Why Does the US Tax Citizens Living Abroad?

The United States maintains a unique approach to taxation. Unlike most nations that tax based on residency, the U.S. government levies taxes on its citizens regardless of where they live. This policy requires a U.S. citizen living abroad to file a federal tax return and report their worldwide income. The reasons for this citizenship-based system are rooted in historical events and legal principles. Navigating this requires understanding U.S. tax provisions designed to prevent double taxation and strict financial reporting rules.

The Principle of Citizenship-Based Taxation

The United States operates under a system of citizenship-based taxation (CBT), taxing citizens on their income no matter where it is earned. This approach is rare, as nearly every other country uses residence-based taxation (RBT). Under an RBT system, tax obligations to a home country typically cease when an individual moves abroad permanently. Eritrea is the only other country that enforces a similar form of taxation based on citizenship.

The historical roots of America’s CBT system trace to the Revenue Act of 1861, which was enacted to finance the Union’s efforts in the Civil War. This legislation established the principle of taxing citizens living abroad to ensure they contributed to the nation. The concept was that the benefits of citizenship are not confined by geography, so the obligation to support the government extends to all citizens.

This principle was legally cemented in the 1924 Supreme Court case Cook v. Tait. A U.S. citizen in Mexico argued that Congress could not tax his income derived entirely from Mexico. The Court ruled that the government benefits and protects its citizens worldwide and, in return, can require them to help bear the costs of government. This decision established that U.S. citizenship itself is a sufficient connection to justify taxation, regardless of an individual’s physical location.

Defining a U.S. Person for Tax Purposes

For tax purposes, the term “U.S. person” is broadly defined. The primary group subject to worldwide taxation is U.S. citizens, including those born in the United States, naturalized citizens, and those born abroad to a U.S. citizen parent. These are sometimes called “accidental Americans” if they have minimal ties to the country.

Another category consists of lawful permanent residents, known as Green Card holders. An individual holding a Green Card is considered a U.S. resident for tax purposes and is subject to the same worldwide income reporting requirements as a citizen. This obligation continues until the Green Card is officially surrendered or revoked.

The definition also extends to individuals who meet the substantial presence test. This formula counts days spent in the United States over a three-year period. A person physically present in the U.S. for at least 31 days in the current year and a combined 183 days over the current and two preceding years can be classified as a U.S. resident for tax purposes.

Mechanisms to Prevent Double Taxation

To address the issue of the same income being taxed by both the United States and a foreign country, the U.S. tax code provides two primary tools. These provisions are designed to reduce or eliminate the U.S. tax liability on foreign income. The choice between them depends on factors like the tax rate in the country of residence and the nature of the income.

Foreign Earned Income Exclusion

The Foreign Earned Income Exclusion (FEIE) allows a U.S. person to exclude a certain amount of foreign-earned income from U.S. taxation. This amount is indexed for inflation annually; for the 2024 tax year, the maximum exclusion is $126,500. 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 taxpayer to be a resident of a foreign country for an uninterrupted period that includes an entire tax year. The physical presence test requires the taxpayer to be physically present in a foreign country for at least 330 full days during any 12-month period. The FEIE is claimed using Form 2555, Foreign Earned Income.

Foreign Tax Credit

The Foreign Tax Credit (FTC) offers a different approach. Instead of excluding income, the FTC provides a dollar-for-dollar reduction of a taxpayer’s U.S. income tax liability for income taxes already paid to a foreign government. This credit is generally more beneficial for individuals living in countries with income tax rates higher than or similar to those in the U.S.

The FTC can only be used to offset U.S. tax on foreign-source income and is limited to the amount of U.S. tax that would have been due on that income. Unlike the FEIE, the credit can be applied to any type of foreign income, not just earned income. The FTC is calculated on Form 1116, and taxpayers in high-tax countries may find it eliminates their U.S. tax liability and results in excess credits for future years.

Reporting and Enforcement Framework

The U.S. enforces its worldwide tax system through a framework of information reporting that operates independently of an individual’s tax liability. This system is designed to promote transparency and give the IRS visibility into the foreign financial activities of U.S. persons. Failure to comply with these reporting obligations can lead to substantial penalties, even if no tax is owed.

Report of Foreign Bank and Financial Accounts

A component of this framework is the Report of Foreign Bank and Financial Accounts (FBAR). This report is filed with the Financial Crimes Enforcement Network (FinCEN), not the IRS. A U.S. person with a financial interest in or signature authority over foreign financial accounts must file an FBAR if the aggregate value of those accounts exceeds $10,000 at any time during the year.

Foreign Account Tax Compliance Act

The Foreign Account Tax Compliance Act (FATCA) of 2010 expanded enforcement. FATCA requires foreign financial institutions (FFIs) to report information about accounts held by their U.S. clients directly to the IRS. FFIs that do not comply face a 30% withholding tax on certain U.S.-source payments, compelling global banks to act as reporters for the IRS.

FATCA also requires certain U.S. taxpayers holding foreign financial assets above specific thresholds to report those assets on Form 8938, Statement of Specified Foreign Financial Assets. This form is filed with their U.S. tax return.