Because the United States (US) taxes the income of its citizens, resident aliens, and domestic corporations regardless of where it is earned, there are special tax rules for the taxation of income earned in other countries. Nonresident aliens and foreign corporations are also taxed on income that is effectively connected to a trade or business conducted within the US. Additionally, special tax rules apply to residents of US possessions and to US shareholders of foreign controlled corporations.
For US taxpayers working in other countries, the US tax code provides either a foreign income exclusion credit of almost $100,000 or a foreign tax credit to lessen the burden of double taxation by 2 countries on the same income. The taxpayer can also choose to deduct expenses for living and working in the foreign country. For more information on the foreign earned income exclusion, see Foreign Earned Income Exclusion, and for more information on the foreign tax credit, see Foreign Tax Credit.
Special Tax Rules for Residents of US Possessions
If a taxpayer becomes a bona fide resident of a US possession or ceases to be a bona fide resident, then Form 8898, Statement for Individuals Who Begin or End Bona Fide Residence in a US Possession must be filed for the tax year in which the taxpayer has worldwide income exceeding $75,000; otherwise a $1000 penalty may be imposed.
A US citizen who is a year-long resident of Puerto Rico reports income on the Puerto Rico tax return. Income from US sources is also reported on the Puerto Rico tax return, but a credit may be claimed for the income taxes paid to the US. A nonresident of Puerto Rico reports Puerto Rico income on a Puerto Rico return.
Bona fide residents of American Samoa can claim a possession exclusion on Form 4563, Exclusion of Income for Bona Fide Residents of American Samoa, excluding their American Samoan sourced income.
Foreign Currency Conversion
Income that is reported on the US tax return must be in US dollars. If the taxpayer receives foreign income in foreign currency, then the amount must be converted to USD using the official rate, the open market rate, or other relevant rate that gives an accurate conversion amount.
Sometimes, a foreign currency cannot be converted. A blocked currency is one that cannot be converted into USD. In such a case, the taxpayer receiving income based on a blocked currency may delay reporting the income until the earliest of:
- the currency becomes convertible into dollars;
- the currency is actually converted into dollars;
- the currency is used to pay personal expenses;
- the currency is given as a gift or transferred pursuant to a will; or
- the taxpayer was a resident alien who gave up his US residency status.
No expenses can be deducted during the deferral period and the method cannot be changed without the permission of the IRS.
When the currency becomes unblocked, then all of the income earned during the years that the currency was blocked becomes taxable in the year when it becomes unblocked. The amount is converted into US dollars at the applicable conversion rate for the tax year in which it is reported. If the taxpayer earns income from more than 1 country with blocked currencies, then separate returns must be filed for each country.
Foreign Bank Accounts
If the taxpayer has a foreign bank account with an aggregate value exceeding $10,000, then it must be reported on Form TDF 90-22.1, Report of Foreign Bank and Financial Accounts. The form is filed with the Department of the Treasury by June 30 after the tax year in which the taxpayer had a financial interest in the foreign bank account.
There are hefty penalties for failure to report foreign bank accounts. If the failure is not willful, then a civil penalty of up to $10,000 can be assessed. For willful failure, the fine can be the greater of $100,000 or 50% of the amount in the foreign bank account. Criminal penalties may also apply.