Last week we talked about year-end tax planning. This week we are going to discuss tax forms that every US taxpayer with foreign income or foreign assets needs to know.
One of the key tax principles we have been discussing since the earliest posts is that a having good handle over taxes includes more than just proper reporting and correct calculations of the tax liability.
Tax return reporting is what we do after the fact. Before the fact, we use tax planning to reduce our taxes.
Tax planning can be complex, but it doesn’t have to be. Simple tax planning steps can be taken by any of us, even if our income is low, to help us reduce our tax liability.
This week we are going to start discussing tax reporting, the after-the-fact part of taxation, in more detail. We are starting this discussion now because we are already in December (can you believe it?), which means that in just a couple of months, the 2020 tax season will begin. We better start getting ready!
Proper tax reporting is important because it also helps keep our tax liability to a minimum. How does it do that?
By taking care of our tax reporting correctly, we can stay out of trouble with the IRS and any relevant state tax authorities.
Sometimes the IRS and state Departments of Taxation make mistakes when processing our flawlessly prepared tax returns. We can’t do anything about their mistakes, but we can give them as little reason to contact us as possible by being well informed, and careful, about doing things correctly on our end.
Shall we give it a try?
We will start today by reviewing the most important tax forms that may need to be included in your tax filing. Since most of you have income and/or assets outside the United States, we are going to focus on the twenty most commonly used tax forms that apply to foreign income and/or assets.
Let’s get started:
Form 1040 or 1040-NR Individual Income Tax Return: this is the mother of all of forms. The form that is used to consolidate the information from all the other forms, bring all the amounts together, and calculate the tax liability. Form 1040 is used by US tax residents to report their worldwide income and Form 1040-NR is used by nonresidents to report their US source income. We covered sourcing of income and tax reporting obligations of residents and nonresidents in CBP No. 19, No. 21 and No. 22.
Schedule A Itemized Deductions: this is the form where taxpayers take deductions to reduce their tax liability for things such as medical and dental expenses, taxes such as state and local and other taxes, mortgage interest, gifts to charity and other deductions such as losses from theft or federally declared disasters. What itemized deductions are most common among our readers?
- For US expats who use the Foreign Earned Income Exclusion (FEIE): Medical and Dental are expenses. Why? Because although there is a 7.5% Adjusted Gross Income floor before medical and dental expenses become deductible, the FEIE reduces AGI. This allows taxpayers using the FEIE to deduct much lower amounts of medical expenses than taxpayers who do not use the FEIE. Let’s use an example: Annie’s only income is $120,000 of foreign wages. Annie qualifies for the FEIE. Her AGI is $12,400 ($120,000 – $107,600 of FEIE). Annie can deduct medical expenses above $930 (7.5% of $12,400) in her Schedule A. If she wasn’t using the FEIE, she would only be able to deduct medical expenses above $9,000 (7.5% of $120,000). Using the FEIE allows Annie to deduct $8,070 more in medical expenses than what she would be allowed to deduct if she didn’t use the FEIE.
- Tax planning opportunity for taxpayers using the FEIE: keep track of all your medical expenses because even low amounts can become deductible. Caveat: be mindful of the standard deduction. If your deductible medical expenses are low, using the standard deduction may provide a greater tax benefit unless you have other deductible itemized expenses such as mortgage interest, state property taxes and gifts to charity.
- For US taxpayers who pay foreign income taxes and don’t use the foreign tax credit: foreign income taxes that are not used as a foreign tax credit are tax deductible. Caveat: foreign tax credits reduce income tax dollar for dollar. Foreign tax deductions reduce tax at the marginal tax rate. Foreign tax credits are therefore generally more valuable than foreign tax deductions. Make sure to calculate your tax owed under both options before choosing to forgo the tax credit and use the income tax deduction.
- For US taxpayers with principal or vacation homes abroad: the mortgage intertest deduction. Mortgage interest is deductible even if the mortgage is foreign, with the same restrictions as US mortgage interest: the mortgage must be on the principal or second residence; and the interest must apply to the portion of the mortgage balance that is below the relevant threshold (up to $750,000 or $1,000,000 for married filing jointly returns and up to $375,000 or $500,000 for everyone else)
Schedule B Interest and Ordinary Dividends: this form is used to report interest and dividend income. For taxpayer with foreign bank accounts though, the most important part of this form is Part III: Foreign Accounts and Trusts, where questions are asked about the ownership of foreign accounts, the country where those accounts are located, and any transactions with foreign trusts. The instructions to this form state that Schedule B must be filed even by taxpayers who have no interest or dividend income, if they had a financial interest or signature authority over a financial account in a foreign country, or if they had transactions with a foreign trust. In these times of negative or zero interest rates, it is possible to have foreign bank accounts and no income to report from them. Even in those cases, Schedule B must be filed to report that the foreign accounts exist, and even if the aggregate balance of those accounts is below the FBAR filing threshold.
Schedule C Profit or Loss from Business: this form is used to report income and expenses related to conducting a business. Schedule C is required when the business is conducted in the form of a sole-proprietorship, which means that the taxpayer is conducting the business directly in their own name, with no entity involved (no LLC, no S Corp or no foreign entity) or the taxpayer is conducting the business through a disregarded entity, such as a single member LLC or a foreign equivalent of a single member LLC, as long as the foreign entity has made an election to be treated as a disregarded entity for US tax purposes. Schedule C applies whether the business is conducted in the USA or abroad. In the case of a business conducted abroad, for example, a US citizen living in France providing services as an independent English tutor, in addition to the Schedule C, since 2018, Form 8858 is also required.
Form 8858: this form is used by US persons who are tax owners, directly or indirectly through another foreign corporation or partnership, of foreign disregarded entities, to report the business activity of such entities. Also, thanks to changes in our tax law enacted under the Tax Cuts and Jobs Act of 2017, as of 2018, this form must also be used by US persons who operate foreign branches.
What is a foreign branch? The IRS defines a foreign branch as a business operation carried on by a US person outside the USA. The IRS will use facts and circumstances to determine if a foreign branch exists. Examples of such facts and circumstances includes keeping separate books and records, having a fixed place of business or an office abroad, or conducting any business activities that would be considered a permanent establish under the provisions of a tax treaty. Any US person, including individuals, can be deemed to have a foreign branch. It is precisely because of this broad definition, that the American providing English tutoring services in Paris would have an obligation to file Form 8858, as ridiculous as it may seem. Form 8858 is an information return, which means that no items of income flow from this form to Form 1040. The items of income flow from the Schedule C to Form 1040. And yet, this form is an additional reporting requirement for the American tutor in Paris, one which the IRS believes carries an automatic failure to file penalty of $10,000. Isn’t that lovely?
There is sufficient meat to this form to merit its own issue of CBP, which we will take care of after having introduced the 20 main forms we will discuss in the coming issues of CBP. For now, this introduction should do enough to spike your interest, if you think this form may apply to you.
And with this, I leave you until next week.
Un abrazo y Buena onda,