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Foreign Earned Income Taxation Vs. Passive Income Taxation

Tax Benefits Of Moving Overseas

The single most frequently asked question with regards to asset protection and taxation overseas is this:

“What can I do to make my passive income qualify for the Foreign Earned Income Exclusion… so I don’t have to pay tax on it?”

The answer is: Nothing. There’s nothing an American can do to avoid your U.S. tax liability on passive income.

Passive income isn’t earned income, and there’s no way to make it appear to be earned income. If you’re an American, you owe tax on your passive income to the IRS, no matter where in the world you’re living when you collect that passive income.

I gave that answer again and again. Still people tried to come up with scenarios that would convert their passive income to active income.

“What if I earn the passive income from day trading?”

Every day trader thinks that the two hours he sits at his laptop each morning buying and selling stocks for his own account should allow him to classify the gains from those trades as active income.

It does not.

“What about pension income?” someone asked. “I earned that money.”

Sorry, no. Pension income is not current earned income.

“What about rental income if I put the property earning it into an offshore corporation and pay myself a salary from that corporation?”

Nope. Rental income is passive. Earning the income in an offshore corporation doesn’t make it active income. In fact, putting the rental property into an offshore corporation creates additional tax liability, thanks to Passive Foreign Income Company rules.

If you’re an American, the only tax break you get at the federal level moving overseas is the Foreign Earned Income Exclusion (FEIE) and that, as the name lays out, is for foreign-earned income only—that is, income from work performed outside the United States.

Note the two critical pieces to this. We’re talking about income from work performed (that is, earned income)… and we’re talking about income from work performed outside the United States. Even if you’ve got foreign-earned income, the exclusion applies only if you qualify as a bona fide resident of another country or if you spend at least 330 days per year in countries other than the United States and can prove it.

In addition, moving overseas can allow you to eliminate the state tax on pension income if you live in a state that taxes pensions. Note that most states don’t tax Social Security income.

The real tax benefit associated with going offshore has to do with moving an existing business or launching a new business in another country. In this case, you can benefit by deferring taxes on profits earned by your company but not paid out to you. This tax deferral strategy works for small companies just like it works for Apple, et al.

The tax deferral can allow you to grow your business faster, but it is only a deferral. When the profits are paid out as dividends or salary to you, you’ll be taxed at that time.

You don’t go offshore to save on taxes… at least not if you’re an American. Citizens of other countries can legally avoid taxes altogether if they take up residency in a country that taxes on a jurisdictional basis, such as Panama, Malaysia, Belize, Nicaragua, or Costa Rica.

Americans go offshore for diversification and asset protection. These benefits are available to everyone else, too.

Diversifying your investments and assets into other economies and currencies is the smartest possible hedge against whatever might happen back home, regardless which country’s passport you hold.

Lief Simon