EP 13: Between A Rock & A Hard Place: A Quick Guide To Mitigating Double Taxation
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The U.S. taxes you on your worldwide income, regardless of where you live. If you live in the U.S. and have foreign income, or live abroad, you have to report your foreign income on your U.S. return.
The other country in the equation is also very interested in your income, especially if you live there. And so the fear of being double taxed is real and justified.
We are going to talk about Avoiding Double Taxation.
In this episode, we'll discuss the two main ways of mitigating this issue.
FEIE - Foreign Earned Income Exclusion and Foreign Tax Credits
In addition, we'll also discuss how income is classified, income sources, and tax treaties, as well as some ideas on dealing with stock options (RSU's ISO's, etc).
We'll end it by talking about some financial planning opportunities, that you can use in this situation, as well as the idea that we are not just focused on saving taxes now, but we are looking at a long-term approach.
The speakers' views and opinions discussed in this episode, should not be considered financial, tax, or legal advice. Consult your advisor for any legal, cross-border tax, and financial advice.
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Jane Mepham, CFP (00:05.302)
Since we are recording this on the cusp of tax season, our thoughts are a lot about taxation, tax planning, tax savings. And so we are going to talk about a subject that everybody who lives in the US and has foreign income,
or you live abroad and you have to report your foreign income on your US return, it's probably going to be really, really interesting. The topic today is avoiding double taxation.
Manasa Nadig, Enrolled Agent (00:43.606)
Yes, yes, Jane. And most important, for those of you, like Jane just said, have a footprint in more than one country, or you live abroad and you have to report your worldwide income on your US taxes, your biggest worry is, is my income subject to double taxation? And if it is, how can I find ways to mitigate that? Right? So...
Let's break this down. There are several ways of mitigating double taxation and we'll talk about the two most important ones. The first one is the FEIE or the foreign earned income exclusion. So by its very definition you can see that this is an exclusion that you can take from reporting some or all of your earned income.
from foreign sources. So when we look at earned income, we can see that necessarily means it's either wages and salaries or some kind of self-employment income from a foreign source. And also, because it is a foreign earned income exclusion, it becomes necessary that you pass one of two tests, which is either
the bona fide test or the physical presence test. And under each of these, there are some nuances, but the biggest point is that you should have been living outside the country, that is outside the United States, for more than 330 days in a year. Sometimes this can be a rolling period.
And we can go into those details maybe at a later date. But just to explain what the foreign earned income exclusion is, there are these annual limits every year. And so for example, for 2023, it's $120,000 that you can exclude against your foreign earned income. You should have lived outside the country. And you should have a
Manasa Nadig, Enrolled Agent (03:06.738)
being able to claim either the bona fide test or the physical presence test. All of this is reported on Form 2555, where you will provide the Internal Revenue Service information on your employer. Again, about
the number of days you were outside the country. And even if you made trips to the US and went back, what that was so that the IRS has a chance to see that even though you came in and went out, the total number of days you were outside the country was at least 330 days or more. And also, you know, your spouse can claim a foreign earned income exclusion.
their foreign earned income if they had any if you're filing married filing jointly.
Now you wonder what if my income was more than the $120,000 it was for 23, right? Which is the foreign earned income exclusion limit. Now for the overage that goes past the exclusion if the same income was taxed in the foreign country that this income is from, then you have that tax that you paid in the other country.
for use as a foreign tax credit. Also, if you were in a country where there was no taxation, there are a lot of countries that don't have taxes on their earned income, then that income that goes over the foreign earned income exclusion limit will be subject to US taxes. And of course, what
Manasa Nadig, Enrolled Agent (05:10.866)
and how much taxes you pay on this will depend on how you file, what is your filing status, whether you have dependents, whether you claim the standard deduction or the itemized deduction, et cetera. So basically, that's a 3,000-feet view of the foreign earned income exclusion, which is one of the ways that you can mitigate double taxation up to a certain limit.
Jane Mepham, CFP (05:39.378)
Actually, before we jump to the FTC, which you've mentioned, can we stay on this for just one more second and have you talk about the five-year rule that you and I talk a lot about when you're using the FEIE. Could you just briefly explain what that five-year rule is?
Manasa Nadig, Enrolled Agent (06:01.418)
Yes, yes, definitely, Jane. It's an important rule to remember, especially when you're planning on using the FEIE. And a lot of things that goes into this, which we will discuss more as we go along, but the five-year rule basically is that if you were using the foreign earned income exclusion on your taxes, and then you decide that was not the best way for you
or that was not mitigating taxes, or you had enough of a foreign tax credit that you could offset, for whatever reason, you decided to stop using the FEIE. Then remember that you cannot go back to using the FEIE for five years. You have to wait for five years before you can make the foreign earned income exclusion again.
Jane Mepham, CFP (07:00.266)
So, wait a minute. So the part that's crazy that I think trips a lot of people, so we tell them you can't go back to using it for five years. Does it matter how long you've used it? So could I have used it for five continuous years, 10 continuous years, and then I stop and it's like, okay, Jane, sorry, you have to wait for five years. Is that what you're saying? It doesn't matter how long you've used it before? Oh.
Manasa Nadig, Enrolled Agent (07:00.434)
So that's the five-year rule. Yeah.
Manasa Nadig, Enrolled Agent (07:26.994)
Yeah, it doesn't matter for how long you've used it. If you stop, then you have to wait for five years to go back to it. Yes.
Jane Mepham, CFP (07:35.902)
Okay, okay. Sounds good. It really does make taxation complex. But let's talk about then some other important aspects on top of this that we want people to know as they figure out how to avoid double taxation. And I know there's a whole bunch of things you and I have talked about. So let me have you actually talk about income and the source of income.
Manasa Nadig, Enrolled Agent (07:42.658)
for sure.
Manasa Nadig, Enrolled Agent (08:03.518)
Yes. So the other tax mitigation strategy is the foreign tax credit. The foreign tax credit basically is a way for you to claim taxes that you have paid in the country where your income is sourced from and you claim that on your U.S. taxes and you know therefore you avoid
double taxation. A, from the very nature of the fact that it's a foreign tax credit, you should have paid these taxes or that you should have owed these taxes on the same income to another country. And how the tax is calculated is kind of complicated and it's not something that you can just sit and do on the back of an envelope. But again,
3,000 feet view, right? So we look at the taxes that you have paid or you owe to the other country. You adjust the income and the taxes paid in the other country to fit the year in the United States. Say for example, and we've talked about this before, there are countries which are on the same cadence as the US, which is the calendar year.
or they could be on a different cadence, where their financial year could go for different months. So you have to make sure that the income and the taxes that you're calculating is adjusted for the US tax year, which is the calendar year. You have to look at the exchange rates, right? So the treasury announces exchange rates for most countries every year.
And these treasury exchange rates come out in the end of the year, around December or beginning of January. And then you can apply these exchange rates to the foreign tax credit, which is usually an average tax rate for the whole year. And that makes a difference. And then the calculation itself is the foreign tax credit is
Manasa Nadig, Enrolled Agent (10:27.222)
proportion of your foreign income to your total worldwide income. So there's that math, you know, the numerator is the foreign total foreign taxable income and the denominator is your total worldwide taxable income. And I like to point out to my clients that the closer this fraction is to one,
you know, the bigger will be your foreign tax credit. And like I said, again, this is, you know, a very broad overview of this topic. And the most important thing to remember is that your foreign tax credit on your US tax return cannot go over your US tax liability, which means that you cannot claim a refund from the IRS for taxes that,
over what you paid to the other country. Now obviously your next question is, hey I paid a lot of taxes to the other country, what about all of that I couldn't use? Right? So don't worry those taxes can be carried forward for 10 years and as long as you have foreign income, you have to have foreign income to be able to use these
Jane Mepham, CFP (11:31.243)
Yes.
Manasa Nadig, Enrolled Agent (11:52.258)
foreign tax credits against that foreign income.
How about that Jane?
Jane Mepham, CFP (11:59.359)
pretty nerdy, but I think it's what it is and that's what it entails if you find yourself in this situation. So, let me pull you back out a little bit. Could you say something about, because this is one that I see people bring up, foreign housing exclusion and just give it like a brief treatment?
Manasa Nadig, Enrolled Agent (12:23.058)
Yes, yes. So the foreign housing exclusion is based off of essentially where you live if you're claiming the foreign earned income exclusion. And each country has a certain calculation which is on the IRS website. It's very readily available. You can go and look it up. It's based on where you live, which city, et cetera. And there's a certain, you know,
an additional housing exclusion available to you. And there is a top limit. You can't go over a certain number and claim that a housing exclusion. But if you are spending that much money or your employer provides housing to you, that's another option that you can look at, which is the foreign housing exclusion, which is a part of the foreign earned income exclusion. And it gets also calculated and claimed on the same form.
as the FEIE. Does that help?
Jane Mepham, CFP (13:24.386)
Okay, great. It really does, but I'm going to just keep throwing these questions that I'm seeing as we're talking through this. Obviously, we've talked about the FTC. There's also the whole idea of the active passive packets. Do you want to say something briefly about that?
Manasa Nadig, Enrolled Agent (13:44.462)
Absolutely, yes. So the foreign tax credit basically is, you know, there are various different categories of income on which the foreign tax credit can be claimed. Sometimes you look at a foreign tax return and you can easily demarcate how much income went against what. But let's step back a little bit to what Jane was saying earlier. There is...
income that's active, which is your earned income from wages, salary, self-employment, etc. And then there is the passive income, which is your income from investments and rentals, etc. And there is also certain other income, which is like guilty income, etc. And guilty is not guilty. It's an acronym, G-I-L-T-I. And, you know, there are different categories of income. And
It is important when you're calculating your foreign tax credit to be able to assign brackets to these income sources and what categories that they would fall into and what taxes can be assigned again to these different sort of categories. So
how much of the tax was towards active income and how much of it was towards passive income, et cetera. And that's the breakdown and the form on which the foreign tax credit gets calculated is the 1116, 1116. And there is a way that you can show the Internal Revenue Service what income was from which category and how much of the tax is going towards which and all of that good stuff. Yeah.
Jane Mepham, CFP (15:39.302)
a great explanation and you saying that has actually brought to mind something I've seen with clients who were working in the US and now they've moved overseas when it comes to their stock options. So the whole idea of active passive buckets really comes into this. And so if you have options, and this could be all kinds of different options, RSUs,
ESOPs, let's see ESPPs, ISOs, you really want to pay attention to this bit or you really want to be thinking about it. So let's use the example of somebody, though here they moved to the, I mean to another country overseas and they had RSUs or other options that had been granted to them. Now using RSUs as an example, because we know you don't really choose when that...
vest and when it vest, it actually becomes your income. You're actually going to find, let's say, as soon as that vest in the U S because that's part of your compensation, the U S will tax you. If you happen to live in a country where they don't tax overseas income or worldwide income, you'd be okay. But if you happen to live in another country where they tax you on your worldwide income,
taxation, they will tax you on that. But this is where as Manasa has explained, you know, using FTC and other mitigating strategies, really I think the foreign tax credit, you'll be able to get some of that credit back.
And so one of the things we've said, it's really not business as usual for you. So if you have foreign income and you've got stock options, the best thing you can do is really get a little bit nerdy, draw yourself a little chat that says, this is what I have here. This is the date when I got this. And this is the type of options that I got. Okay. I then moved over.
Jane Mepham, CFP (17:45.878)
to these other country and this is when this vest and really using that will be able to help you hopefully figure out what is being double taxed and what you can do to mitigate some of that. So I think what we're really saying, Manasa is it's not business as usual, right?
Manasa Nadig, Enrolled Agent (18:07.63)
Absolutely. And since we're talking about foreign tax credit, you should also, and to your point earlier, if you are in a country where there is taxation, or you have income from maybe more than one country where one country has taxation and another country does not have any taxation.
It happens. People move around a lot these days. There is a lot of things that can apply to you. And then maybe you have to look at how maybe you can combine these factors, where you can take both the FEIE and the FTC. That can be another planning option. And also a way that you can classify
probably income from more than one country and you're paying taxes to both those countries, then how are you mitigating those double taxation, you know, if you're subject to it. Also, Jane, you know, when you're talking about RSUs and ESOPs and all that good stuff, I think we should also look at tax treaties.
and in other parts of the world, they are called double tax avoidance agreements or DTAs. So tax treaties, the provisions in the tax treaties and the DTA also become a very, very important aspect of your tax planning. And that is something that's always in the background of what we do. The tax treaty sometimes points you to what you should be doing.
Jane Mepham, CFP (19:30.474)
Yes.
Manasa Nadig, Enrolled Agent (19:58.122)
in terms of tax planning and financial planning, especially if, you know, let's say for example, if you're one of those auto workers who has income from maybe both Canada and Mexico and the United States, and you know, all of these countries are taxing your income, you know, what are your options then? Where were you? How long were you outside the country? That becomes another thing.
And also remember, if you are a green card holder, and if you live outside the US, then you might have even more options to look at maybe closer connections or other things where double taxation can be mitigated. So definitely tax treaties are important as well to take into consideration when you're looking at.
mitigating double taxation.
Jane Mepham, CFP (20:58.17)
So you mentioned green card and green cards and being outside the US. And I think we probably need to do a whole different post on this because I do get a lot of questions on, okay, I'm leaving the country and my green card. But anyway, coming back to the whole idea of double taxations and double taxation avoidance, one of the things as we mentioned to keep in mind is you really want to do take a long time view on this.
focused on helping you reduce or avoid double taxation this minute, we need to be thinking long term, five, 10 years, because at the end of the day, we still want you to be able to save obviously for your future, for your retirement. So one thing that comes to mind is if you apply the FEIE, for example, you exclude your income and you want to contribute to, let's say, your IRA or anything like a raw, you
that cause for an income, you need to be mindful of the fact that if you end up excluding all your income, then as far as the US is concerned, you won't have money to put into some of these retirement vehicles. So you want to be careful about how far you exclude your income if you're thinking of saving for the long term.
But other things like, let's say the 529, one of our favorite accounts, you should be able to save into that with your after tax dollars, as long as the beneficiary has social security number or 19 number. So keep in mind, I think really the whole idea is it's long term and you want to keep that in mind. Is there anything else you want to add to this, Manasa? I don't want to go too far on this.
Manasa Nadig, Enrolled Agent (22:50.006)
No, no, I think this is really great. One thing that I would like to add to the FEIE is to remember that it cannot be a partial FEIE if you decide to go down that route to your point earlier about having enough earned income to be able to make these contributions is you can't say, oh, I'm gonna take the FEIE, but I'm going to only take like, you know.
Jane Mepham, CFP (23:06.532)
Oh.
Jane Mepham, CFP (23:10.43)
Mm. Yeah.
Jane Mepham, CFP (23:17.696)
Mm-hmm.
Manasa Nadig, Enrolled Agent (23:19.926)
maybe $60,000, you can't do that if you decide to take it. It has to be up to the annual limit, which your income may be lower than that, and then therefore all of it might get excluded. So this is kind of when what we were talking about earlier, right, Jane, before we started recording is how much of these nuances go into tax and financial
Jane Mepham, CFP (23:21.991)
Okay, that's good to know.
Mm-hmm.
Jane Mepham, CFP (23:41.535)
Mm-hmm.
Manasa Nadig, Enrolled Agent (23:49.326)
planning when you have a footprint in more than one country. And how important it is to keep those conversations going with both your tax and your financial professional and have them maybe talk to each other as well. And also remember that where cross-border matters are involved, not one size fits all. Sorry.
has to be a unique planning that goes for each of you. So you can't go with, oh, my friend is doing this. So that's another important thing that I remember having to say to a lot of my clients. So yeah. But I think we spoke about good double tax avoidance strategies today, and we're good to wrap up today's episode and you know.
Dear listener, we love to bring you this content. And if you have questions that you want us to answer or have topics you would like us to cover, please go to our website, theiamcafe.com, subscribe to our newsletter, and please like, share, and subscribe. Bye for now.
Jane Mepham, CFP (25:11.274)
Bye. I got my coffee.
