It is becoming increasingly difficult for US citizens residing abroad to obtain competent information relating to the preparation of the US Federal individual income tax returns.Despite the multiple media sources available to individuals, and the Internal Revenue Service web-site, specific questions are usually met with generalised answers. And the IRS Publications on specific subjects are difficult for the non accountant to comprehend.

Myths and misunderstanding

One of the all-time misunderstandings deals with who is required to file a US tax return and its interplay with the foreign-earned income and housing exclusions. The first part of the question is easy to answer. If you are a US citizen or resident alien, single, under 65 years of age, and have gross income of less than $8,450, you are not required to file a US tax return.

If you are a US citizen or resident alien, married filing jointly, with both spouses under 65 years of age, and have gross income of less than $16,900, you are not required to file a US tax return.

The ongoing myth is that if you have earned income of less than $82,400 in 2006, this earned income is automatically exempt from US income tax and you do not have to file a US tax return.

What is misunderstood is that the foreign-earned income exclusion is an election that one can make to exclude up to $82,400 of income in 2006. The "election" is made by filing your 2006 tax return including a completed Form 2555 with the return to "elect" the foreign earned income exclusion.

The 2006 US Federal income tax return had a normal due date of April 15, 2007. The "election" can be made by filing a 2006 tax return including a completed Form 2555 no later than April 15, 2008. If you fail to file your 2006 US tax return before this 2008 date, the Internal Revenue Code precludes you from electing the exclusion at a future date.

Why wouldn't a person want to elect the foreign-earned income exclusion?

Generally, if you live in a country that has a higher tax rate than the United States the foreign tax credit that you can claim can be of more value to you than the foreign-earned income exclusion. For example, suppose you are married and filing jointly, have $200,000 of taxable income, and pay $50,000 in taxes to a foreign country.

We will also suppose that you decided to elect both the foreign earned income and housing exclusion and that the total exclusions are $100,000. Under the current tax law if you elect the exclusion you lose the portion of the foreign tax credit allocable to the excluded income. So in this example $100,000/$200,000 x $50,000=$25,000 of foreign tax credits will be disallowed leaving you with a $25,000 usable foreign tax credit.

The US Federal income tax on $200,000 is about $45,000. But the June 2006 tax law change moved the tax benefit of the exclusions from the highest tax brackets to the lowest.

So the tax benefit of the $100,000 exclusions is only about $18,000. So if you elect the exclusions, your US income tax is $45,000 less $18,000 or $27,000. As all your income was earned outside the United States you can offset the tax by using the $25,000 of foreign tax credits that are available. This will leave you with a tax due of $2,000.

However, if you did not elect to take the foreign-earned income and housing exclusions, your US income tax would be $45,000 that can be offset with the entire $50,000 of foreign tax credits leaving you with a net tax of zero.

Hence, most US citizens who live in countries with a tax rate higher than the United States, usually do not elect the foreign-earned income and housing exclusions, or revoke the right to continue the exclusions if they were previously elected.

For most, if not all, US citizens living in Bermuda, it is beneficial to elect the foreign earned income and housing exclusions. But they must be elected by filing a tax return.

If you have failed to file a us tax return, can you make a retroactive election?

Possibly. As noted earlier, the tax law requires that the election be made within one year of the original filing date. But, the regulations contain a peculiar clause that allows for a retroactive election, but only if you have not been contacted by the Internal Revenue Service inquiring as to why you have failed to file that particular years tax return.

For example, suppose you are single and earned $75,000 from 2000 to 2006 and did not file a tax return because you believed in the myth that you did not have to do so if your earned income was under $80,000. If you have not received a letter from the Internal Revenue Service inquiring why you have failed to file your 2000 to 2006 tax returns, you can still make the election under the Regulations by filing all of your prior year tax returns.

However, if you have been contacted by the Internal Revenue Service you are precluded from making a retroactive election. The tax due on $75,000 will be about $15,175 and you will likely be assessed a 25 percent penalty for failure to file and pay the tax due, along with other penalties and interest for underpayment of tax, late payment of tax, etc. It is likely that you will owe the Internal Revenue Service about $25,000 for each year that you have not filed.

And as it is likely that you do not have $175,000 to pay the Internal Revenue Service, under current regulations the IRS will not even speak to you about settling your case for a lower amount without an initial cheque from you for $35,000.

So if you have not filed for prior years, you should seriously consider doing so, as the alternative could be personal bankruptcy, and even that will not make the IRS debt go away.

The tax advice given by this column is, by necessity, general in nature. You should, of course, check with your own US tax consultant as to how specific transactions affect you since tax advice varies with individual circumstances.

James Paul Sabo, CPA, is the President of ETS Ltd., PO Box HM 1574, Hamilton HM GX, Bermuda. Questions should be sent to sabo@expatriatetaxservices.com.