What Is Double Taxation—and How Can Expats Avoid It?
As an American citizen, you’re required to file a US tax return even if you’re living abroad. If you already owe income tax to a foreign government, you could end up paying twice on the same income. Here’s what you need to know about US double taxation—and how to avoid it.
- Double taxation occurs when someone is taxed twice on the same assets or stream of income.
- US expats are often subject to double taxation, first by the US, and again by their country of residence.
- The IRS offers several tax credits and exclusions that expats can use to avoid double taxation.
What Is Double Taxation?
Double taxation means that you are taxed twice on the same income or assets. Americans living abroad are often subject to double taxation. This happens when you owe taxes to both the US and your country of residence.
Is Double Taxation Legal?
Fair or not, double taxation is allowed under US law. Some activist groups, such as Americans Against Double Taxation, oppose this and hope to remove double taxation from US tax law. For now, however, double taxation remains a reality for many Americans living overseas. The good news is that there are tax treaties, credits, and exclusions that expats can use to help avoid double taxation. (More on that below.)
Who Is Subject to Double Taxation?
Most expats are taxed by both the US and the country they reside in, resulting in double taxation. The US is one of the only countries in the world that taxes citizens regardless of where they live and work. Because of this, when a US citizen moves to another country with an income tax, they will have to report their income to both governments and face double taxation.
This applies to “accidental Americans” as well. For example, if you were born to at least one US citizen parent living abroad—thus becoming an automatic US citizen yourself— you would still be required to file a Federal Tax Return with the IRS. Once again, this would put you at risk for double taxation.
Shareholders in C-corporations, or regular corporations, are also a common target of double taxation, no matter where they are based. When a C-corporation generates profits, it must pay income taxes at the corporate level. Once the profits are distributed to individual shareholders in the form of dividends, those shareholders must report and pay taxes at the personal level for their piece of the pie.
This means that the shareholders only get to keep what’s left after the income has already been taxed twice, once at the corporate level and again at the personal. As a result, some C-corporations convert to an S-corporation or partnership to avoid double taxation. An S-corporation is a special type of corporation that is treated by the IRS as a partnership and not as a C-corporation.
Still with us? Double taxation can be a confusing concept, so just to make sure we’re on the same page, here are some helpful examples.
Double Taxation Examples
Mark, a US citizen, moved to the Netherlands to serve as an accountant for the Dutch branch of his company. His salary is $70,000. Because the Netherlands taxes residents, Mark will have to report that income to the Dutch government. However, because the United States imposes citizenship-based taxation, he will also have to report that same $70,000 to the IRS.
This would result in having to shell out two tax payments for a single year’s salary, reducing his take-home income significantly.
Lisa moved to Thailand, where she set up shop as a freelance web developer. She makes $85,000 per year, which she reports to the Thai government. But once again, as a US citizen, she will have to report the same amount on a US Federal Income Tax Return.
Because of this, Lisa could find herself losing a huge cut of her profits through US double taxation.
Julio left his home in Kansas and moved to Beijing, China to become an English teacher. He earns the equivalent of $30,000 per year. Being a US citizen, he must report that $30,000 to both the Chinese government and Uncle Sam.
US double taxation strikes again.
However, in all three of these examples, the people involved would almost certainly not be required to actually pay twice. This is because US tax law provides ample opportunities for Americans living abroad to avoid double taxation.
How to Avoid US Double Taxation as an Expat
1. Tax Treaties
The US has a number of tax treaties in place with foreign countries to prevent US double taxation. The two main types of treaties are:
- Income Tax Treaties
- Totalization Agreements
These treaties determine which country has the right to tax certain sources of income for citizens living overseas. For example, you may be required to report dividends to your country of residence, while pension payments are taxed only by the IRS.
However, almost every US tax treaty has a “saving clause.” This clause guarantees the right of each country to tax its own citizens as if the treaty didn’t exist. For US expats, this means that even if your country of residence has a US tax treaty, it won’t be a magic pill to save you from double taxation.
Still, many tax treaties do provide useful benefits for Americans living abroad. A qualified tax professional can explain your options and give tailored guidance for your specific situation.
2. Foreign Earned Income Exclusion
For some types of income, you won’t have to bother scanning tedious tax treaties to prevent US double taxation. Expats can use the Foreign Earned Income Exclusion (FEIE) to exclude a certain amount of foreign income from US taxation. The maximum exclusion amount changes each year. For tax year 2023, the FEIE exclusion limit is $120,000.
The FEIE can only be used to exclude “earned income from a foreign source.” Earned income refers to income that was received as compensation for a service, such as:
- Self-employment income
FEIE cannot be used to exclude unearned income, such as:
- Capital gains
- Pension payments
- Rental income
- Unemployment benefits
- Distributions from trusts or retirement accounts
To claim the FEIE, you must qualify under either the bona fide residence test or the physical presence test.
3. Foreign Tax Credit
Of all the options for avoiding US double taxation, the most reliable is the Foreign Tax Credit. In fact, this credit was instituted for the sole purpose of warding off double taxation for Americans living abroad.
If you qualify for the Foreign Tax Credit, the IRS will give you a tax credit equal to at least part of the taxes you paid to a foreign government. In many cases, they will credit you the entire amount you paid in foreign income taxes, removing any possibility of US double taxation.
If the Foreign Tax Credit you can claim exceeds the amount you paid in foreign taxes, you can carry the excess forward or back to reduce your tax liability in other years. And unlike the FEIE, the Foreign Tax Credit can be used to reduce taxes on both earned and unearned income.
Need Help Avoiding Double Taxation? We’re Standing By!
Hopefully, this article has given you a better understanding of what US double taxation is and how you can avoid it as an expat. Between tax treaty benefits, the Foreign Earned Income Exclusion, and the Foreign Tax Credit, it’s very rare that an American citizen living abroad will ever be subject to US double taxation.
Still, US tax law is nothing if not complicated—especially for citizens living abroad. It’s easy to make a mistake and either fail to meet your obligations or pay more than you need to.
Contact us, and one of our customer champions will gladly help. If you need very specific advice on your specific tax situation, you can also click below to get a consultation with one of our expat tax experts.