US citizens face the most unique tax situation in the world as they are the only developed country to impose tax on individuals who have citizenship. Every other country bases their tax on residency – how many days a person was in the country during the year. This means no matter where in the world a US citizen lives, they must file a US tax return and pay their required tax. It is critical to understand the options available to US citizens to ensure they are compliant while not overpaying tax.
There are three different approaches US citizens can take:
1. Use Form 2555 to exclude foreign income
2. Use Form 1116 to claim a foreign tax credit
3. File under a treaty-based position
Because the third option requires specific circumstances to be met, it is more of a case-by-case scenario. The main focus of this article will be to look at how a hockey player, John, can use the foreign income exclusion (Form 2555) and foreign tax credit (Form 1116) to best position himself and pay the least amount of tax.
Form 2555 – Foreign Income Exclusion
To qualify for the foreign income exclusion, citizens may only be physically present in the United States for 30 days out of 360 consecutive days. This can be in a singular calendar year (all of 2024) or stretch over two calendar years such as August 2024-July 2025. Taxpayers are not eligible to file if they do not meet these requirements. With entry/exit from the country being something that is easily tracked, taxpayers should be mindful of meeting/not meeting these requirements.
If a citizen spends enough days outside of the country, they have the option to utilize the foreign income exclusion but do not have to. When taking the foreign income exclusion, each individual taxpayer may exclude up to $126,500 (for their 2024 tax return) of foreign earned income. Taxpayers may also take an exclusion for housing expenses that are not included in their foreign income.
Just because an individual is eligible to exclude their income, should they? That will depend on the country they are living in and whether they have children. A taxpayer should carefully consider their situation because choosing to stop taking the exclusion will prevent them from being able to claim it again for five years. The biggest reason to not take the foreign income exclusion is it prevents a taxpayer from claiming credits for dependents. In addition to having dependents, it is not necessarily beneficial to utilize the exclusion for most athletes playing overseas unless they are playing in a country with a lower tax rate than the United States.
Form 1116 – Foreign Tax Credit
When a US citizen earns foreign income and pays taxes to another country, they are eligible to claim a credit for taxes paid up to the tax the United States imposes on that same income. When playing in a country with a higher income tax, the foreign taxes paid will cover the total US tax liability. If there were not enough foreign taxes paid, the taxpayer would pay the difference.
Individuals may claim a foreign tax credit while utilizing the foreign income exclusion. However, it may only be claimed against income/tax exceeding the exclusion amount.
Where taxpayers, particularly professional athletes, tend to face a dilemma is when they have foreign income as well as income sourced inside the United States, whether that is passive income - interest, dividends, or capital gains or employment income – changing teams in the summer. Having US sourced income and foreign sourced income forces a taxpayer to prorate their tax credit based on the percentage of income being earned inside and outside the country. For example, if a taxpayer earns $200,000 during the year, with $100,000 being US sourced and $100,000 being foreign sourced, they would only be able to claim 50% of their potential foreign tax credit, which often results in a balance due for the year.
One of the benefits to utilizing the foreign tax credit is the ability to both roll-forward and roll-back excess credits. Individuals who work in a country with a higher income tax rate than the United States often will have more foreign taxes paid than their US tax liability. In this situation, individuals may roll-forward any leftover amounts for use any year in the future. Conversely, if they have a deficit in a past year because they were employed in a country with a lower tax rate, taxpayers can go back up to three years and roll-back excess foreign taxes from the current year and claim a refund!
Using Foreign Income Exclusion & Foreign Tax Credit
John started playing overseas in Sweden and was single. He has committed to living in Sweden full-time, only visiting home for two weeks in the summer. By being in the United States for less than 30 days, John becomes eligible to use the Foreign Income Exclusion. During the first year playing overseas, John made $100,000. To make John’s tax situation simple and less of a need to find record of foreign taxes paid, Form 2555 was utilized and the entirety of his income was excluded from tax. The next year John made $150,000, putting his marginal tax rate at 24% in the United States. In Sweden, John is paying ~33% on his income so he has paid ~$49,5000 in Swedish tax. In the United States, John’s tax would be $25,538.
Taking the foreign income exclusion does not change what your income tax rate would be. Utilizing the foreign income exclusion would allow John to not pay tax on $126,500 BUT he would still pay 24% on $23,500 ($150,000-$126,500). However, John would be able to take a foreign tax credit to offset the remaining liability. Any excess foreign tax credits would be rolled forward for future use. While playing in a country with a higher tax rate than the United States, John’s ending liability would be the same regardless of using the Foreign Income Exclusion or taking a foreign tax credit. John’s clear benefit from utilizing the exclusion would come if he were to in a country with a significantly lower income tax rate than the United States.
The question is should he continue using the foreign income exclusion or exclusively take the foreign tax credit because he has enough foreign taxes paid to cover the entirety of his liability? Because John used the Foreign Income Exclusion last year and revoking that exclusion will preclude him from utilizing it again for five years, he should continue to use it as he would be able to combine it with the foreign tax credit. Since the impact on the amount owed would be the same, there is no reason to revoke the exclusion until there is a major change in his situation.
As John’s playing career comes to an end, he has started working a stable office job, making $80,000 a year, gotten married, and started a family but has decided to continue to live overseas full-time. As John’s situation has changed, he should re-evaluate his use of the foreign income exclusion. With the birth of a child, John would benefit from revoking his foreign income exclusion and only using the foreign tax credit to cover his liability. This would allow John to claim the Child Tax Credit resulting in him receiving a $2,000 refund. To claim the child tax credit, John has ensured his child has a US Social Security number before filing his tax return.
By choosing to utilize the Foreign Income Exclusion at the start of his time overseas, he chose the simpler solution but gave himself less flexibility going forward. Athletes playing abroad should see a clear tax advantage in utilizing the Foreign Income Exclusion to begin taking it. Unless that advantage exists, the recommended path should be to take foreign tax credits.
Conclusion
Navigating the United States’ tax system as a citizen living abroad is difficult. Excluding your foreign income on Form 2555 is a simple and easy solution but is rarely the more beneficial approach and requires taxpayers to be diligent in their time spent in the United States. Choosing one or the other will not impact a taxpayer’s future social security calculation. Often times, reporting income and taking the foreign tax credit to offset the tax liability is more beneficial to US Citizens working abroad as it allows them to claim child tax credits and not concern themselves with how many days they are spending in the United States. For many international athletes, having the flexibility to come home during breaks should make this option more appealing.
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