Major 2020 US expat tax concerns for UK accountants

From state residency woes to FBAR/FACTA reporting, filing a US tax return can be difficult for US taxpayers residing in the UK.

Compounding those difficulties, the US’ Internal Revenue Service (IRS) has instated new legislation in recent years, ranging from zombie tax breaks to a revamped standard deduction.

As the US tax season ramps up ahead of April 15, UK accountants filing for US expat clients need to be aware of commonly missed and misconstrued IRS requirements.

While Americans living in the UK often have to double file taxes, the two countries have a reciprocal tax agreement that aims to stop double taxation on both income and capital gains tax.

“US citizens and resident aliens are taxed on worldwide income no matter where they live or where the income is earned,” Russell Schneidewind, lead tax research analyst at H&R Block’s Tax Institute, explained via email.

“They are also usually taxed in another country if living in that other country or working in that other country. They can then use two different methods to try to remove this double taxation.”

US expats can either take advantage of Form 1116 (Foreign Tax Credit) to claim a credit for their already-paid foreign taxes, or Form 2555 (Foreign Earned Income), which allows an exclusion of up to $100,800 of foreign-earned income.

Notably, once used, Form 2555 remains in effect until the taxpayer revokes it.

“The primary difference between the two is the Form 1116 credit can be taken on other types of income than earned income such as pensions and gains from a sale of property, and the Form 2555 can only be taken on earned income such as wages and self-employment income,” said Schneidewind.

“Another difference is that there is a time abroad and main place of earning income requirement for the Form 2555 that does not exist for the Form 1116. Which is better depends on the specific circumstances of the individual.”

While both forms can be used on the same tax return, the same earnings cannot be used on both forms. There is an additional form, Schedule A, which can be used to claim itemised deductions, including a foreign income tax deduction.

However, the IRS’ Publication 54 recommends “as a general rule” that expats should claim either a credit or a deduction on their returns; those two cannot be combined.

Prioritising the IRS’ timescale

Another difference between the US and UK’s tax requirements is what each country believes constitutes a tax year.

“US tax documentation and reporting generally follows a calendar year, as such individuals may need to combine their P60s with pay stubs and other payment records as an American working in the UK to reflect a full tax year,” said Schneidewind. “This then should give them the same income for both countries’ tax years.”

Expats should file using their earnings from between January 1, 2019 and December 31, 2019, disregarding the UK’s tax year.

“In the US, an employee has a required tax year and must use the calendar tax year,” Kasia Strzelczyk, an enrolled agent at 1040abroad, said over email. “Self-employed taxpayers can choose any tax year, and this will be done the first year they file a US tax return.

“If they file their first tax return using the calendar tax year and later begin business as a sole proprietor, become a partner in a partnership, or become a shareholder in an S corporation, they must continue to use the calendar year unless they get IRS approval to change it, or meet one of the exceptions listed in the instructions to Form 1128, Application to Adopt, Change or Retain a Tax Year.”

Additionally, both US citizens and green card holders residing outside the US on April 15—tax day—receive an automatic two-month extension on their tax return to June 15.

However, any US taxes owed are still due April 15, and will accrue interest from this date.

FBAR, FACTA and pensions payments

Among others, US citizens, corporations and partnerships are all required to file a Report of Foreign Bank and Financial Accounts (FBAR) with the Treasury Department.

While it is technically due on April 15, the Department will automatically grant an extension to October 15 to those who miss the deadline.

The FBAR can be completed electronically through the BSA E-Filing System, but accountants and CPAs filing for a client must first be authorised to do so through FinCEN Report 114a. Individuals filing for themselves do not need to do this.

Similarly, under FACTA reporting, US taxpayers holding at least $50k in foreign financial assets need to disclose this on their federal tax return. The FBAR does not take the place of FACTA reporting; qualifying individuals need to file both.

Additionally, the IRS has extensive guidance for expats declaring pension and annuity distributions, noting special rules for green card holders, religious missionaries, and social security payments.

“However, as a general rule, under the US – UK tax treaty, individuals can deduct contributions to a qualified UK pension scheme on their US taxes,” Schneidewind said. “This is done the same way as would be a US plan. Plus, their UK account is treated similarly to a US 401(k) or IRA, letting their retirement investments grow tax free.

“Additionally, in most cases, the UK pension is subject to FBAR reporting and, depending on the amount in the account, it may be subject to FATCA reporting as well. Some UK pensions are also treated as a foreign grantor trust, which will require additional filing.”

If the expat has moved to the UK in the last few years, they may have had a 401(k) closed out automatically by their former employer, particularly if they previously worked in a state or federal role.

In this case, a Form 1099-R will need to be filed, showing how much federal and state income tax was withheld, if any; this form can also be used to note distributions from annuities, IRAs, and retirement plans, among others.

Additionally, clients should be advised that new regulations are in place for inherited IRAs. The Secure Act now requires beneficiaries to withdraw their funds and close the account after 10 years; however, it no longer requires any minimum distributions (RMDs) within that time.

Federal filing versus state returns

State tax returns can be a complex matter, as each state has its own set of rules surrounding the return—and whether or not a former resident of the state even needs to file.

A journal article in ‘The Practical Tax Lawyer’ explained that, “As a federal constitutional matter, the fact that a person is domiciled in a state is sufficient basis for the state to tax the person’s worldwide income regardless of where that income is earned.”

However, many states have wildly varying rules on what they consider a domiciliary. For instance, the journal states that New Jersey, New York and Oregon all treat domiciliaries who spend under 30 days in the state, without having a “permanent place of abode in the state,” as nonresidents.

Strzelczyk further explained that US expats do not have to have a residency in any state.

“The only issue with that is that one might not have a strong case to argue that they are no longer a resident of the state they were last a resident of,” said Strzelczyk. “Instead, we’re dealing with a patchwork of rules, as we have 50 states, and it is possible to not be a resident in any state.”

Strzelczyk also said that it is a non-issue in most cases, as some expats won’t owe any state taxes. However, it is advisable to check with the expat’s state-specific treasury or revenue department for guidance.

US citizens and green card holders are entitled to file their federal income tax returns for free via the IRS’ Free File software, which also allows qualifying expats to electronically file for state.

H&R Block’s Schneidewind recommends speaking with an expat tax advisor before committing to this route—particularly if they have unique life situations and complex accounts.