Fiscal Cliff Tax Deal’s Implications For Americans Abroad

As it stands today, the 11th hour fiscal cliff deal approved earlier this week resulted in US$1 of spending cuts for every US$41 in tax increases, making it possibly the most one-sided victory since the Battle of Little Bighorn. By comparison, when President Ronald Regan increased taxes, he secured US$3 in spending cuts for every US$1 in tax hikes. When George H. Bush was at the helm, he negotiated US$2 in spending cuts for every US$1 in tax hikes.Most of the casualties in this battle royale are individuals with incomes of more than US$400,000 a year and couples making more than US$450,000 annually, but there will be significant pain and suffering for those with incomes as low as US$250,000 annually.

I also note that any hope of a tax system that treats married couples and single persons with some level of equality was blown away. Two single persons could earn US$800,000 combined before being smashed by the tax hikes, compared with only US$450,000 for a married couple. I’ll leave you all to interpret the strategies for addressing this on your own.

More specifically, here’s how this deal breaks down:

• Tax rates will increase from 35% to 39.6% for individuals with incomes of more than US$400,000 and couples earning more than US$450,000 per year.

• Tax rates on dividends and capital gains would also rise, from 15% to 20% on incomes of more than US$400,000 per year for single people and of more than US$450,000 for couples.

• Personal exemptions and deductions will be phased out, beginning with single people earning more than US$250,000 and couples earning more than US$300,000 per year.

• The estate tax will increase but less than Democrats wanted. The tax for estates valued at more than US$5 million is increasing from 35% to 40%. Democrats wanted a 45% rate for inheritances of more than US$3.5 million.

Under the deal, these new tax rates on income, investment, and inheritances are permanent.

Here, however, is the very good news for the American abroad: The Foreign Earned Income Exclusion (FEIE) survived and even got a little bump up for the cost of living. If you are living and working abroad, you can exempt up to US$97,600 from taxes in 2013, up from US$95,100 in 2012.

Also, the self-employed expat can avoid unemployment, Social Security, and FICA tax increases (also called self-employment taxes) by incorporating offshore and qualifying for the FEIE. By operating your business through an offshore corporation, you might be able to eliminate these taxes completely, which would amount to a savings of about 15%.

Note, though, that the 2013 tax increases and phase-outs will apply to any ordinary income over US$97,600 and all passive/investment income.

Because the tax brackets ignore the FEIE and expats are taxed on their worldwide capital gains (now at 20% rather than 15%), many higher-earning Americans abroad could be shocked by their 2013 tax bill.

The self-employed overseas, though, have a number of planning opportunities. For example, you could retain earnings over the FEIE amount in your offshore corporation or use a Solo 401-K to shelter income in a retirement plan.

The overseas investor could make tax-advantaged investments through your IRA, thereby avoiding the 20% short-term capital gains tax. In fact, the sophisticated offshore IRA investor can avail of a number of tax advantages – just ask Mitt Romney.

Lief Simon