A Guide to Cross-Border Taxation: What You Need to Know as a U.S. Citizen Abroad

American taxpayers living abroad are theoretically taxed on their income first by the foreign country where they reside, although in practice there are often timing discrepancies in tax filings. In addition, both U.S. citizens and permanent tax residents living abroad must continue to file U.S. tax returns and report all of their worldwide income. In some cases, they will owe U.S. tax on their income during their time working abroad; however, there are special tax provisions in place to help avoid double taxation.

U.S. taxpayers who are living and working in a foreign country will normally not owe any state tax on their foreign income, because U.S. states generally base their taxation on an individual’s residency or intent to be domiciled within the state. However, many U.S. states are rather aggressive in pursuing former state residents in an effort to tax them, so always take care to follow the state’s rules to officially terminate residency.

Expatriate Assignments and Tax-Equalized Employment Packages

Often, American citizens and tax residents are initially sent abroad on a short-term assignment with their employer, usually for three years or less. In these cases, the employee might be offered a “tax-equalized” contract, which means two things. First, the employer will insulate them from most of the tax and administrative complexity of their foreign assignment and will completely handle their tax preparation needs. Second, the employer will also see to it that the employee is effectively taxed at the same rate as if they had still been living in the United States, thereby removing the effect of different tax rates from the overseas assignment—this is known as calculating their “hypothetical” tax.

At the end of the day, the employer basically ensures that the employee is equalized and made whole on a net after-tax basis. The employer will either pay the extra tax owed over and above the employee’s hypothetical tax liability or will keep any net tax advantage in situations where the employee’s effective net tax liability would have been lower while on assignment.

Tax-equalized contracts are becoming increasingly less common (except among senior-level executives). In part, this is because they are difficult to manage and inherently expensive and complicated. Additionally, there has been a general shift in business attitudes with regard to overseas assignments. Such assignments used to be seen as a significant hardship, but now overseas assignments are increasingly seen as an important opportunity for global experience and career advancement.

“Localized” Employment Contracts

Ultimately, far fewer tax-equalized contracts are being offered by employers, and instead employees are often from the start considered to be “localized” to whatever country they are sent. Localized employees are pretty much on their own. The responsibility for properly filing income tax returns shifts to them.

Many foreign countries have special tax incentives to attract foreign workers, such as a window of time—perhaps as long as 10 years—where an individual will experience a lower effective tax rate than would a typical resident of that country, and where the individual’s foreign assets and income are also not taxed in that country.

Where there is a good deal of income or net worth, the personal financial situation of a localized employee can become extremely complicated. Often these individuals and families have a very difficult time finding professional advisors who can offer informed and personalized financial advice; they are often left on their own to figure things out.

U.S. taxpayers living abroad will often find that they owe little to no additional U.S taxes on their foreign income. This is the result of two unique tax provisions that benefit those living abroad: (1) foreign income exclusions—including both the Foreign Earned Income Exclusion (FEIE) and the Foreign Housing Exclusion; and (2) foreign tax credits (FTCs).

Foreign Earned Income Exclusion

For many people, the FEIE ensures that foreign income is essentially taxed only by the earner’s country of residence. The FEIE allows U.S. citizens and tax residents to exclude a certain amount of their foreign-earned income for U.S. tax purposes every year, which in 2023 is $120,000 (adjusted annually for inflation). So, while those living abroad are still taxed on their worldwide income, the amount that is considered taxable in the United States is reduced by a significant portion every year.

Foreign Housing Exclusion

In addition to the FEIE, there is a related Foreign Housing Exclusion for foreign housing expenses such as rent and utilities. This enables U.S. taxpayers abroad to exclude from their U.S. taxable income a portion of their compensation that goes toward overseas lodging. Typically, the maximum allowable excluded amount is 30% of the amount of the FEIE ($36,000 for 2023). However, in most high-cost international cities it can be higher. There is also a base floor amount that you are not allowed to deduct, which is 16% of the maximum FEIE amount ($19,200 for 2023). This amount is subtracted from the taxpayer’s total housing expenses for purposes of calculating the housing exclusion.

Foreign Tax Credits

In situations where U.S. taxpayers still owe tax after taking advantage of the FEIE and Foreign Housing Exclusions, they still have the option of applying FTCs to reduce or eliminate any U.S. tax liability.

FTCs allow U.S. taxpayers to claim a dollar-for-dollar credit for taxes paid in a foreign country against any U.S. tax that is due on their foreign-sourced income. Consider, for example, that if the effective tax rate that they pay in a place like the United Kingdom is higher than their tax liability to the IRS, by applying a credit to their U.S. tax liability for the foreign taxes that have already been paid, they would not have to pay any additional U.S. tax. They may even accumulate a foreign tax credit carry forward, which can be used at a later date to reduce U.S. tax—if they continue to have foreign earned income in the future.

However, there is another element to this called the “scale-down rules,” which limit the use of certain FTCs when you also use the FEIE and/or housing exclusions. Essentially, U.S. taxpayers may not claim a credit for foreign taxes that relate to income that was already excluded for U.S. purposes via the FEIE and/or housing exclusion.

Revoking the Foreign Earned Income Exclusion

When living in a country with a higher tax rate than the United States, people are likely to have sufficient foreign tax credits to offset the U.S. tax on foreign income items, making the Foreign Earned Income and Foreign Housing Exclusions unnecessary. Surprisingly, utilizing these exclusions can result in owing higher U.S. tax than if you didn’t use them (or significantly reduce foreign tax credits that carry over and can potentially be used in the future). The reason for this is complex, but essentially there are “stacking rules” when using the FEIE that cause all non-excluded income to be taxed at higher tax rates (stacking rules require excluded income to be added back for purposes of calculating tax rates).

This means that if there is income that is not eligible for foreign tax credits, it will be taxed at a higher average rate. Fortunately, the FEIE and/or the Foreign Housing Exclusion can be revoked. But be careful: once revoked, they generally cannot be elected again for five tax years!