Using the 2555 and expat tax exclusion is NOT always the best move for your taxes. In this video, I cover the Form 1116 and Foreign Tax Paid, and why you might consider going that route instead.
- The difference between the 2555 Expat Tax exclusion and the 1116 form and Foreign Tax Paid.
- Benefits to the 1116 you might not have considered.
- One example of how I helped an expat recover money from the U.S. government.
I hope this video helps clarify some of the issues. I’ve included a transcript of the video below for your reference. If you have any questions, the comments are enabled and you can feel free to contact me at anytime for a free consultation.
So the topic tonight is, “Should I use a 2555 and the expat exclusion or should I just use foreign tax paid which I always call FTP and 1116 without the exclusion?” And like I said in the last video in 2555, all expats know that they can use an exclusion of some sort. They are usually not sure about how much but it’s always around a $100,000, usually they know that. So, what most expats don’t know is that you really don’t have to use the exclusion at all, you can actually let the tax turn just calculate as if you are still in the United States and come up with a tax that you owe and use the foreign tax paid in your country of residence to pay the bill.
If you are in a high tax country, that will provide you with some more benefit, actually, because if China tax rate is 45%, very quickly and at a very low income level, when you pay full tax in China, then you are going to end up covering your US tax bill way more than you need to because the tax rate that you are probably in is 28% or so in America. So, the Chinese tax that you’ve already paid would cover the tax due on your US tax return and even if you use the exclusion, and it was zero tax and under both messages they were zero tax, the foreign tax paid method would benefit you more because any excess of, say Chinese tax, paid above the US tax owed, the US tax return can be carried forward for ten (10) years.
This is a huge benefit.
If you worked in China for five (5) years, your US tax rate was 28%, you’re paying full Chinese tax, you would have a credit that would roll forward every year in your US tax return that would roll forward for ten (10) years there that you could use against your income tax to pay that bill. So if you left in the 6th year after living in China for five (5) years and move back to the US, I would be talking to you, saying, “Hey look, I think you should finally exempt for federal tax withholding for depending on how big your credit is.” But let’s just say for one (1) year, two (2) years, and pay your tax bill with the credit is for you to use them up, so if you move back that’s a benefit that you can use to pay your income tax bill and that’s a huge benefit.
I often help clients to amend that part of their tax returns
Because what I’ve also learned after working in this area for the last five (5) or six (6) years in expat taxes is that normally there is like a three (3) year statute of limitations for the IRS to take a look at your tax return or to amend your return but this foreign tax paid area 1116 former 1116 in the tax return can be opened up and amended ten (10) years back and you can change it, amend it etc. because it’s got a ten (10) year window. That’s the only part of the US tax return that can be changed like that for that for that long of a period. And that’s a benefit!
I can go back− you know its 2014 right now and I can go back to 2005 if you just use the exclusion and you didn’t do these foreign tax credits right, and I can open it up again. Of course the IRS doesn’t want to give you the money and they are slow to pay, but at the end of the day they know they owe you and I’ve had clients that they have had to wait a year or year and a half but they eventually got the money.
Another situation like that is you have a client who didn’t pay any foreign tax and he gets caught, and you have to go back and pay− this one client had to go back and pay $120,000 USD in tax/Chinese taxes. And then we opened up this five (5) or six (6) years but the same years in the US tax returns and we amended them all and used the Chinese tax paid as credits against what he owed and asked for refunds.
It took a while to get that one (1) year or two (2) years but we eventually got some money back for him.
So ten (10) year carried forward foreign tax credits…
This is when the expertise and the accountant really comes in. You know, TurboTax pretty much sucks excuse me for expat tax. Its fine when it is in the US but I have corrected so many returns for plans to use turbo tax and they couldn’t− I mean I think I could file using TurboTax, but I would have to figure out how to manipulate the software to make it do what I want it to do and there is not enough fail safes built in under the expat tax return method or doing your expat tax return in turbo tax, there’s not enough fail safes built in so if you made a mistake, you really don’t know if you made a mistake and turbo tax is not going to auto correct you.
That that’s a risk, doing your own return if you are an expat in turbo tax but of course its fine if you are in the US I think. I also use turbo tax for in the US when I wasn’t working in the tax area.
But most accountants have heavy software that they are going to be able to switch back and forth and look at and say, “Ok this client has this situation, he’s got all his income, he’s got all his deductions centered etc., he’s got all his dependents centered, he’s got his tax situation..” and then he can flip back and forth between the foreign tax paid method and the 2555 method and that it pretty effective. You can really do that in TurboTax. So, I think the expertise and the accountant in that case really helps you a lot. You can say ‘hey look, under this method there is this credit carried forward for ten (10) years, under this method under 2555 we still don’t pay any tax but there is no carried forward.
The only caveat for this is that if you choose one method, you can’t flip flop back and forth every year to benefit you. So if you choose the foreign tax paid method, you got to stick with it for five (5) years, you can’t really change it back to the exclusion method until five (5) years of tax returns have been filed.
So if you are going to stay− that’s why I ask my client what’s your plan, are you going to stay in China for the next two (2) to three (3) years, are you going to move to Russia? But if you are going to move to Russia, then maybe I’m going to use exclusion because its only 13% flat tax in Russia and you are not going to have a carried forward. Guys in Russia or Americans in Russia, they always have to top up and pay an extra part of their tax between say they’re in the 20% tax bracket, they have got to pay 13% to Russia up to the 28% in America. The only ways to lower your tax in America if you live in Russia is that you know for their foreign tax exclusion, for 2014 you get $99,200.00 plus any housing you paid in rent above $15,000.00, so, that becomes your exclusion.
In this case, the way to lower your income tax paid to the US is just to live better.
So I have one client, you know Moscow is high and is very expensive, so I had one client and he was paying say $40,000.00 a year in rent USD and we said well, ok let’s have you live better and let’s increase it to $70,000.00 of rent. You can’t pay like a million dollars but the IRS uses, I think it’s about $114,000.00 in Hong Kong and it’s about $108,000.00 in Moscow and they are the top two (2) cities I think. So you got a pretty high range for rent so you can just live better and your exclusion go up and you will owe less US tax.
So that is better than paying the IRS for sure.
So any way I hope that makes sense to you and I will see you on the next video.