It is not uncommon for a young adult who was born in the U.S. to noncitizen parents living temporarily in the U.S. to live abroad. Although he or she may never have returned to the U.S., the young individual is a U.S. citizen, and that status brings with it U.S. tax obligations. In many cases, the young adults may not have had income or personal property, and therefore may not have had reason to file a U.S. tax return. As those young adults graduate from university and enters the workforce, or become the recipients of gifts and bequests, the matter of U.S. tax filing obligations becomes more significant.
Consider Ms. A, a typical young adult, born in the U.S. but living abroad. She may have a bank account in a foreign county, but ordinarily will not have her own source of income. At some point, Ms. A may receive gifts and bequests from her foreign parents or grandparents. At this point in her life, Ms. A's U.S. tax compliance obligations become complex. Because of her fact pattern, she faces many complex filing obligations simply because she resides abroad and almost all of her employment income, investment gains, and family gifts may need to be reported to the I.R.S. Moreover, compliance failures can generate stiff penalties. Ms. A's family may wonder whether she should relinquish her U.S. citizenship. Taking that action triggers further tax obligations and is not a straightforward solution in many instances.
This article discusses the U.S. tax obligations of Ms. A, and suggests two paths forward to exit the U.S. tax system, based on her age.
U.S. INCOME TAX
The most significant filing will be Form 1040 (U.S. Individual Income Tax Return). All U.S. citizens are required to report worldwide income and pay income tax to the I.R.S. regardless of where they live. While the due date of this return generally is April 15 of the following year, if Ms. A resides outside the U.S., and works or attends university on a full-time basis outside the U.S., she may qualify for an automatic two-month extension to file a tax return. This automatic extension of the filing date does not extend the time for payment of tax. Interest will be due for amounts not paid by April 15.
If an individual who lives outside the U.S. is not able to file a return by the end of the two-month extended period, she may file for an automatic four-month extension by filing Form 4868 (Application for Automatic Extension of Time to File U.S. Individual Income Tax Return) by June 15 following the close of the taxable year. If timely filed, the tax return is due not later than October 15. In addition to the extension to October 15, taxpayers who are based outside the U.S. can request a discretionary two-month additional extension of time to file tax returns to December 15. It is customary for the I.R.S. to grant the extension. If for any reason the I.R.S. denies the request, it nonetheless extends the due date of the return until 10 days from the date of the denial.
The young adult may be required to make estimated tax payments during the course of the year on Form 1040-ES. Estimated tax rules apply a "pay-as-you-go" system for tax and is the method used to pay tax on income that is not subject to U.S. withholding, meaning income other than salaries. This includes income from self-employment, interest, dividends, rent, gains from the sale of assets, prizes, and awards. If the taxpayer does not pay enough estimated tax throughout the year, the I.R.S. will impose a penalty based on interest rates set by the I.R.S. for the late payment.
FOREIGN INCOME AND TAXES
If another country imposes tax on Ms. A's income, the U.S. will allow her to claim a foreign tax credit for the taxes paid to that other country. Foreign tax credit computations are made on Form 1116 (Foreign Tax Credit (Individual, Estate, or Trust)). Note that the income that is taxed by the foreign country must be considered foreign- source income under U.S. tax concepts in order for the credit to provide a benefit. Changes to I.R.S. regulations applicable to foreign tax credits require a jurisdictional nexus between the income and the foreign tax. Even if the nexus exists, U.S. law generally does not allow the foreign tax credit to offset U.S. tax on U.S. source income.
If Ms. A resides and works abroad, a foreign earned income exclusion and a deduction or an exemption for foreign housing amounts may be available to her when computing her taxable income. Form 2555 (Foreign Earned Income) is used for this purpose. If certain requirements are met, an individual may exclude up to $112,000 of foreign-earned income in 2022. In addition, up to $15,680 may be excluded or deducted in 2022 for the foreign housing amount. The maximum amount of those foreign benefits is adjusted annually to reflect inflation.
To claim the foreign-earned income exclusion, the foreign housing exclusion, or the foreign housing deduction, Ms. A must meet all three of the following requirements:
- Her tax home must be in a foreign country. A tax home is the general area of a person's main place of business, employment, or post of duty, regardless of where she maintains a family home. If a person does not have a regular or main place of business because of the nature of her work, her tax home may be the place where she regularly lives. If she has neither a regular or main place of business nor a place where she regularly lives, she is considered to be an itinerant and her tax home is wherever she works at any particular time.
- She must have foreign earned income.
- She must be either (i) a U.S. citizen who is a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year, generally January 1 through December 31, or (ii) a U.S. citizen who is physically present in a foreign country for at least 330 full days during any period of 12 consecutive months.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.