employed abroad but operating without a corporation, you’re liable for 100% of FICA and Social Security… and you can suffer a reduction of your FEIE based on business expenses you claim.
In other words, the FEIE is a great start. But, again, you can do more.
Maximizing Tax Benefits
To maximize the tax benefits of residing abroad and (legally) minimize your total tax obligation in the United States, here’s what you want to do:
First, form an offshore corporation in a zero-tax jurisdiction, register that company with the IRS, and open a foreign bank account in its name.
Second, draw a salary of up to US$101,300 (the amount of the FEIE is increased slightly every year) from that foreign corporation. As long as you qualify for the FEIE, and the company’s income is derived from active, not passive, business, you will have no U.S. federal income tax liability on this income.
Voliá. The properly registered and domiciled foreign corporation is not responsible for Medicare, Social Security, or FICA.
Furthermore, you are now not self-employed; you are an employee of your offshore corporation, and therefore not subject to self-employment taxes either (that is, no Social Security, no Medicare, no FICA).
Plus, all the expenses of the offshore corporation are now additional deductions and do not reduce your FEIE.
And… operating this way, you might be able to retain some or all of the offshore corporation’s earnings in excess of the FEIE. Careful planning in this area can allow the deferral of U.S. income tax on active business income inside the corporation.