First rule in financial management is maximizing cash flows. For most expats, the biggest cash outlays are taxes (accounting anywhere from 25% to 50% of their income, or more, if they are being taxed in both countries). As such, proper tax planning to minimize cash outlay is critical in building one’s wealth.
Tax planning ideas generally fall into following three strategies:
- Deferring Income
- Accelerating Expenses, and
- Changing character of income and/or expenses
The first two strategies involve using accounting methods to push out the income to future years and/or pull in expenses from future years. However, a more interesting way to save taxes is the third strategy, which involves using definitions in tax law to re characterize income and/or expenses.
US tax laws have been developed through collaboration with various lobbying groups requesting specific carve-outs. Once such carve outs or tax incentives have been created, it must be offered to all taxpayers. However, the tax law would be written in fairly esoteric ways to only apply under specific fact patterns (to minimize tax revenue loss). It would be the CPAs and attorneys role to mold your fact patterns to fit into these laws.
For example, US government gives significant tax benefits to US citizens and US resident aliens working overseas, as they mostly likely are also being taxed in foreign countries. Although foreign tax credit provides some equity, additional incentives are provided to encourage US taxpayers to explore opportunities overseas.
Let’s take an example of Jim and Judy Adams with two years overseas assignment in Hong Kong. During their foreign assignment, Jim would receive $100,000 of annual salary, $25,000 cost of living and overseas differential, $25,000 for family allowance, $15,000 for education allowance, $5,000 for home leave allowance and $30,000 for housing allowance, totaling to $200,000 in compensation package. As Jim is the sole company representative in Hong Kong, Jim maintains both an executive office and a home office, which Judy helps out. They may be able to exclude their entire foreign earned income of $200,000 from US taxation, if they properly structure their compensation and income.
If this couple were working in US with the same amount of income, they would have to pay $55,000 in income taxes (not counting FICA and Medicare taxes). In addition to US taxation, they now have to consider Hong Kong taxes on their income. Assuming that no tax planning is done and the Adams may exclude the standard $80,000 of foreign earned income plus housing allowance, the Adams would be paying $21,000 in US taxes (not counting FICA and Medicare taxes). Instead of calling the entire $200,000 as salary and commission for Jim, since Judy is helping out in the office, Jim may be able to split the salary between himself and his wife as much as 50/50 or other reasonable basis. In addition, since they are incurring $30,000 in housing expenses, if they re characterize (third tax planning strategy) or reclassify their salary into housing allowance, they may be able to exclude a higher amount of foreign earned income.
This is possible since each working spouse would be able to deduct the standard exclusion amount of $80,000 plus housing allowance. If Jim was the only person receiving the salary, then they would be limited to $80,000 exclusion plus housing allowance. The Adams would still receive the same amount of money ($200,000), but now they have re characterized their income to maximize allowable exclusions.
Using the definitions provided in the law, you could benefit by exploring ways to fit your fact patterns into the ones paved by others. Such exercise will allow you to organize your finances and improve your cash flows.