Tax Talk Thursdays: Common Tax Traps for U.S. Expats—and How to Avoid Them

Living abroad can be an exciting adventure, but for U.S. citizens, it comes with a unique set of tax obligations. The U.S. is one of the few countries that taxes its citizens on worldwide income, regardless of where they reside. This can lead to unexpected tax traps for expatriates. Here are some common pitfalls and how to navigate them.

1. Assuming You Don't Need to File U.S. Taxes

Even if you've paid taxes in your country of residence, you're still required to file a U.S. tax return if your income exceeds the filing threshold. This includes reporting all worldwide income, not just income earned in the U.S.  As long as you are a U.S. citizen or a green card holder you have a U.S. tax filing obligation.

Avoidance Tip: Always file your U.S. tax return, even if you owe nothing. Utilize provisions like the Foreign Earned Income Exclusion (FEIE) and Foreign Tax Credit (FTC) to mitigate double taxation.

2. Overlooking Foreign Bank Account Reporting (FBAR)

If you have foreign financial accounts exceeding $10,000 USD in aggregate at any time during the year, you're required to file an FBAR (FinCEN Form 114). Failure to do so can result in hefty penalties.

Avoidance Tip: Keep track of your foreign account balances and ensure timely FBAR filings. Remember, this is separate from your tax return.

3. Misunderstanding the Foreign Earned Income Exclusion (FEIE)

The FEIE allows qualifying individuals to exclude a certain amount of foreign-earned income from U.S. taxation. However, it doesn't apply to all types of income, such as passive income.

Avoidance Tip: Determine if you qualify for the FEIE based on the bona fide residence or physical presence test. Consult a tax professional to understand which income types are eligible

4. Neglecting to Report Foreign Investments

Owning foreign mutual funds, ETFs, or other investments can trigger complex reporting requirements and potential tax liabilities under the Passive Foreign Investment Company (PFIC) rules.

Avoidance Tip: Before investing abroad, understand the U.S. tax implications. Consider consulting with a tax advisor to navigate PFIC rules and reporting obligations.

5. Assuming Tax Treaties Eliminate All U.S. Tax Obligations

While the U.S. has tax treaties with many countries to prevent double taxation, these treaties don't exempt you from filing U.S. tax returns. Moreover, not all income types are covered under these treaties.

Avoidance Tip: Review the specific tax treaty between the U.S. and your country of residence. Understand which income types are covered and which aren't.

6. Failing to Report Foreign Gifts or Inheritances

Receiving a significant gift or inheritance from a foreign person may require you to file Form 3520. Failure to report can result in substantial penalties.

Avoidance Tip: If you receive a foreign gift or inheritance exceeding $100,000, ensure you file the necessary forms to stay compliant.

7. Overlooking State Tax Obligations

Some U.S. states require you to file state tax returns even if you're living abroad, especially if you maintain ties to the state.

Avoidance Tip: Determine your state residency status and understand the filing requirements. Consider severing ties with your state of prior residence if possible.

8. Owning More Than 10% of a Foreign Corporation or Partnership

U.S. expats who own more than 10% of a foreign corporation, partnership, or LLC can trigger serious reporting requirements—specifically Form 5471 or Form 8865. The penalties for noncompliance can reach $10,000 per form, per year.

Avoidance Tip: If you're starting or investing in a foreign business, consult a tax advisor beforehand. These rules are detailed and can apply even if you're not actively involved in management.

9. Overlooking Reporting Requirements for Foreign Pensions

Many foreign pension plans—especially employer-sponsored pensions or personal retirement accounts—are considered foreign trusts under U.S. tax law. This means they may trigger Form 3520 and Form 3520-A reporting requirements.

Avoidance Tip: If you have a foreign pension (e.g., a UK SIPP, Australian superannuation, or Canadian RRSP), you may be required to report contributions, earnings, and distributions. File Form 3520 for annual contributions or withdrawals and Form 3520-A for annual trust activity. Penalties can be up to 35% of the value of distributions or contributions.

Navigating U.S. tax obligations as an expatriate can be complex, but with awareness and proactive planning, you can avoid common pitfalls. Always consult with a tax professional experienced in expat tax issues to ensure compliance and optimize your tax situation. If you are an expat and need assistance with your taxes please contact us at info@mkhstaxgroup.com.