How Does U.S. Citizenship-Based Taxation Work?

The United States employs a system of citizenship-based taxation, meaning the U.S. government taxes its citizens on their income regardless of where they reside in the world. This practice stands in stark contrast to the residence-based system used by most other nations. Under a residence-based system, a country taxes individuals based on their residency status, meaning non-residents are only taxed on income sourced from within that country.

The U.S. is one of only two countries, the other being Eritrea, that enforces taxation based on citizenship. This means a U.S. citizen living abroad must report their worldwide income to the Internal Revenue Service (IRS), an obligation that exists irrespective of how long the citizen has lived outside the U.S. This system creates a layer of financial complexity for Americans overseas, as they must navigate the tax laws of both their country of residence and the United States.

Determining Your U.S. Tax Status

For U.S. tax purposes, a “U.S. person” includes several categories of individuals. U.S. citizens retain their tax obligations regardless of their physical location, including “accidental Americans” who acquired citizenship at birth but have never lived in the United States.

Another category includes U.S. lawful permanent residents, known as Green Card holders, who are subject to the same worldwide income reporting obligations as citizens. Tax residency for a Green Card holder continues until the card is formally relinquished or judicially revoked; simply letting the card expire does not terminate this status.

The final category consists of individuals who meet the Substantial Presence Test, a mathematical formula used by the IRS to determine tax residency. A person meets this test if they are physically present in the United States for at least 31 days during the current year and a total of 183 days during a three-year period. The 183-day total is calculated by counting all days of presence 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.

The Worldwide Income Reporting Standard

A fundamental principle of the U.S. tax system is the requirement for its citizens and residents to report all income from all sources, both within and outside the United States. The IRS mandates that this income be reported in U.S. dollars, requiring taxpayers to translate any foreign currency amounts using a consistent exchange rate method. This comprehensive reporting ensures that all potential tax liabilities are assessed.

The scope of reportable income is extensive and includes:

• Wages, salaries, and tips from foreign employers
• Income from self-employment or freelance work
• Interest from foreign bank accounts and dividends from foreign corporations
• Rental income from properties located in other countries
• Gains from the sale of assets, like stocks or real estate

A requirement to file a U.S. tax return can exist even if no tax is ultimately due. If a U.S. person’s worldwide income exceeds the filing threshold for their filing status, they must file a return. This holds true even if tax credits or exclusions, which are applied later, reduce the final tax liability to zero. Failure to report global income can lead to significant penalties.

Mechanisms to Mitigate Double Taxation

To prevent U.S. persons from being taxed twice on the same income—once by their country of residence and again by the United States—the tax code provides two primary mechanisms: the Foreign Tax Credit (FTC) and the Foreign Earned Income Exclusion (FEIE).

The Foreign Tax Credit, claimed on Form 1116, allows taxpayers to reduce their U.S. income tax on a dollar-for-dollar basis for income taxes paid to a foreign country. This credit is available for foreign taxes on wages, interest, dividends, and royalties. The amount of the credit is limited; it cannot exceed the U.S. tax liability on that same foreign source income. The FTC is often a beneficial option for those living in countries with income tax rates similar to or higher than those in the U.S.

The Foreign Earned Income Exclusion, claimed on Form 2555, allows eligible taxpayers to exclude a certain amount of their foreign earned income from U.S. taxable income. For the 2025 tax year, the maximum exclusion is $130,000. This exclusion only applies to earned income, such as salary and self-employment income. To qualify, 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 a U.S. citizen to be a resident of a foreign country for an uninterrupted period that includes an entire tax year. The Physical Presence Test requires a U.S. citizen or resident to be physically present in a foreign country for at least 330 full days during any period of 12 consecutive months.

Choosing between the FTC and the FEIE is an important consideration. The FEIE can be simpler and may eliminate U.S. tax liability if foreign earned income is below the exclusion threshold. However, claiming the FEIE may limit the ability to contribute to an IRA or claim the child tax credit. The FTC, while more complex, can be more advantageous for those in high-tax countries and can be carried back one year or forward ten years. A taxpayer cannot claim both the FEIE and the FTC on the same dollar of excluded income.

Key Informational Reporting Requirements

Beyond the standard income tax return, U.S. persons with financial interests abroad are subject to key informational reporting requirements. The two most prominent are the Report of Foreign Bank and Financial Accounts (FBAR) and the Statement of Specified Foreign Financial Assets, which is part of the Foreign Account Tax Compliance Act (FATCA) regime.

The FBAR must be filed with the Financial Crimes Enforcement Network (FinCEN), a bureau of the Treasury Department, not the IRS. This report is required if a U.S. person has a financial interest in or signature authority over foreign financial accounts, and the aggregate value of those accounts exceeds $10,000 at any point during the calendar year. The FBAR is filed electronically and is due by the same date as the federal income tax return, with an automatic extension available.

FATCA reporting is done through IRS Form 8938, Statement of Specified Foreign Financial Assets, which is filed with the U.S. income tax return. The filing thresholds for Form 8938 are higher and more complex than for the FBAR. For a single taxpayer living abroad, a Form 8938 is required if the total value of specified foreign financial assets is more than $200,000 on the last day of the tax year or more than $300,000 at any time during the year.

While there is overlap in the accounts reported on the FBAR and Form 8938, the requirements are not identical. Form 8938 requires reporting a broader range of assets, including certain foreign stocks not held in a financial account and foreign partnership interests. Filing one form does not relieve the obligation to file the other; if a taxpayer meets the criteria for both, they must file both reports. The penalties for failing to file these informational reports can be substantial.

Ending U.S. Tax Obligations

The only way for a U.S. person to permanently end their U.S. tax obligations is through the formal process of expatriation. This involves a U.S. citizen officially renouncing their citizenship or a long-term resident relinquishing their Green Card. This action has significant tax consequences governed by specific rules.

Upon expatriation, an individual may be subject to an exit tax if they are classified as a “covered expatriate.” A person falls into this category if they have a net worth of $2 million or more on the date of expatriation, have an average annual net income tax liability for the five preceding years that exceeds $206,000 for 2025, or fail to certify on Form 8854 that they have complied with all U.S. federal tax obligations for the five preceding years.

For those deemed covered expatriates, the exit tax is calculated as if they sold all of their worldwide assets at their fair market value on the day before they expatriated. This “mark-to-market” tax applies to the net unrealized gain in their property. There is a specific exclusion amount ($890,000 for 2025) that can be applied to this gain, with any excess taxed at prevailing capital gains rates.

The process of expatriation is irrevocable from a tax perspective and requires careful planning. It involves the legal steps of renouncing citizenship, filing a final U.S. tax return, and the expatriation statement, Form 8854. The decision to expatriate is a serious one with lasting financial and personal implications.