Imagine this: you're presented with a remarkable chance to live and work in Switzerland – a country that's always been on your travel wishlist. The offer comes with an enticing salary package and amazing benefits. But wait, what about the tax implications? Could you accidentally get into a tangle with the IRS?
If you're a U.S. citizen living and working abroad, you should prepare for potential tax complexities.
The United States boasts a taxation system like no other. Even if you're living abroad, you're still required to report and, in certain cases, pay taxes on your worldwide income. In simple terms, being a U.S. citizen means you're still tethered to U.S. tax obligations, regardless of where you currently call home.
Now, let's talk about Switzerland's tax system. Depending on the canton (which is like a Swiss state) you're residing and working in, Swiss income taxes might take a considerable chunk out of your earnings.
But in this blog, we're going to zero in on your U.S. income tax matters.
Understanding the Basics
So, what's in store for a U.S. citizen like you living and working in Switzerland? Well, here are three potential income tax breaks that might just brighten your financial outlook:
1. **Foreign Earned Income Exclusion:** This nifty provision lets you exclude up to $120,000 of your foreign income from federal income taxes.
2. **Housing Exclusion or Deduction:** You can also exclude or deduct certain foreign housing costs, like rent and utilities (except for telephone), from your taxable income.
3. **Foreign Tax Credit:** This one allows you to lessen your tax burden by the amount of taxes you've paid to Switzerland. It aims to prevent double taxation on your foreign earned income, but you can't use it on income that you've already excluded using the first two options.
Exciting, right? In this blog, we're your guide to navigating the intricate world of U.S. taxation while living and thriving abroad.
The Journey Begins: Foreign Earned Income Exclusion
Let's start with the Foreign Earned Income Exclusion, shall we? As a U.S. citizen living and working in Switzerland (or any other land), you could be eligible for this exclusion, which allows you to exclude a portion of your foreign wages from your U.S. taxable income.
But what's considered "foreign earned income"? Well, it's the money you earn for your personal services performed while you're living abroad. To qualify for this exclusion, you need to have a tax home in your host country and meet one of two residency requirements.
If you meet these criteria, you could potentially avoid federal income taxes on up to $120,000 of your earned income in 2023. And yes, both regular employment wages and self-employment income could qualify for these fantastic "living abroad" tax perks.
Decoding Tax Home and Residency
But what's this "tax home" thing? Well, it's not your physical home; it's the place where you regularly conduct your business. Your goal is to have that business location be in your host country to enjoy tax-free income.
If your work nature makes it tough to have a regular business location, your tax home becomes your "regular place of abode" (read: your residence). But keep in mind that if you're back in the United States for any stretch of time, your foreign tax home might slip away.
There are two primary tests for residency: the physical presence test and the bona fide residence test. The physical presence test involves residing in your host country (Switzerland, in this case) for 330 days within a 12-month period, which doesn't have to be continuous. This gives you some leeway for vacations or work-related travel outside your host country.
As for the bona fide residence test, it's a bit more strict. You must live abroad for the entire tax year without any days allowed for living or working in other countries. This one comes with no prorated exclusion for your first partial year.
To meet either test, courts consider factors like your intent to stay, having a home, family location, employment nature, and ties to the foreign country.
Making the Most of It
Here's a pro tip: if you're living abroad, plan your visits back to the U.S. so you meet the 330-day physical presence test within a calendar year. This way, you'll ensure Swiss residency under the safer test.
But remember, to qualify for the income exclusion, you have to collect your earned money before the taxable year ends following the year you earned it.
Dive into the Foreign Housing Exclusion
Now, let's explore the Foreign Housing Exclusion or Deduction. If $120,000 of tax-free income isn't enough for you, this option lets you claim an extra exclusion for certain housing costs. Here's the scoop:
1. Add up eligible expenses, like rent, utilities (excluding telephone), insurance, and repairs.
2. Deduct 16% of the $120,000 exclusion ($19,200) from your housing costs above.
3. Your foreign housing exclusion can't exceed 30% of the $120,000 exclusion ($36,000).
For instance, if your qualified housing costs in Switzerland are $60,000, subtracting $19,200 from it leaves you with $40,800. But since the maximum deduction is $36,000, your foreign housing exclusion or deduction would be $36,000.
Remember, certain expenses like capital expenditures, mortgage interest, real estate taxes, and more don't qualify for this exclusion.
Claim Your Exclusions
To get the ball rolling on your first taxable year for claiming these exclusions, you'll need to elect them using IRS Form 2555. This election stays valid for future years unless you decide to revoke it.
And if you're married and both you and your spouse are claiming these exclusions for the first time on a joint return, both of you should fill out a Form 2555.
Foreign Tax Credit: Taming Double Taxation
Now, let's tackle the foreign tax credit. Many foreign countries impose income taxes, and since you're in Switzerland, you'll likely pay taxes there. However, the U.S. doesn't want to tax your income twice. So, you can claim a foreign tax credit that reduces your U.S. tax liability by the amount of taxes you've paid abroad.
However, keep in mind that you can't claim both the foreign tax credit and the foreign earned income or housing exclusion/deduction on the same income. In other words, no double dipping. Your challenge is to figure out which of these two tax breaks benefits you more.
But wait, there's a twist – the foreign tax credit comes with some advantages. You can carry any unused credit amounts back one year and, if not used, forward for up to 10 years. If you've got dependent children with you in Switzerland, you might be eligible for the additional child tax credit. Plus, you have the flexibility to revoke your decision, unlike the irrevocable foreign earned income exclusion.
Reporting Foreign Financial Accounts
Since you'll likely have Swiss bank accounts as a U.S. citizen in Switzerland, be aware of your reporting duties regarding foreign financial accounts. If the total value of all your foreign accounts exceeds $10,000 at any time during the year, you're required
to file the Report of Foreign Bank and Financial Accounts (FBAR).
You may also need to disclose additional information on Form 8938, Statement of Specified Foreign Financial Assets.
If you have relatives or assets in foreign countries, your reporting obligations are far greater than what you have to report on the FBAR and Form 8938. Be sure to review the following article periodically: Beyond the FBAR: Discover Little-Known Traps in Foreign Reporting.
The tax forms shown in this PDF flowchart are some of the key forms required for reporting foreign financial transactions, income, and ownership. Failing to file these forms can result in hefty fines and penalties. Individuals as well as businesses need to understand and comply with the requirements.
Tax Treaties
You'll be interested to know that the United States has income tax treaties with many countries. Such treaties can impact your tax obligations. Treaties like these exist for various reasons, but mainly to prevent double taxation by promoting cooperation between countries in tax matters.
Under these treaties, you may be eligible for certain credits, deductions, exemptions, and reductions in the rate of taxes on certain items of income you receive outside the U.S.
For example, Article 23 of the 1996 tax treaty between the U.S. and Switzerland allows you to avoid double taxation. If you pay income tax in Switzerland, you can receive a credit against the U.S. tax on the same income.
Important. Foreign taxing authorities may require proof from the U.S. government that you filed an income tax return as a U.S. citizen. This proof would be needed to entitle you to the treaty benefits. Make sure you obtain these documents to help minimize your foreign tax liability.
Tax treaties with the U.S. vary from country to country. It’s best to consult with an international tax specialist who can provide some certainty and clarity for individuals and businesses operating overseas.
Social Security
International agreements (known as “totalization agreements”) eliminate dual taxation on Social Security and Medicare taxes.
The United States has entered into such agreements with 25 foreign countries. Totalization agreements exempt wages from Federal Insurance Contributions Act (FICA) taxes.
This is a beneficial tax break if your earnings are subject to taxes or contributions for similar purposes under the social security system of a foreign country. A similar exemption exists if you are self-employed.
Key point. You cannot use the social security taxes paid to a foreign country as taxes paid for the foreign tax credit due to a totalization agreement, because such an agreement eliminates the double-taxation threat.
For example:
· If your U.S. employer sends you to work in Switzerland for five years or less, you typically pay U.S. Social Security taxes and are exempt from Swiss social security taxes.
· If you are hired in Switzerland by a Swiss company, you generally would pay Swiss social security taxes and would be exempt from the U.S. Social Security taxes.
· If you are self-employed and live in Switzerland, you would pay Swiss social security taxes and would be exempt from the U.S. Social Security taxes.
Other Considerations
Aside from income tax obligations, U.S. citizens moving overseas should also consider other tax-related aspects. These may include inheritance and gift taxes, property taxes, and the potential impact of dual citizenship on taxation. Consulting with a tax professional who specializes in international taxation is highly recommended so you can navigate these complexities effectively.
Takeaways
As a U.S. citizen, you report and potentially pay taxes on your worldwide income, regardless of where you reside.
In this article, we sent you to Switzerland and triggered the possible use of either
· the combined foreign earned income exclusion and housing exclusion/deduction, or
· the foreign tax credit.
The foreign earned income exclusion permits you (as a U.S. citizen) to exclude up to $120,000 of your foreign earned income from federal taxes. To qualify, you need to have a tax home in Switzerland and meet one of two residency requirements, which involve staying in Switzerland for a certain duration.
The housing exclusion or deduction allows you to exclude or deduct certain foreign housing costs.
Alternatively, you can claim a foreign tax credit, which can reduce your U.S. tax liability by the amount of foreign taxes you paid to Switzerland. The foreign tax credit allows you to avoid double taxation. But you cannot claim, on the same income, both the foreign tax credit and the foreign earned income or housing exclusion/deduction.
The foreign tax credit has advantages over the foreign earned income exclusion because the foreign tax credit gives you
· the ability to carry back one year (and forward for up to 10 years) unused amounts,
· eligibility for the additional child tax credit, and
· the possibility of revoking the decision (in contrast to the irrevocability of the foreign earned income exclusion).
You can reach our CEO and Owner Peter Ellefson anytime at Peter@eplfs.com
Disclaimer: Laws and regulations are subject to change, and readers are advised to consult EPL advisors for personalized advice and compliance with specific state requirements. This information is not specific advice and is meant for general education.