The Increased Costs of Working Abroad

Under provisions of the Tax Increase Prevention and Re- conciliation Act of 2005 (TIPRA), signed into law on May 17, 2006, U.S. citizens and permanent residents working abroad may see significant tax increases beginning with the 2006 tax year. The TIPRA changes to the Sec. 911 foreign earned income and housing exclusions have the greatest effect on individuals living in low- or no-tax countries; those with a working spouse, investments or other income will be affected as well.

TIPRA Amendments

Three primary changes have been made under the TIPRA. The Sec. 911 foreign earned income exclusion is indexed for inflation beginning in 2006, rather than after 2007. The computation of the housing exclusion has changed. The combined exclusions now reduce the amount of income taxed at the lower applicable tax rate (rather than at the higher rates, as under prior law).

Indexing of the income exclusion, which was to start in 2008, was accelerated by two years. For 2006, the maximum income exclusion increased from $80,000 to $82,400. Annual adjustments will continue each year.

Housing: The base housing amount is now computed differently and a new limit has been added. The base amount is now 16% of the maximum income exclusion, or $13,184 for 2006 ($82,400 × 16%). Excludible housing costs now cannot exceed 30% of the maximum income exclusion. The IRS may raise or lower the 30% threshold based on a location’s cost of housing, as compared to the U.S. Adjustments to this threshold may significantly change an expatriate’s tax liability. No guidance has been issued yet.

Computations

The exclusions previously reduced the amount of income taxed at the top tax rates, but now reduce income taxed at the lowest rates. Post-TIPRA Sec. 911 first computes tax on all income, as if the exclusions had not been claimed. The benefit of the exclusions at the lowest tax rates is then subtracted, causing nonexcluded income to be taxed at a higher rate.

The figures below illustrate the change in the tax computation for an individual claiming the exclusions. They assume a married person is living abroad for all of 2006 with $85,000 qualifying foreign income, no housing exclusion and $30,000 other income (reduced by deductions and exemptions).

Recommendations

Individuals may need to make larger estimated tax payments or increase withholding to account for the tax increase. Employers will need to change the withholding computation for an employee who has submitted Form 673, Statement for Claiming Benefits Provided by Section 911 of the Internal Revenue Code. Employers with a tax reimbursement program may also need to adjust financial accruals for the increased tax reimbursement costs.

Practitioners and self-preparers alike may now find that separate returns provide a lower total family tax cost for individuals working abroad; this was rare under the prior law.

From John E. Allis, CPA, CPP, GPHR, John Pao, CPA, and Rafael Carsalade, PKF Texas, Houston, TX