The Tax Increase Prevention and Reconciliation Act of 2005 is a misnomer for U.S. citizens residing in Bermuda. This tax legislation that was recently passed by Congress will significantly increase U.S. Federal individual income tax for U.S. citizens residing in Bermuda. The legislation pertaining to expatriates is retroactive to January 1, 2006.
Old Law
Once an individual met certain qualifications, an election could then be made to exclude $80,000 of foreign earned income from U.S. income tax. The income that was excluded came from the highest tax bracket and could yield a tax benefit as high as $28,000.
In addition, to the extent foreign housing costs exceeded 16% of grade GS-14, step 1, of a General Services Administration employee ($12,448 in 2006) all reasonable foreign housing costs in excess of this amount could be excluded. For example, if an executive was paying $10,000 a month for housing in Bermuda, the 2006 housing exclusion would have been $107,552. The foreign housing cost that was excluded also came from the highest tax bracket and could yield a tax benefit as high as $37,643.
Hence, the combined tax benefit of both exclusions was $65,643 under the old tax law.
New Law
The $80,000 foreign earned income exclusion is immediately indexed for inflation and the maximum 2006 foreign earned income exclusion will be $82,400.
The new tax law almost eliminates the foreign housing exclusion. The base amount of foreign housing costs has been changed from 16% of grade GS-14, step 1, of a General Services Administration employee ($12,448 in 2006) to 16% of the current year maximum foreign earned income exclusion (16% x $82,400 = $13,184 for 2006). However, the new law limits the amount of the foreign housing exclusion to 30% of the current year maximum foreign earned income exclusion (30% x $82,400 = $24,720 for 2006). Hence, the maximum foreign housing exclusion that can be claimed in 2006 is $11,536 ($24,720 less $13,184). A short cut method of determining the maximum foreign housing exclusion is to multiply the maximum foreign earned income exclusion, $82,400, by 14% = $11,536.
Thus, the maximum foreign earned income and housing exclusions that an individual may claim in 2006 is now $93,936.
Unfortunately, Congress did not stop there. The last portion of the new tax law moves the tax benefit of the foreign earned income and housing exclusions from the highest tax brackets, to the lowest tax brackets.
Examples
The question that you should be asking is how does this affect me?
The following example is that of a couple filing a joint tax return, only one spouse works, there are no dependents, and no itemized deductions nor investment income. Compensation is $120,000, and the individual spends $20,000 on local housing costs. The income tax has been rounded for presentation purposes.
Old Law New Law Increase
Income tax $1,600 $3,500 $1,900
The following example is that of a couple filing a joint tax return, only one spouse works, there are no dependents, and no itemized deductions nor investment income. Compensation is $170,000, and the individual spends $20,000 on local housing costs. The income tax has been rounded for presentation purposes.
Old Law New Law Increase
Income tax $9,500 $16,900 $7,400
The following example is that of a couple filing a joint tax return, only one spouse works, there are no dependents, and no itemized deductions nor investment income. Compensation is $420,000, and the individual spends $120,000 on local housing costs. The income tax has been rounded for presentation purposes.
Old Law New Law Increase
Income tax $51,100 $97,700 $46,600
The following example is that of a couple filing a joint tax return, only one spouse works, there are no dependents, and no itemized deductions nor investment income. Compensation is $620,000, and the individual spends $120,000 on local housing costs. The income tax has been rounded for presentation purposes.
Old Law New Law Increase
Income tax $118,700 $167,700 $49,000
The following example is that of a couple filing a joint tax return, both spouses work; there are no dependents, and no itemized deductions nor investment income. Each spouse has compensation of $100,000, and they spend $20,000 on local housing costs. The income tax has been rounded for presentation purposes.
Old Law New Law Increase
Income tax $1,600 $4,400 $2,800
Should I Continue To Work In Bermuda?
The U.S. Federal income tax benefit of doing so has been drastically decreased. There are several factors to take into account before you make a decision. If you are working for an employer who has a tax equalization program, the change in the tax law will have the effect of increasing your employer’s costs, not yours.
If you do not have a tax equalization program, will your current employer adjust your compensation to account for your decreased tax home pay? About two years ago, the potential elimination of the foreign housing exclusion was floated in Congress for about 6 months, and at that time local employers were not inclined to compensate employees for the increased tax costs. At a minimum, this topic should now be broached with your local employer.
How Can I Measure the Impact On Me?
With difficulty. As noted above, there is a two step impact. One is to move the tax benefit of the exclusions from the highest brackets to the lowest brackets, and the second is to eliminate most of the foreign housing exclusion.
If your local housing costs exceed $24,720, the change in the tax law will have an increasingly greater impact on you as the amount you pay for local housing costs exceeds $24,720.
As each individual has different facts it is difficult to generalize, but the maximum tax benefit that you can realize going forward on a combined maximum foreign earned income and housing exclusion of $93,936 where only one person is employed is:
MFJ Single HH
Tax benefit $16,600 $20,650 18,850
Does the Change In the Tax Law Affect All Expatriates Equally?
No. It increases income taxes for expatriates working in countries such as Bermuda where there is no income tax or a low income tax. This would encompass Bermuda, countries in the Persian Gulf, and Hong Kong.
If a foreign country has a local income tax of 25% or more, the foreign tax that a U.S. citizen is now paying would generally eliminate the additional U.S. income tax under the new tax law.
Is There Any Relief Available?
A glimmer at best. The new law allows the Treasury to increase or decrease the 30% limit where differences in local housing costs exist. Given the Treasury’s insatiable need for additional tax revenues, it is doubtful that any meaningful change will be made.
What Should I Do Now?
You need to recompute your 2006 estimated tax liability and immediately increase your June 15 estimated tax payment or adjust your Federal tax withholding. You also need to consider the tax benefit of continuing your employment in Bermuda.
The tax advice given by this column is, by necessity, general in nature. You should, of course, check with your own U.S. tax consultant as to how
specific transactions affect you since tax advice varies with individual circumstances. |