How Does Citizenship Based Taxation Work?

The United States employs a citizenship-based taxation system, a practice that is uncommon globally. This approach requires U.S. citizens to report their worldwide income regardless of where they reside, unlike the residence-based systems used by most other nations. This policy has been a long-standing feature of the U.S. tax code. As a result, Americans living overseas must navigate the tax laws of their country of residence while simultaneously complying with U.S. tax requirements.

Who is Subject to US Taxation

For tax purposes, the term “U.S. person” is a broad classification that includes several groups required to report their worldwide income. These rules apply regardless of where an individual lives or earns income.

The primary category is U.S. citizens, which includes individuals born in the United States, those born abroad to a U.S. citizen parent, and naturalized citizens. This obligation is tied to citizenship status itself, not residency. Even individuals unaware of their status, sometimes called “accidental Americans,” are subject to these rules.

Lawful permanent residents, or Green Card holders, are also considered U.S. residents for tax purposes, even if they live outside the country. This status remains until the Green Card is officially surrendered or administratively terminated. Simply letting a Green Card expire does not end U.S. tax obligations.

Individuals who are not citizens or Green Card holders may be considered U.S. residents if they meet the Substantial Presence Test. This test is met if a person is physically present in the U.S. for at least 31 days in the current year and a total of 183 days over the last three years. The 183-day total is calculated by counting all days in the current year, one-third of the days in the first preceding year, and one-sixth of the days in the second preceding year.

Core Filing and Reporting Obligations

U.S. persons must file an annual federal income tax return, Form 1040, to report their worldwide income. The requirement to file is determined by income thresholds that vary based on filing status, age, and income type. This obligation applies to U.S. persons both at home and abroad.

U.S. persons with foreign financial activities have additional reporting requirements. The Report of Foreign Bank and Financial Accounts (FBAR), or FinCEN Form 114, must be filed electronically with the Financial Crimes Enforcement Network (FinCEN), not the IRS. An FBAR is required if a U.S. person has financial interest in or signature authority over foreign accounts whose aggregate value exceeds $10,000 at any time during the year.

The $10,000 FBAR threshold is the combined total of the highest balances of all foreign accounts, not a per-account limit. These accounts include bank accounts, brokerage accounts, mutual funds, and certain foreign insurance policies. The FBAR is filed separately from the income tax return to provide the government with information to combat financial crimes.

Another reporting requirement is the Statement of Specified Foreign Financial Assets, Form 8938, which is filed with the income tax return. Introduced under the Foreign Account Tax Compliance Act (FATCA), this form has different thresholds and covers more assets than the FBAR. The filing thresholds are higher than the FBAR’s and depend on filing status and country of residence.

A single individual in the U.S. must file Form 8938 if their foreign financial assets exceed $50,000 on the last day of the tax year or $75,000 at any time during the year. For single taxpayers abroad, these thresholds increase to $200,000 and $300,000, respectively. Specified assets include foreign stocks, securities not in a U.S. account, and interests in foreign entities.

Common Tax Relief Provisions

To mitigate double taxation, where income is taxed by both the U.S. and a foreign country, the tax code provides relief mechanisms. The two primary provisions are the Foreign Earned Income Exclusion (FEIE) and the Foreign Tax Credit (FTC). These allow U.S. persons to reduce their U.S. tax liability on foreign income.

The FEIE allows qualifying individuals to exclude a portion of their foreign-earned income from U.S. taxation. To be eligible, a taxpayer must have a tax home in a foreign country and meet either the bona fide residence test or the physical presence test. The bona fide residence test requires residency in a foreign country for an entire tax year, while the physical presence test requires being in a foreign country for 330 days during any 12-month period.

For the 2025 tax year, the maximum exclusion is projected to be around $131,500 and is adjusted annually for inflation. This exclusion applies only to earned income, like wages, not passive income such as interest or dividends. The exclusion is claimed by filing Form 2555 with the tax return.

The Foreign Tax Credit (FTC), claimed on Form 1116, offers a different approach. The FTC provides a dollar-for-dollar credit against U.S. tax liability for income taxes paid to a foreign country on foreign-source income. To be creditable, the foreign levy must be a legal and actual income tax liability.

Choosing between the FEIE and FTC depends on factors like the foreign tax rate. If the foreign rate is higher than the U.S. rate, the FTC is often more advantageous, as excess credits can be carried to other tax years. If the foreign tax rate is low, the FEIE may be the better option. A taxpayer cannot claim both the exclusion and the credit on the same income.

Tax Implications of Renouncing Citizenship

The complexities of U.S. tax compliance lead some individuals to consider renouncing their citizenship. This act of expatriation has its own tax consequences, particularly for those classified as “covered expatriates.” This status is determined by a series of tests at the time of expatriation.

An individual is a covered expatriate if they meet any one of three criteria. The first is a net worth of $2 million or more on the date of expatriation. The second is having an average annual net income tax liability over a certain threshold for the five preceding years, which is indexed for inflation. The final criterion is failing to certify on Form 8854 that they have complied with all U.S. tax obligations for the prior five years, which automatically makes them a covered expatriate.

Classification as a covered expatriate can trigger an “exit tax.” This tax is calculated under a mark-to-market regime, treating the individual as if they sold all worldwide assets at fair market value the day before expatriation. Any unrealized gains from this deemed sale are subject to capital gains tax, though a significant exclusion amount can be applied to reduce the taxable gain. This exit tax serves as a final settlement of U.S. tax obligations on asset appreciation.