U.S. citizens and permanent residents are required to file and pay American taxes no matter where they live. This means, Americans living in Germany still need to file their taxes with the IRS. (The only way out of this is to renounce U.S. citizenship, a decision which should not be taken lightly, but is something we can advise on for those who are interested.) Luckily, there are so-called double taxation treaties between many countries, including between the U.S. and Germany, which set out what taxes are paid to which country in cases where a person would have to pay taxes in more than one jurisdiction. This helps the countries attract foreign business and workers by not doubling their tax burden, and it also helps individuals and businesses by making sure they don’t have to pay the same tax twice in two jurisdictions. U.S., citizens and permanent residents who file their income taxes have two options under the U.S.-German double taxation treaty to limit their tax liability: either the Foreign Earned Income Exclusion or the Foreign Tax Credit.
Foreign Earned Income Exclusion – IRS Form 2555
The Foreign Earned Income Exclusion allows a U.S. citizen or permanent resident to exclude a portion of the income they earned outside the U.S. – reducing their taxable income in the U.S. The amount that can be excluded changes slightly every year, and is $107,600 for the 2020 tax year. That essentially means that no U.S. income taxes would need to be paid on the first $107,600 of income for a U.S. citizen or permanent resident earning income outside the U.S.
Note: You still have to file even if your income is below the threshold! An IRS Form 2555 will have to be filed to declare the foreign earned income in addition to the regular tax forms.
Note: Amounts earned in foreign currencies must be calculated into USD for the purposes of filings and determining income and credit amounts.
Example: John Smith is a U.S. citizen living and working in Berlin with an annual income of €60,000. Because he is a U.S. citizen, he files and pays his German taxes and files his U.S. taxes with the IRS using From 1040 and Form 2555. The foreign income of €60,000 is then excluded from his U.S. taxable income, and because it is under the $107,600 threshold, he owes no U.S. taxes on that income.
In order to qualify for the Foreign Earned Income Exclusion, you need to meet one of two tests:
Bona Fide Residence Test
The the bona fide residence test if you are a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year.
Physical Presence Test
You meet the physical presence test if you are physically present in a foreign country or countries 330 full days during any period of 12 consecutive months including some part of the year at issue. The 330 qualifying days do not have to be consecutive.
Foreign Tax Credit – IRS Form 1116
The other option available to U.S. citizens and permanent residents is the Foreign Tax Credit. The Foreign Tax Credit is – as its name implies – a tax credit – meaning it is subtracted from the tax amount payable (as opposed to reducing the taxable income). With the Foreign Tax Credit, the amount of taxes paid outside the U.S. is subtracted from the tax amount owed in the U.S.: The Foreign Tax Credit may alternatively be used as a tax deduction – meaning the amount is subtracted from your taxable income. This is similar to the Foreign Earned Income Exclusion, but the difference is that the taxable income is reduced by the amount of taxes paid abroad, as opposed to the amount of income earned abroad.
Note: You can only use either the Foreign Earned Income Exclusion or the Foreign Tax Credit for a particular set of income. That means you cannot exclude the foreign income and then also get a tax credit for the same income – you have to choose which method you want to apply. (If income is above the $107,600 limit, you may apply the Foreign Earned Income Exclusion to the first $107,600, and then use the Foreign Tax Credit on the income above that amount.)
Example: Tom Miller is a U.S. citizen living and working in Frankfurt with an annual income of €150,000 (calculated to $183,800). Because he is a U.S. citizen, he files and pays his German taxes and files his U.S. taxes with the IRS using Form 1040 and Form 1116. Because his income is above the $107,600 threshold for the Foreign Earned Income Tax Exclusion, he decides to opt for the Foreign Tax Credit. In Germany, he paid €40,000 (calculated to $49,000) in German income tax, which can now use as a tax credit in the U.S. The IRS applies income tax to his entire $183,800 income which comes to $30,000. The $49,000 is then subtracted from the $30,000 owed income tax as a tax credit (30,000 – 49,000 = -19,000), leaving Tom with a tax liability of $0.
Alternatively, Tom could have applied the Foreign Earned Income Tax Exclusion to his first $107,600, and then calculated the tax he paid on the rest of his income above that, and then subtracted that amount from his remaining tax liability in the U.S. So if the German tax paid on the $76,200 amount above the Earned Income Tax Exclusion ($183,800 – $107,600 = $76,200) was $30,000, that $30,000 could then be applied as tax credit and subtracted from his remaining U.S. tax amount.
We are happy to set up a consultation meeting to discuss the international tax system, how it applies to you or your business, and what strategies you can use to minimize your tax liability. We work with top-notch accountants in Germany and the U.S. who are experienced with complex international filings, or we are happy to work with your current accountant to implement an international tax strategy that works for you. Contact us via email or phone to schedule an appointment. We look forward to helping you!